No, Stock Markets Today Don’t Look Like Black Monday
We’re almost 30 years out from the largest single-day drop in the Dow Jones Industrial Average. In October 1987, the “Black Monday” crash erased 22.61% of the market’s value in a matter of hours. And it left investors paranoid about the prospect of another contagious flash crash.
As you’ve probably heard by now, HSBC recently issued a “red alert.” Its technical analysis team has identified a “head and shoulders” pattern in the stock market today, which supposedly indicates an imminent fall in stock prices.
Fearmongers and perma-bears have been making lots of allusions to the 1987 crash in discussing this indicator. And the financial media has been eating this stuff up.
Let’s put aside the fact that these market-timing technical analysis techniques have been widely discredited since the ‘80s. Instead, let’s ask the question: Do stock markets today resemble the lead-up to Black Monday?
The answer is a simple no.
The behaviors that caused the Black Monday crash are not nearly as common in today’s stock markets as they were in 1987. And we also have numerous safeguards in place now to prevent such a crash from happening again.
Index Arbitrage With Program Trading: It’s an ‘80s Thing
The principal cause of the 1987 crash was a technique known as program trading. It’s similar to the modern practice of algorithmic trading, but much… clunkier.
The ‘80s-style program trading involved buying and selling stock indexes and stock futures. The idea was to exploit differences between the price of a stock index future and the index itself. In other words, if the S&P 500 was trading at a lower price than S&P 500 futures, it would sell some futures. Then it would buy back the same number of index shares for cheaper, creating an instant profit.
This type of program trading, known as “index arbitrage,” is a bit like shorting. It involves selling high and then buying back low. And as you may know, a stock goes down when it’s shorted heavily. On that fateful Monday in 1987, so many traders were doing index arbitrage that they sent several major stock indexes plummeting.
Index arbitrage still exists, but fortunately it’s much less popular now than it was in the ‘80s. Today, it makes up less than 1% of activity on the New York Stock Exchange. Wall Street has learned its lesson about messing with stock indexes. Thus, it’s unlikely that the entire financial sectors of several countries could ever crash in unison again.
Circuit Breakers and Other Backstops
Another difference between the markets of today and those of 1987 are the failsafes.
Back in the ‘80s, there was no way to “pull the plug” on a market that was spiraling downward. The crisis illustrated the need for a “circuit breaker” mechanism that could suspend trading on an exchange that was panicking.
Fortunately, after the crash, regulators created those circuit breakers. They’ve been used only once during a moderate Dow slide in 1997. But they serve as a deterrent against the kind of risky bets that caused the Black Monday crash.
Traders in the stock market today can’t hammer down the price of a major stock index by program trading it. They’d trigger a circuit breaker and shut down the market before their selling spree caused a major financial crisis.
There is some validity to the phrase “history repeats itself.” But it’s less applicable to finance. A major crash can wipe out the retirement savings of millions of Americans. So traders and regulators adapt after each financial crisis to make sure they don’t repeat their mistakes.
That’s not to say that stock markets will never crash again. New mistakes will be made in the future, and they’ll occasionally cause the stock market to slide.
But the notion that we are about to relive 1987 is simply untrue. The behaviors, practices and regulatory gaps that made the Black Monday crash possible are gone. Like legwarmers or Molly Ringwald movies, we left them behind in the ‘80s.