Black Monday: 20 years after

By Elizabeth Strott

It was 20 years ago today . . . and it was an era of opulence, with movies like "Wall Street" glamorizing money and greed. The stock market had nearly doubled in a single year, with the Dow Jones Industrial Average rising 44% by August 1987 from a year earlier. And then, on Oct. 19, 1987, Wall Street faced something it had not seen since 1929: a crash.

In one day, the Dow plummeted 508 points, or 23%, to 1,739, wiping out $500 billion from the index.

In point value alone, that was worse than some of some of the most brutal losses of this past summer, when the Dow was more than six times higher. On a percentage basis, the 1987 loss was three times the 7% drop the Dow suffered on the day the New York Stock Exchange opened after the Sept. 11 terrorist attacks.

• Talk back: Where were you 20 years ago on Black Monday?

For many on Wall Street, "Black Monday" was a surreal day of panic, fear and utter dismay.

What led to the crash?

A number of factors contributed to the market's massive spiral on Black Monday, including the bombing of an Iranian oil platform by two U.S. warships, although no single event set it off.

"In 1987, we still don't really know the event that caused the crash," said Michael Johannes, an associate professor of finance at Columbia Business School. "One of the things that was so shocking was that there was no big event, no attack, no macroeconomic event that caused the crash."

Although the Dow had broken the 2,000 mark in January, and bulls had been driving the market for the previous few years, there was a growing sense of trouble ahead. Leveraged buyouts and hostile takeovers were rampant, with junk bonds financing many speculative deals. The Securities and Exchange Commission had already started to investigate a number of top Wall Street players for insider trading in 1987, including Ivan Boesky, Martin Siegel and Michael Milken.

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Inflation jitters were also a factor, with light, sweet crude oil having jumped 11% (to $22.39) the previous July. The dollar was falling and the foreign trade deficit was widening.

Meanwhile, as investors rushed into the equity markets, the 30-year Treasury was soaring, hitting a yield of 10.16% the Friday before the crash. (The 30-year bond yield rises when investors would rather put their money in stocks; today, by comparison, the yield on the 30-year bond is 4.77%.)

On Friday, Oct. 16 -- with the Dow having already lost a total of more than 260 points in three straight trading days -- then-Treasury Secretary James Baker outlined his concerns about the economy, giving already-jittery investors a weekend to fret.

When Black Monday comes

But even investor worries wouldn't have been enough to cause the plunge, analysts now say, without something called program trading -- an automated "portfolio insurance" strategy that institutional traders had been using to hedge their portfolios against market declines.

When the opening bell rang on Monday morning, traders and the systems they used were deluged with orders. The bears were on the warpath, and the portfolio-insurance programs kicked in with automated short sales, compounding the selling pressure and adding to the chaos.

"The problem in '87 was the assumption there would be enough liquidity in the market to replicate portfolio-insurance options. That didn't happen," Bill Gross, chief investment officer for Pacific Investment Management, told the Pensions & Investments newsletter.

The computer programs put stop-losses on stocks and started sending a slew of sell orders to the New York Stock Exchange computer system, called DOT. Trading volume more than doubled to 604.3 million shares, easily topping the previous record set only three days earlier. But the massive volume inundated the DOT and caused huge delays, adding to the confusion and collapsing the system.

"Nobody had seen anything like that before," said Columbia's Johannes.

"I was running the floor for Paine Webber," Art Cashin, director of floor trading at UBS, told CNBC this morning. "The final hour was like a dream sequence. You knew what you were doing, but you couldn't believe it was real."

The Fed to the rescue?

The Federal Reserve tried to step in the next morning to help stave off further losses. "The Federal Reserve, consistent with its responsibilities as the nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system," the Fed said in a statement Tuesday before the markets opened.

Later on Tuesday, the Fed, led by newly appointed Alan Greenspan, held a conference call with members of the Federal Open Market Committee to discuss what role the Fed should play in trying to calm investors and the markets. "I think we're playing it on a day-to-day basis. And in a crisis environment, I suspect we shouldn't really focus on longer-term policy questions until we get beyond this immediate period of chaos," Greenspan said during the call.

The Fed ended up holding such calls every business day for almost two weeks, until Oct. 30.

In the end, the market managed to right itself. The Dow rose 200 points on the two sessions immediately following the crash, and two months later found itself up 2% for the year, just shy of 1,939.

And for long-term investors, the payoff has outweighed the pain.

If a person had invested in the Dow stocks on Oct. 12, 1987, that person's portfolio would have tanked nearly 30% from the crash on Oct. 19.

But if that investor weathered the storm and held onto that investment, the portfolio would have jumped 462% over the next 20 years. A portfolio worth $7,035.33 the week before the crash would be worth $56,212.32 as of this Wednesday's market close, according to Dow Jones.

Will it happen again?

It would take a drop of nearly 3,200 points in today's trading world to have the same percentage loss as Black Monday, but some are preparing nonetheless.

"In any market, there are a lot of young people that don't remember the last mess and a lot of older people who were burned from the last mess," said Peter Morici, professor at the University of Maryland School of Business and former chief economist at the U.S. International Trade Commission. "The young don't react and the older people overreact."

But observers say that changes instituted after the '87 plunge -- such as so-called circuit breakers, which shut down trading amid panic selling -- make a repeat almost impossible.

"A terrorist attack, something like this could generate a 20% drop," Johannes said. But "I can't see where a day when nothing really happens pushes the Dow down 20%. It won't be the case where we wake up one day and, the next thing you know, the Standard & Poor's 500 Index is down 15%. People have more sensors turned on; it's less likely for it to happen."

"We have to remember that the stock market is not the economy -- it's where we keep score," Morici added. "My feeling is that it's certainly possible that we could have another bust, but we're going to have it only if the housing market drags it down. The stock market doesn't have within it its own seeds of destruction."