On October 19, 1987, the Dow suffered the biggest one-day percentage drop in its 111-year history (see our previous post). Known as Black Monday, that day saw the Dow plummet 508 points, causing economic panic around the world. While a recurrence is seen as slim by market analysts, they do admit to its remote possibility, and some are concerned about disturbing parallels in today’s market. History is a strict task-master and the shrewd futures trader will learn her lessons.
In 1987 blind, computer-generated program trading was blamed for sending the market into free fall. Market analysts fear that reliance on computers and the speed of computer trading could lead to a similar disaster today. In fact, this summer the subprime mortgage catastrophe and accompanying credit crunch triggered a market sell-off that cost some quantitative funds significant losses. As in 1987, computers generated sales, all trying to sell the same stocks at the same time. With no buyers, the only direction they could go was down.
“When all these computers head for the exit at the same time, and everybody is doing the same thing, that’s how you get a crash,” explained Tony Kolton, chief executive of MarketHistory.com in a recent interview with the Los Angeles Times.
While some analysts feel that exotic financial securities like mortgage-backed bonds could draw the market into a 1987 scenario, others say a repeat of Black Monday is unlikely. They cite the following differences between the two eras:
- In 1987, soaring share prices stretched market valuations. In the first 8 months of 1987, the Dow gained 44%. This year, the gain to date is less than 12%.
- In 1987, S&P 500 index stocks cost 23 times their earnings. Today, the cost is a more reasonable 18 times earnings.
- In 1987, the Federal Reserve was increasing interest rates to combat inflation. Today, inflation is under better control and the Fed recently lowered interest rates to ease the credit crunch.
What haven’t changed in 20 years are the two financial emotions that drive the market: greed and fear. In 1987, greed led many to consolidate their holdings in one area of the market. They were unprotected when the market started heading downhill. Many investors panicked. Fear fueled the market’s downward spiral resulting in even heavier losses.
Today, computers have made the market easily accessible to individuals. According to the Securities Industry and Financial Markets Association, 50% of U.S. households had some sort of market exposure in 2005, compared to only 32% in 1989. Advanced technology and home computers have made it possible for inexperienced investors to impact the market in ways they couldn’t 20 years ago. Greed and fear coupled with that inexperience could again create a market fiasco to rival Black Monday.
If Black Monday has lessons to teach, it is these:
- Don’t be greedy. Limit your exposure to an affordable risk.
- Don’t panic. Remove your emotions from your trading decisions.
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