The Oct. 19, 1987, stock market crash almost seems to have receded from significance in the face of a continuing bull market.
Yet, a lone Monday in October saw the biggest one-day drop - 22.6% - in the modern history of the stock market, dating to 1926. And, that led to changes designed to prevent a recurrence.
Among the steps taken were:
Circuit breakers are used whenever the New York Stock Exchange falls 350 points.
Specialists have increased their capital.
A linking of margin on the stock market with margin in the futures market is allowed.
Still, there are questions. Are the changes enough to prevent another precipitous drop? And how likely is such a drop, given the lofty multiples of the market?
Many analysts contend the market is overvalued - as many contended in 1987 - yet no one predicts another crash, at least not soon. One investment manager noted the sound fundamentals of the current U.S. economy make a crash far less likely. Two aspects are present now that were absent in 1987: the strong positions of both the banking system and the U.S. dollar.
The reason the market started to fall that day still generates debate, but there's almost unanimous agreement that it was portfolio insurance that turned the decline into a free fall.
That derivatives-based protection strategy - particularly popular among some major pension funds - was designed to limit the potential downside risk while allowing almost all of the potential upside gain.
Even one of its creators - Mark Rubinstein, professor of finance at the University of California, Berkeley - acknowledges: "Portfolio insurance caused a downward force on the market and helped exacerbate the market crash."
His company, Leland O'Brien Rubinstein Associates Inc., Los Angeles, created portfolio insurance and was its dominant marketer.
"Portfolio insurance didn't give us the crash, but it deepened it and made it worse."
Bruce I. Jacobs, principal and co-chief investment officer at Jacobs Levy Equity Management Inc., Roseland, N.J., who this month completed a forthcoming book on the 1987 crash, blames portfolio insurance.
As the market started to fall, portfolio insurance triggered a flurry of mechanistic - that is, not caused by fundamental reasons - sell orders. The sales triggered a cascade of more portfolio insurance sells and panic among other investors, who also started to sell. Astute front-runners, sensing the trigger of sell orders, sold still more, ahead of portfolio insurers, causing the market to continue to fall.
The crash prompted a number of market reforms, spurred notably by the so-called Brady Commission report.
"The report was more interested in why the market went down as rapidly and chaotically as it did, than in what caused the market to begin to fall," said Robert R. Glauber, lecturer in business at the Kennedy School of Government at Harvard University, Cambridge, Mass. He was executive director of the commission.
Steps in right direction
"I think the steps that have been taken in reform are in the right direction," Mr. Glauber said. The reformed "market mechanism makes it likely the adjustment process of a decline will be less chaotic."
But "that doesn't mean markets won't go down," he added, only that the market reforms should mitigate a fall.
"I think the market is today as overvalued as it was then," Mr. Glauber said.
But he sees less chance of a market crash on the order of 1987.
"There are mechanisms in place to allow the market to better able cope with selling pressures." These mechanisms include the circuit breakers adopted by the exchanges and better capitalized specialists.
Said Robert G. Kirby, senior partner at Capital Guardian Trust Co., Los Angeles, a member of the Brady Commission: "I think everybody is universally proud of how it turned out."
The commission endorsed - and the New York Stock Exchange adopted - circuit breakers that impose temporary trading halts when the market moves up or down by extraordinary amounts.
In the report, "we were focusing on how close we had come to a real live meltdown," Mr. Kirby said. "We concluded the main contributing factor was portfolio insurance."
The Brady reforms were designed to prevent a cascading fall, such as in 1987.
"The market can pause and rational thought process take over," he said.
"There are people out there skilled at moving markets." He criticized program traders, who trade large blocks of stock at once.
"I don't think program trading is good for anybody," Mr. Kirby said. "It adds volatility and creates uncertainty."
Program traders could allow investors to exit the market quickly by selling portfolios of stock in a single trade.
Dismissing the relevance
Some investment professionals dismiss the relevance of the crash, especially since the Dow Jones industrial average now weaves in and out of the 8000 range, up from about 2250 on Black Monday.
" The crash of 1987 was a non-event," said Mike Wolf, executive vice president and senior portfolio manager, American Express Asset Management, Minneapolis.
"There were no macroeconomic disasters," he said, adding "1987 has no real effect on the real economy."
"Anyone who put money into the market at the height" - in August 1987 - "just before the crash . . . made a lot of money" since then, he said.
But Mr. Wolf said the crash showed "volatility was going to be a fact of life from then on. Anything is possible in terms of market reaction."
Some investment professionals almost welcomed a major correction.
(contd. Part 2)
