Applying the lessons of the Crash of '87 to today's markets

Key Points
  • Market circuit breakers and electronic trading are the result of efforts to prevent another 1987-style crash.
  • A similar drop in the Dow today would be almost 5,000 points.
  • There's a much greater awareness of how interconnected the markets are today.
trader (c) on the New York Stock Exchange gathers his thoughts 16 October 1987 as the Dow Jones Industrial Average dropped a record 108. 36 in one day trading record.
Maria Bastone | AFP | Getty Images

Oct. 19, 1987. That was the day the Dow Jones industrial average dropped 508 points, or 22.6 percent, the biggest one-day decline in the history of the stock market.

To put this in perspective, a similar drop in the Dow today would be almost 5,000 points.

That's as much as the Dow has gained in the last 18 months, which has been one of the great market rallies of all time.

What was the fallout 30 years ago, and could it happen again?

There were many "causes" cited for the Crash of '87, including high valuations in the market (stocks had run up more than 40 percent that year), a too-strong dollar, and "portfolio insurance," which hedges a portfolio of stocks against the market risk by short selling stock index futures. Staying long the market while at the same time shorting futures limits upside, but was also supposed to protect against the downside.

Except it didn't. In a panic, futures and cash markets are linked. Selling in one begets selling in the other.

A presidential commission was convened to figure out what happened, and while the authors placed the fundamental blame on portfolio insurance and "reactive selling by institutions" (i.e. they panicked), the Brady Commission also noted the drop was greatly exacerbated by what were called faulty market mechanisms, as well as "system failures," and "intermarket failures." These are polite ways of saying that traders were deluged with buy and sell orders that the trading systems could not handle.

Art Cashin, who was running the floor that day for PaineWebber, said that the situation felt "unreal."

"Orders flowed in faster and faster and the tape ran later and later," he said. That caused information to lag, which created more panic.

The commission concluded that the market structure could not handle the selling volume: "Market makers possessed neither the resources nor the willingness to absorb the extraordinary volume of selling demand that materialized."

The commission recommended that systematic circuit breakers be implemented across all exchanges, which would halt trading when the Dow hit certain percentage declines. They were adopted in 1989 and are still with us. These system-wide circuit breakers were triggered only once — on Oct 27, 1997, during the "Asian flu" crisis.

But there were other consequences. The '87 crash accelerated the move toward electronic trading. The commission found that one of the main problems was the delay in trading caused by the pressure on trading systems that were not designed to handle such massive volumes. Tom Joyce, who was on the block trading desk at Merrill Lynch in 1987, told me "The Brady Commission catalyzed a deep review of the markets that ultimately pushed the move toward electronic trading." Electronic trading cut down the time to trade and increased available trading volume.

Could it happen again? Sure, the markets could have a big drop, and they have. The Dow dropped 1,000 points during the trading day in August 2015. But it's unlikely to happen due to an inability of the market to handle the order flow, which the commission found was a very big contributing factor to the drop.

Portfolio insurance? It's still around. Traders still go long stocks and short futures as a hedge. But it's not done in a vacuum. There's a much greater awareness of how interconnected the markets are today.

The bottom line: No one has repealed the laws of gravity. When a lot of people are looking to sell really fast, the markets will drop.

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