The danger of Black Monday becoming a mere data point
Failure to fully explain stock market crash of 1987 should be warning for investors
I don’t remember leaving our Cannon Street office on the evening of Black Monday, October 19, 1987. But I remember vividly where I was two hours later at 8.30pm. I was standing at the bar in Kettners, a fashionable Soho restaurant, drinking champagne at least partly to celebrate the profits made by Adam, Harding & Lueck, the company I had started that year with two partners.
We had been betting on stock markets around the world declining. The FTSE 100 had obligingly done exactly that the previous Friday, when City offices were half empty following the UK’s worst storm in living memory. That Monday, there had been further heavy falls in American stocks and we were again making money for our clients. The Dow Jones Industrial Index had just closed down 508 points that day — the biggest one-day fall in American stocks of all time.
I also remember vividly what happened 12 hours later. While I was in a meeting at our offices with a prospective client, bond and interest rate markets began rallying strongly. Over the course of the morning, all our glorious profits of the night before were wiped out. And then some. And then some more. By the end of the meeting we had lost 25 per cent of our funds. A 10 per cent gain on the month had been transformed into a 15 per cent loss.
Of course, we know now that the 1987 stock market crash elicited an immediate, “equal and opposite” reaction from Federal Reserve authorities. There is no clearer example of the reflexive dialectic between financial markets — though the rescue of LTCM 11 years later, and the global financial crisis a decade after that, provided partial reprises.
Price changes on those days in stocks and bonds were tens of standard deviations from the norm — or would be if return distributions were normal and standard deviation thereby a meaningful statistic.
Prices moved a lot and, as in the 2008 financial crisis, assumed relationships between markets collapsed, forcing the Fed into drastic intervention. Ultimately, the sharp decline in interest rates prevented further stock market falls and led, gradually, to an accelerating decline in the US dollar.
People generally seek fundamental explanations for dramatic events in financial markets. Bad US trade figures a few days before, comments from the Bundesbank: these were explanations offered. But the smoking gun lay with the “portfolio insurers”: algorithm-toting professors running trading strategies that overloaded the young S&P 500 futures market with selling.
In my 30-year career in the markets since, a move of this magnitude and duration in stocks has never been repeated. Since 2000 there have been two massive declines, but each has occurred over months or years and have been profitable for Winton and similar firms. The flash crash was dramatic, but over before we had a chance to react.
With the great growth of momentum trading in recent decades, I have sometimes worried about a repeat of the portfolio insurance phenomenon. Market liquidity has grown, but whether that would help in the event of short-term instability is uncertain. My fear of another 1987-type event is what has limited Winton’s willingness to use leverage.
Belief in the general framework of market efficiency was surprisingly unaffected by the events of October 1987. Were the efficient markets hypothesis really a hypothesis, that day’s events would have disproved it. Academic economists and practitioners somehow managed to pull the frayed threads together. To this day, many continue to believe that markets follow a random walk, with all the mathematical consequences that entails.
Today, more than $600bn is invested in so-called “smart beta” exchange traded funds — most in strategies that assume profitable returns will result, almost automatically, from exposing a portfolio to anything that can be defined as a “risk”.
Yet financial market history is characterised by discontinuities. With the passage of time, Black Monday and other major events fade from the collective memory of investors and become abstract data points — what academics somewhat benignly term “fat tails”. Real markets do not dance to a tidy mathematical tune. They change and evolve through time, and portfolio managers need skill and creativity to keep up.
David Harding is founder and chief executive of Winton Group