by: Wayne Duggan, Benzinga Staff Writer
The financial crisis in 2008 and 2009 resulted in some of the scariest and most volatile days in the history of the U.S. stock market. Yet even with all the chaos of the banking crisis, there wasn’t a single day in 2008 or 2009 as bad as October 19, 1987.
This week marks the 30-year anniversary of the worst day in U.S. stock market history, a day the stock market plummeted 23 percent from open to close. “Black Monday,” as it became known, marked the first time Wall Street became acutely aware of the true danger of computerized trading. Here’s a look at what went down, why it happened, and what we learned.
What Triggered The Sell-Off?
The 1987 crash didn’t necessarily come out of the blue. Prior to Black Monday, the Dow Jones Industrial average had logged two historically large declines: a 3.8 percent drop on Oct.14 and a 4.6 percent drop on record volume on Friday, Oct. 16. On the morning of Oct. 18 (late evening Oct. 17 stateside), U.S. warships attacked an Iranian oil platform in the Persian Gulf in retaliation for a previous Iranian attack in the region.
On the next trading day, Oct. 19, what started off as a steep sell-off quickly cascaded into an all-out collapse, and the Dow finished the day down 22.6 percent.
Why Was It So Bad?
A number of factors contributed to the set-up for the sell-off, but computerized trading is typically blamed for the extreme nature of the collapse. Traders and money managers leery of the extended valuations in stocks following the 1980’s bull market placed computerized stop-loss orders to theoretically limit downside in the event of a market pull-back.
However, these traders failed to account for the liquidity that these computerized trades would sap out of the market when executed all at once. Lack of liquidity sent share prices tumbling further, triggering even more computerized selling.
What Did We Learn?
Traders learned to respect the impact that lack of liquidity can have on the market, and regulators implemented a series of new “trading curbs” that were intended to prevent the type of liquidity-fueled death spiral that happened on Black Monday. Today, large sell-offs in single stocks or the market as a whole will trigger “circuit breakers,” or temporary trading halts. These circuit breakers were first implemented in 1989.
Today, the S&P 500 Index triggers its first 15-minute circuit breaker if it falls 7 percent in a single day. Additional 15-minute circuit breakers are triggered following 13 percent and 20 percent declines.
While these circuit breakers may not necessarily prevent another -23 percent day, they give exchanges time to recover from sudden sell-offs and they serve to help prevent panic selling and confusion.
The only time a U.S. stock market circuit breaker has been triggered occurred on October 27, 1997. Trading was halted at 2:36 p.m. when the Dow hit its 350-point circuit breaker and then the market was prematurely closed for the day at 3:35 p.m. when it hit its 550-point circuit breaker. The following day when stocks resumed trading, the Dow finished the day up 337 points.
Could Black Monday Happen Again?
With the S&P 500 PE ratio currently at 25.4 and its cyclically-adjusted PE ratio at 31.1, stocks are far more expensive on an earnings basis than they were back in 1987. It’s likely that another crash is on the way at some point. Whether that crash happens a month, a year or 10 years down the line is difficult to determine.
For investors and traders looking to avoid the fallout associated with Black Monday, the best offense is a good defense. Be prepared for a market crash and have a concrete plan in place for which stocks you would buy or sell at which prices, and always make sure you are financially prepared for a potentially extended period of major market losses.
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