Exactly 25 years ago today the Dow Jones Industrial Average fell 22.6%. What came to be known as Black Monday was actually the culmination of a four-day slide of over 30%. In historical terms the one-day loss was the largest in history, far exceeding the 12.8% loss in The Great Crash of 1929.
Mass panics aren't triggered by single events. It takes a confluence of outside shocks and man-made idiocy to shave one-fifth off the market in a single day. The crash in 1987 wasn't something the market did to investors; traders and the government did it to themselves. In the attached clip I discuss what really drove Black Monday, with Eric Singer, author of the book Trade the Congressional Effect and Manager of Congressional Effect Funds.
The Three-Prong Attack on Market Bulls
1. Unintended Consequences of Populist Legislation
The 1980s were an era of the leveraged buyout. Corporate raiders would use relatively cheap junk bonds (now called "High Yield" bonds, to make them seem classy) to fund hostile takeovers. The additional leverage would inevitably lead to layoffs or flat-out liquidations of targeted companies — think Gordon Gekko's effort to chop up Blue Star Airlines.
In response, Singer says the House Ways and Means Committee "floated a trial balloon on making interest on junk bonds non-deductable to protect the management of large companies." In today's terms, DC tried to protect the 1% from the .01% by hiking taxes.
The instant the proposal hit the newswires, stocks thought to be takeover candidates collapsed.
2. James Baker Picks a Fight with Germany
The announcement of a larger-than-expected trade deficit came on October 14, 1987. In response, Treasury Secretary James Baker got tough with U.S. trading partners, specifically Germany. Baker's message, according to Singer, was "if you don't lower rates, we're going to lower the dollar and you're going to have export problems."
Getting tough with trading partners makes for a great soundbite in presidential debates. As the reaction in 1987 shows, actually threatening to start trade wars is less crowd-pleasing.
3. Portfolio Insurance
With the laws that were in place at the time, traders couldn't short individual securities without waiting for an uptick. Traders, being the same then as they are now, worked around the law with elaborate derivatives called portfolio insurance. The promise of these magical instruments was that they could perfectly hedge against losses by buying or selling options against real stock.
When things got ugly, stock sellers had to sell and options holders wouldn't. The disconnect between the two led to panic — which is complicated. Singer makes it simple. Portfolio insurance was simply "a precursor of what we're doing today with high-frequency trading."