Is black monday set for repeat?

It's 20 years to the day since the worst stock market crash in living memory. But the events of October 1987 may have some valuable lessons, as world stock markets head for new highs. By James Moore
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The Independent Online

It was just over 20 years ago that what has come to be known simply as the Great Storm smashed through southern England, producing gusts of more than 100mph, killing 18 people and uprooting 15 million trees.

A couple of days later, on Monday October 19 – 20 years ago today – a second hurricane whipped through the world's stockmarkets, causing the biggest single day fall the Dow Jones Industrial average had seen. It tumbled by 508 points to 1739, a bigger single day fall than had even been seen during the Wall Street Crash. The contagion spread around the world, rocking markets in Hong Kong, Sydney, Franfurt, and, of course, London.

The 1987 crash was a bloodbath, wiping hundreds of millions of pounds from the value of shares around the world. David Buik, from BGC Partners, describes Black Monday as "a absolute horror show". Journalists dusted down their history books for stories of leapers who ended it all during the 1929 affair having lost everything.

"You have to remember that the markets had been closed on the Friday before Black Monday because the hurricane meant that nobody could get in. Trees were down all over the place and they had blocked the train lines.

"Even on Monday there was still only a skeleton staff on hand at many stockbrokers, because of the damage and they found it tough." The situation was made worse in Britain because trades were settled on a two week cycle by paper, causing panic selling as people feared they would be unable to cover their positions. It was only a year or so after "big bang" which had revolutionised London's markets, but left frazzled dealers struggling to cope.

And yet within a matter of months the storm had blown itself out, the markets recovering all their losses. If one looks at a graph of stockmarkets over the last 100 years, the "crash" of 1987 barely registers, despite the panic among those who were around at the time. But what caused it? And more to the point, are we stoking up a similar bloodbath today? The answer to the first question is: Nobody really knows for sure. A number of theories have been put forward, and the cause of the crash was probably a combination of several of them. Andrew Milligan, head of global strategist at Standard Life Investments, which overseas £141bn, notes that the price to earnings ratio of stockmarkets around the world had been sharply rising from the mid 1980s. The higher the p/e of a company, the more an investor is paying to access its earnings through its shares.

In 1985 the p/e was between 8 and 10, rising steadily to 14 in 1986 to a high of 18 in 1987. And while, Mr Milligan says, the economy had been recovering in 1987, leading to hopes of much higher corporate earnings, the US Federal Reserve and the German Bundesbank had started to raise interest rates in an attempt to control inflationary pressures that were making themselves known.

That stoked fears of a slowdown killing off the anticipated boost to corporate earnings that investors were hoping to tap into by chasing share prices higher. So the economic conditions for a market correction – if not a crash – were certainly there.

More controversial among experts was how much of an impact programme trading, and a strategy that aimed to hedge portfolios of shares against market falls, had on the situation.

"People thought they could insure against market falls by selling futures," says Mr Milligan. "In very simplist terms, this actually exacerbated the situation when share prices started to fall."

Many believe the computer driven programme trades, which execute a rapid series of transactions and were used to help execute this strategy, were a major contributor to Black Monday.

Mr Milligan credits some fleet-footed action from the world's central banks, which cut interest rates, for the almost equally dramatic recovery that happened a few months later. Mr Milligan doubts whether something similar will happen today, notwithstanding the sub prime debt crisis and resulting credit crunch

He says: "Inflation is under control and the economy is slowing rather than moving more quickly. The conditions are very different."

However, Charles Proctor, a partner in the Banking, Finance and Regulation group at international law firm, Bird & Bird, argues that we are no safer today than we were in 1987.

"Should a perfect storm of circumstances come together again, another Black Monday could occur," he said. "In 1987, there were those who blamed the collapse of markets on the then unsophisticated programme of trading technologies that drove share prices lower regardless of any assessment of fundamental value. However, has the more sophisticated technology available to the global investment banks done anything other than promote the creation of increasingly complicated instruments packaged and sold to each other, increasing – but doing little to spread – the amount of risk in the dash for profit?" Mr Proctor argues lessons have not been learned and we are not safer.

