A:

Monday October 19,1987, is known as Black Monday. On that day, stockbrokers in New York, London, Hong Kong, Berlin, Tokyo and just about any other city with an exchange stared at the figures running across their displays with a growing sense of dread. A financial strut had buckled and the strain brought world markets tumbling down.

In the United States, sell orders piled upon sell orders as the Dow shed value of nearly 22%. There had been talk of the U.S. entering a bear cycle – the bulls had been running since 1982 – but the markets gave very little warning to the then-new Federal Reserve Chairman Alan Greenspan. Greenspan hurried to slash interest rates and called upon banks to flood the system with liquidity. He had expected a drop in the value of the dollar due to an international tiff with the other G7 nations over the dollar's value, but the seemingly worldwide financial meltdown came as an unpleasant surprise that Monday.

Exchanges also were busy trying to lock out program trading orders. The idea of using computer systems to engage in large-scale trading strategies was still relatively new to Wall Street and the consequences of a system capable of placing thousands of orders during a crash never had been tested. These computer programs automatically began to liquidate stocks as certain loss targets were hit, pushing prices lower. To the dismay of the exchanges, program trading led to a domino effect as the falling markets triggered more stop-loss orders. The frantic selling activated yet another round of stop-loss orders, which dragged markets into a downward spiral. Since the same programs also automatically turned off all buying, bids vanished all around the stock market at basically the same time.

Ominous Signs Before the Crash

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. 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, and as a result, valuations climbed to excessive levels, with the overall market's price-earnings ratio climbing above 20. Future estimates for earnings were trending lower, but stocks were unaffected.

Market participants were aware of these issues, but another innovation led many to shrug off the warning signs. Portfolio insurance gave a false sense of confidence to institutions and brokerages. The general belief on Wall Street was that it would prevent a significant loss of capital if the market were to crash. This ended up fueling excessive risk-taking, which only became apparent when stocks began to weaken in the days leading up the fateful Monday. Even portfolio managers who were skeptical of the market's advance didn't dare to be left out of the continuing rally.

The Bottom Line

Program traders took much of the blame for the crash, which halted the next day, thanks to exchange lockouts and some slick, possibly shadowy, moves by the Fed. Just as mysteriously, the market climbed back up towards the highs it had just plunged from. Many investors who had taken comfort in the ascendancy of the market and had moved towards mechanical trading were shaken up badly by the crash.

Although program trading contributed greatly to the severity of the crash (In its intention to protect every single portfolio from risk, it became the largest single source of market risk), the exact catalyst is still unknown, and possibly unknowable. With complex interactions between international currencies and markets, hiccups are likely to arise. After the crash, exchanges implemented circuit breaker rules and other precautions to slow down the impact of irregularities in hopes that markets will have more time to correct similar problems in the future.

To learn more about market crashes, see "The Greatest Market Crashes."

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