A:

The cause of the stock market crash of 1987 was primarily program trading, used by institutions to protect themselves from significant market weakness. Some secondary factors included excessive valuations, illiquid markets and market psychology.

Program trading exacerbated market weakness even though it was designed as a hedge. These computer programs automatically began to liquidate stocks as certain loss targets were hit, pushing prices lower. Then, the lower prices fueled more liquidation with stocks dropping 22% on the day. This is an example of behavior that is rational on an individual level – but irrational if everyone adopts the same behavior.

One of the core assumptions of these programs was proven false, as it assumed constant levels of liquidity when the program needed to sell. However, the same programs also automatically turned off all buying. Since these programs were ubiquitous, bids vanished all around the stock market at basically the same time that these programs started selling.

Portfolio insurance gave a false sense of confidence to institutions and brokerages that risk was well-managed. The general belief on Wall Street was that portfolio insurance would prevent a significant loss of principal if the market were to crash. However, this false belief ended up fueling excessive risk taking, which only became apparent when stocks began to weaken in the days leading up to the stock market crash.

1987 had been a strong year for the stock market leading up to the crash, as it continued the bull market that began in 1982. However, there were some warning signs of excesses that were similar to excesses at previous inflection points. Economic growth had slowed while inflation was rearing its head. There were also some geopolitical issues related to currency disputes between the United States and Germany. The strong dollar was putting pressure on U.S. exports.

The stock market and economy were diverging for the first time in the bull market. Due to this factor, valuation for the stock market climbed to excessive levels, with the price to earnings ratio climbing above 20. Future estimates for earnings were trending lower, and stocks were unaffected. Market participants were aware of these issues, but the introduction of portfolio insurance led many to shrug off these warning signs.

Rising markets during periods of financial stress can be difficult for even prudent portfolio managers. They must weigh the cost of underperforming the market against the cost of the broader market weakening. Many who are skeptical of the market advance find themselves being forced to buy at elevated levels.

Their job performance is based on how they perform relative to the index benchmarks. Missing a major market rally can cause some to lose their jobs. This was another element contributing to the conditions that created Black Monday, as portfolio managers were forced to buy stocks due to career risk even though they were aware of the market risks.

Eventually, all these variables coalesced to create one of the worst days for the stock market on Oct. 19, 1987. However, the most important factor was program trading and the widespread belief that it would handle all concerns related to risk management. In its intention to protect every single portfolio from risk, it became the largest single source of market risk.

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