30 years since Dow’s Black Monday: The lethal cocktail of events that caused the crash

It is 30 years since the biggest single-day stock market collapse in the US, the reverberations of which sent share prices in major global markets tumbling.

On Monday, October 19, 1987, the Dow Jones Industrial Average crashed 508 points or nearly 23 percent to close at 1739. The collapse ended the five year bull run in US equities that had begun in 1982.

Much of the blame for the panic selling on that day was heaped on program trading, a strategy in which computers execute trades when certain price limits are breached

Over the years, it has become clear that the correction was caused by a combination of factors. And while program trading may have aggravated the meltdown in share prices on that day, it was certainly not the trigger for the crash. The build-up to the fateful Monday had already begun the week before, when the Dow fell 10 percent in three trading sessions, the steepest 3-day drop in almost five decades.

Till then, 1987 had been a strong year for the US stock market because of a booming economy, and strong corporate earnings growth. And then the wheels slowly began to come off the bull market.

Here is a look at the chain of events that eventually culminated in the unprecedented sell off in the US stock market.

# Strong economic and credit growth raised concerns of inflation and overheating. The Federal Reserve responded by raising short term interest rates to temper inflation. Rising interest rates hurt stock market sentiment in two ways. One, corporate profit margins shrank because of higher interest costs. Two, investors shifted some of their money from equity to debt, as they now got better rate of return at a lower risk

# Because of the 5-year long bull run, share prices were rising faster than earnings, and many commentators felt the stock market had become overvalued.

# Program trading strategies were becoming popular. Algorithms would automatically start selling stocks and index futures when certain pre-decided limits were breached.

# On October 14, a government committee proposed scrapping of tax benefits related to financing of mergers and acquisition (M&A) activity. Takeover deals--mostly hostile--financed by debt, were a rage in the US during the 80s. The proposal triggered a sell-off in many stocks thought to be potential take-over targets

# On the same day, the Commerce Department announced the trade deficit for August, which was above analysts’ estimates. This weakened the dollar, raising concerns that Fed would raise interest rates further to support the currency.

# Selling in shares accelerated on Friday (October 16), dragging down the Dow by 4 percent. Many traders sold whatever stocks they could to meet margin calls. This is believed to have reduced liquidity in the system, leaving the market vulnerable if the selling pressure continued.

# As selling pressure continued on Monday, many mutual funds were flooded with redemption requests. This triggered off a vicious cycle, as every wave of selling pushed prices lower, in turn prompting more investors to sell in panic. At some point, a steep decline in share prices triggered selling by computer programs as loss limits were breached. It is widely believed that program selling was the final nail in the coffin for the market which was already hemorrhaging. A Federal Reserve discussion paper later said “this strategy (program trading) was not entirely to blame”, and that many other institutions were heavy sellers on that day.

The following day, before the market opened for trading, the US Federal Reserve put out a statement saying it was ready “to serve as a source of liquidity to support the economic and financial system.”

Later in the day, the market stabilized as companies announced stock buyback programs to arrest the free fall in the prices of their stocks.

Over the next few days, the Fed conducted open market operations, lowered interest rates to provide liquidity to the banking system and eased the rules for lending of securities. In addition, the Fed prodded market participants, in particular banks lending to brokers and dealers, to be flexible with their customers.

All these steps helped limit the fall out of Black Monday on the US economy.

Following Black Monday, stock exchanges introduced ‘circuit breakers’ which allows exchanges to temporarily halt trading when there are steep moves down or up.