Black Monday (1987) - Causes

Causes

Potential causes for the decline include program trading, overvaluation, illiquidity, and market psychology.

The most popular explanation for the 1987 crash was selling by program traders. U.S. Congressman Edward J. Markey, who had been warning about the possibility of a crash, stated that "Program trading was the principal cause." In program trading, computers perform rapid stock executions based on external inputs, such as the price of related securities. Common strategies implemented by program trading involve an attempt to engage in arbitrage and portfolio insurance strategies. The trader Paul Tudor Jones predicted and profited from the crash, attributing it to portfolio insurance strategies which were "an accident waiting to happen" and that the "crash was something that was eminently forecastable". Once the market started going down, portfolio insurance futures sellers were "forced to sell on every down-tick" so the "selling would actually cascade instead of dry up".

As computer technology became more available, the use of program trading grew dramatically within Wall Street firms. After the crash, many blamed program trading strategies for blindly selling stocks as markets fell, exacerbating the decline. Some economists theorized the speculative boom leading up to October was caused by program trading, and that the crash was merely a return to normalcy. Either way, program trading ended up taking the majority of the blame in the public eye for the 1987 stock market crash.

New York University's Richard Sylla divides the causes into macroeconomic and internal reasons. Macroeconomic causes included international disputes about foreign exchange and interest rates, and fears about inflation.

The internal reasons included innovations with index futures and portfolio insurance. I've seen accounts that maybe roughly half the trading on that day was a small number of institutions with portfolio insurance. Big guys were dumping their stock. Also, the futures market in Chicago was even lower than the stock market, and people tried to arbitrage that. The proper strategy was to buy futures in Chicago and sell in the New York cash market. It made it hard -- the portfolio insurance people were also trying to sell their stock at the same time.

Economist Richard Roll believes the international nature of the stock market decline contradicts the argument that program trading was to blame. Program trading strategies were used primarily in the United States, Roll writes. Markets where program trading was not prevalent, such as Australia and Hong Kong, would not have declined as well, if program trading was the cause. These markets might have been reacting to excessive program trading in the United States, but Roll indicates otherwise. The crash began on October 19 in Hong Kong, spread west to Europe, and hit the United States only after Hong Kong and other markets had already declined by a significant margin.

Another common theory states that the crash was a result of a dispute in monetary policy between the G7 industrialized nations, in which the United States, wanting to prop up the dollar and restrict inflation, tightened policy faster than the Europeans. U.S. pressure on Germany to change its monetary policy was one of the factors that unnerved investors in the run-up to the crash. The crash, in this view, was caused when the dollar-backed Hong Kong stock exchange collapsed, and this caused a crisis in confidence.

Some technical analysts claim that the cause was the collapse of the US and European bond markets, which caused interest-sensitive stock groups like savings & loans and money center banks to plunge as well. This is a well documented inter-market relationship: turns in bond markets affect interest-rate-sensitive stocks, which in turn lead the general stock market turns.