On Oct. 19, 1987, the Dow Jones Industrial Average plummeted 22%. That one-day drop, the largest in U.S. history, became known as Black Monday.
The 30th anniversary of the '87 stock market crash is today, and so is the potential for another huge drop.
In fact, another crash isn't just possible, it's probable.
Once again, seemingly smart Wall Street products, pregnant with potential unintended consequences and combined with regulatory ignorance and complicity, practically guarantee it.
Here's what caused the crash in '87, and the chilling truth about the one thing that's different this time that will make the next crash worse...
History Loves to Repeat Itself
The bull market that began in 1982 took stocks 160% higher by 1987.
While that's a great run, it barely compares to stocks in the current bull market, which are up 277% since 2009. Since March 2013, when the Dow eclipsed the 14,200-mark set in 2007, stocks are up 63%.
Leading up to the 1987 crash, equity price increases had been outpacing earnings growth and lifting price-to-earnings ratios in a very similar pattern to what we see today.
Like today, market commentators and analysts were calling the market overvalued in 1987.
The influx of new investors into the market during the 1980s, predominantly pension funds and retirement account money, increased demand for shares and drove prices up. These days, new investors like the growing passive investing crowd are likewise increasing demand for stocks and boosting prices.
Equities were additionally supported in 1987 by favorable tax treatment for corporate buyouts, allowing firms to deduct interest expenses associated with debt issued for buyouts.
The list of companies that were potential takeover targets was growing... and so were their stock prices.
Today, proposed tax cuts for businesses, favorable cash repatriation talk, and hoped-for accelerated depreciation scheduling are bullish news for stocks.
It's clear that conditions are eerily similar, just with a more topical twist. But if we take a look at the actual timeline of the '87 stock market crash, something else becomes clear.
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The Wednesday before Black Monday, news services reported the Ways and Means Committee of the U.S. House of Representatives wanted to eliminate tax benefits associated with financing buyouts and mergers. That took the market down when a host of companies considered buyout candidates fell.
On the same day, the Commerce Department said the trade deficit was above expectations. That hit the dollar hard and prompted fears the U.S. Federal Reserve would tighten, which pushed rates higher in the open market.
Stocks closed substantially lower.
On Thursday, markets continued to slide with heavy selling into the last half hour of the day, all on heavier-than-usual volume.
Markets continued down on Friday, spurred by fear and technical factors like stock index options expiring.
By the end of the week, the market was down more than 9%. This was one of the largest one-week declines of the preceding two decades, and it scared investors across the globe.
Then came the morning on Black Monday.
Stocks in Asia were down, stocks across Europe were getting hammered, and U.S. futures were down.
After the market open and into the close, it was "program trading" that tanked stocks in wave after wave of sell orders.
The False Safety of Insurance and Indexes
Program trading was fairly new in 1987 and consisted of two primary strategies driven by computers.
Portfolio insurance, which bears the brunt of the blame for the crash, was a simple-to-explain-and-sell Wall Street "product." It established levels of portfolio losses for institutional money managers, and, when reached, would trigger the shorting of S&P 500 futures to offset some portion of the portfolio's cash losses. If losses increased, more futures were shorted to hedge (or insure), and losses would be limited.
In theory, it made sense. In practice, it started a negative feedback loop that unleashed waves of selling.
As cash prices (the actual prices of stocks in the market) fell on panic selling, insurance programs sold short futures contracts. As futures prices tanked, panicking investors more, cash selling increased. The more cash prices of stocks and the market fell, the more futures were sold short.
It was unstoppable.
The other program trading strategy that was widely followed was index arbitrage. Index arbitrage, using the S&P 500 as an example, is the buying or selling of futures on the index while simultaneously selling or buying the cash stocks in the index.
Futures on indexes trade on their own, but their basis and their value are based on the market price of all the stocks that make up the index at any moment. In the case of the S&P 500, that's 500 stocks.
If the cash value of all the stocks combined is less than where the futures are trading, index arbitrageurs buy all the stocks and sell the futures simultaneously. It's like buying one stock for a dollar on one exchange and selling it simultaneously on another exchange where someone is paying $1.05.
It works the other way too. When stocks were falling faster than the futures were falling, arbs were supposed to be buying stocks and selling futures, arresting the drop of cash positions. But that didn't always happen. Sometimes futures were lower than cash and traders sold more cash stocks, driving down futures, and sometimes traders just sold whatever they could to get ahead of panic selling.
It was a perfect storm. The Dow closed the day down 508 points, knocking more than 22% off the Industrials value.
Can it happen again? Of course, it can.
Only now, there's a lot more at stake.
There are infinitely more index products now. Index arbitrage is now systemic. And portfolio insurance is packaged in retail products that exist completely outside what investors have in their portfolios and aren't even connected to the stocks they think they insure.
The products you own, the products hedge funds own, the products central banks own... They're all the same.
In my next column, I'll tell you the truth about how they can cause a crash that would dwarf what happened in 1987.
Up Next: This Win Rate Is Incredible
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The post 30 Years after the 1987 Crash, We're Right Back Where We Started appeared first on Wall Street Insights & Indictments.
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.