Black Monday Explained

Black Monday Explained

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During the mid 1980s, the Dow Jones Industrial Average (DJIA) tripled in value and the stock market as a whole boomed. By the late ‘80s, stocks continued to trend higher despite slowing economic growth and rising inflation. Then, on Black Monday (October 19, 1987), the Dow fell by more than 20% in its largest single-day drop ever, cementing this date as one of the most notorious in financial history.

Context

This immense drop did not come out of nowhere–there were clear signs that the market had become excessively overvalued and that a correction was due. For the first time in the ‘80s bull run, the stock market and the economy were diverging: while the economy slowed, the stock market continued to rise. Additionally, in early 1987, the Federal Reserve tightened its monetary policy. This caused a major decline in the money supply within the country, resulting in higher interest rates and a gradual decline in stock prices.

Causes

Despite these factors, the major causes of this crash were portfolio insurance and program trading. Portfolio insurance, which is the short-selling of stock index futures, gave investors a false sense of security as they believed that this practice limited their risk. While this belief was true to some extent (investors’ losses would be capped if the market fell), they took on even more risk, negating the benefits of this method and in turn jeopardizing their portfolios. When the crash came, this higher risk led to more severe losses.

Along with portfolio insurance, program trading (trading via automated computer programs) led to a domino effect of destruction on Black Monday. The computer programs continually sold stocks that hit new lows, pushing the prices even lower. On top of this excessive selling, the programs were designed to automatically stop buying stocks in situations like this, resulting in a large supply of stocks but very little demand, further decreasing stock prices and increasing investor panic.

Effects

A continuation of the crash over the next few days was prevented by quick and arguably suspect moves from the Federal Reserve. To prevent a similar sell-off from happening again in the long-term, a number of protective measures were put in place, most notably trading curbs and circuit breakers. These restrictions temporarily halt trading during times of excess volatility (severe price fluctuations) to reduce panic and prevent major sell-offs.

Lessons

Crashes similar to this one have happened multiple times in the past and will continue to happen. However, it’s important to remember that market crashes are always temporary. By sticking with a well-defined, long-term strategy and preventing emotions from guiding investing decisions, investors can weather bad times and even utilize them to buy undervalued assets and enhance their portfolio’s long-term outlook.

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Managing Editor at | Website | + posts

I’m a senior in the Bay Area. As managing editor, I edit most of the articles published on StreetFins. I also write about personal finance, economic policy, and the stock market.