Mr Milligan does see one similarity between what happened in 1987 and what has happened with the sub prime crisis of today – namely people believing sophisticated strategies could get them something for nothing. Then it was insuring against falling share prices, now it has been getting huge returns from sub prime debt in the belief that packaging them up in a clever manner would protect from the downside. Perhaps the lesson that should be learned is the oldest one in the book. As Mr Milligan says: "You don't get something for nothing and if it looks too good to be true, it probably is."

A short history of stock market crashes

While it provoked high drama in the City at the time, the 1987 crash lasted just a few months and was little more than an October head cold when compared to some of history's more spectacular down turns.

And the pain it caused was moderate when compared to the collapse of Tulip mania in the Netherlands, which produced a nasty bout of full-blown influenza.

In the middle part of the 17th century such was the demand for tulip bulbs that they were changing hands for the price of a modest house in Amsterdam. People sold their possessions so they could get involved, dreaming of riches through playing the bulb market. But by 1637 prices had started to tumble as traders sold and a panic took hold. Thousands of Dutch investors were ruined. Lesser versions took place in other parts of Europe although failed to reach the heights of madness that stuck the Dutch.

In 1720 many British investors were ruined as a result of the South Sea Bubble, that centred on the South Sea Company. It had agreed to finance the British Government's debt of £10m in exchange for exclusive trading rights in the South Seas, or Spanish South America, envisaging a mighty monopoly and money to burn. Unfortunately, it ignored a clause in a treaty with Spain that severely limited the number of ships that could go to the South Sea from Britain in a year and the bubble well and truly popped thanks to the subsequent spat.

October has proved itself a bad month for crashes. October 1929 heralded the start of the Wall Street Crash that brought the Roaring Twenties to a shuddering halt, after speculation on the stockmarket fuelled an economic bubble that was popped by series of tumbles that began on "Black Thursday" October 24. Itwas a major factor behind the depression of the 1930s that led to the Second World War. The pre-crash peak was not reached again until 1954

The 1987 crash – while producing the then biggest daily share price falls – also pales by comparison to the bloodbath that began in 1973, sparked by the collapse of the Bretton Woods System that governed international monetary relations and maintained the exchange rates within a fixed range. It was exacerbated by the 1973 oil crisis, the crash running from January through to December 1974.

The most recent crash was the dot com bubble bursting in 2000. The US market has recovered but Britain has still to regain the high reached on December 1999.

Traders will remember fateful day

There won't be a minute's silence on the floor of the New York Stock Exchange this morning, but that blackest of Mondays will be in everyone's thoughts. In fact, the countdown to the anniversary of the crash of 1987 has already triggered a wave of recollections.

"It was like an abyss," Leo Melamed, then chairman of the Chicago Mercantile Exchange, has been telling documentary makers. "There was a knot in my stomach, and at this moment, as we are talking about it, I can feel that knot."

It was futures trading at the CME that signalled just how far and how fast the Dow Jones Industrial Average was plunging, as if leading it by the nose. Traders in the cash markets back in New York struggled to catch up, cursing the CME and fighting a backlog of trades. By the end of the day, the Dow Jones Industrial Average was down 508 points. At the opening of trading on 19 October 1987, the Dow was at 2,246.74. It fell 22.6 per cent. "I equate it to a force-five hurricane," Robert Hormats, a Goldman Sachs investment banker, told CNBC. "I was stunned. It was so rapid. It was almost surreal."

David Ruder, then chairman of the Securities and Exchange Commission, was forced to relive his horrible two hours when a reporter asked him what – theoretically – the SEC might be able to do to ease the selling. He said the SEC could – theoretically – close the market. But the newswires reported the SEC might actually close the markets, and all hell broke loose. By the end of the day, it was known as the "$3bn typo".

Art Cashin, the UBS trader who still works on the exchange floor 20 years on, recalled to Trader Monthly magazine that the reports led everyone to believe even the SEC was getting panicky. "More importantly, if you're trying to stand pat and not panic, and they're going to have a trading halt, you'll never be able to get out – so get out now. That really helped accelerate things."

But there has been a bullish undertone to most of the coverage. The crash was a "blip", and the valuations on the stock market these days are so much more modest that it cannot happen again. But the tale of the crash is not really a tale of stretched valuations – it is a tale of human emotion, or greed and fear and blind panic. And human emotion has not changed that much in 20 years.

Stephen Foley

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