October 19, 2015


Black Monday Really Did Look Like 1929 Again (Barry Ritholtz, 10/19/15, Bloomberg View)

As in most complex matters, there were many forces that drove the events leading up to the crash. But some stand out more than others. Here are two of the biggest:

Bull market froth: The Dow industrials kissed 1,000 in 1966, then tumbled in the horrific bear market of the 1970s and didn't surpass that number on a permanent basis until 16 years later in 1982. Then, between 1982 and 1986, the Standard & Poor's 500 Index more than doubled. But things really heated up in 1987. In the first eight months of the year the index gained more than 38 percent. A correction was overdue. While many people were afraid that markets were overheated, no one -- no one -- had envisioned a  one-day drop that would wipe out almost a quarter of the market capitalization of the major indexes. That had a different cause.

Portfolio insurance: The technique, invented by Hayne Leland and Mark Rubinstein in 1976, was an attempt to hedge volatility by shorting index futures to protect a long equity portfolio. As market prices fell, the index puts would be executed, locking in a small loss, and shifting the risk of more losses to the party on the other side of that trade. It was an academic concept, one that hadn't been stress-tested yet.  The working assumption was that a ready buyer would be there to take the other side of the trade, getting paid to assume additional risk. Not so much, as it turned out. Buyers eventually were willing, but only at much lower prices. This created a selling spiral that got out of control. The lack of liquidity was also a problem, as index futures were a relatively new product with modest volume and not a very deep trading history. 

The creaky New York Stock Exchange trading structure -- it was dated, and human traders were unable to keep up with the volume -- was another related issue.

There were other factors as well. Broader geopolitical concerns included Iran (it had attacked U.S. merchant vessels) and collapsing oil prices (by 1986, crude oil prices had dropped by about 50 percent). But the most commonly cited political issue was Treasury Secretary James Baker, who made some inauspicious public comments the prior weekend. He disagreed with his European counterparts about the strong dollar and foreign-exchange rates. Some observers point to his comments as the spark in a room filled with gas vapors.

All that really mattered was that a new Fed Chairman had to try and prove his inflation hawk bona fides and hiked rates despite disinflation (see also under 2008).  Chairman Greenspan implicitly acknowledged the error when he dropped rates the day after Black Monday, not that it stopped him from making the identical error in 2000.

Posted by at October 19, 2015 11:13 AM

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