San Francisco Financial Planner, San Francisco Financial Advisor

Lessons from Black Monday

On Monday, October 19, 1987, the Dow Jones Industrial Average* took a 508-point nosedive, falling 22.6% in a single day. The following Friday, at the end of a volatile week, “Wall Street Week” with Louis Rukeyser looked at what was behind the crash that came to be known as Black Monday—and what lasting lessons it might teach us.  (You can watch the entire October 23, 1987, "Wall Street Week" episode at the end of this article.)

Although a number of issues—rising interest rates, the trade deficit, budget problems and leadership worries—dominated economic discussions in the months preceding Black Monday, no one single event seemed to cause it.  The only major external developments over the weekend preceding the crash were a U.S. attack in the Persian Gulf and Treasury Secretary Jim Baker starting a public feud with monetary authorities in West Germany.

Still, the losses continued in the days after the crash, and the Dow closed the week ending October 23 down almost 300 points, at 1950.76.  Broader market measures also declined to levels last seen in 1986, with the S&P 500 Index* down 34.48% and the American Stock Exchange down 59.34%.

End of the Bull Market?

So, was the bull on the 1980’s dead, Rukeyser asked, or merely deeply gored?  The Dow was still up half of its bull-market gain, and at the close of trading on October 23, was higher than its level at the start of 1987.  Moreover, history showed that recoveries from market crashes were increasingly short.  For example, when the Dow plunged from a new high of 381.17 on September 3, 1929, to 198.69 on November 13, 1929 (a 48% drop), it took nearly a quarter of a century—until November 23, 1954—for it to regain the loss.  But when the Dow tumbled after the war, falling from 204.52 on August 13, 1946, to 163.12 on October 9, 1946 (a 20% drop), it regained the loss four years later.  And when the Dow fell from 723.53 March 15, 1962, to 535.75 on June 26, 1962 (a 26% drop), it regained the loss within a year.

Rukeyser, Black Boxes and a Multitude of Counselors

What was behind Black Monday, and would its recovery fall into this historical pattern? To help analyze the situation, Rukeyser brought three guests on his show: Steven G. Einhorn, Co-Chairman of the investment policy committee of Goldman, Sachs & Company; William A. Schreyer, chairman of the board of Merrill Lynch & Company; and John M. Templeton, founder and principal of The Templeton Funds.

One of the more popular theories about the cause of the crash was program trading, in which computers rapidly buy and sell stocks based on external inputs.  As computer technology became more widely available in the 1980’s, trading in this manner grew.  Many analysts accused program trading systems (known today as black boxes) of blindly selling stocks as the markets fell on Black Monday, thereby exacerbating what started as a simple decline.  But the international nature of the stock market crash made this theory questionable.  Program trading was used primarily in the United States, but the crash began in Hong Kong, spreading west through Europe before hitting the United States only after other markets had declined significantly.

The Economy and "The Advice"

Other common theories were economic.  For example, the United States, in an attempt to solidify the dollar and keep inflation low, had tightened monetary policy faster than European industrialized nations had.  One theory was that the subsequent drop in the dollar-backed Hong Kong stock exchange led to a crisis in investor confidence.

Debate about these issues, and other possible causes of Black Monday, continue today with no firm conclusions reached. But, Einhorn, Schreyer and Templeton—when asked what they thought was the single most important lesson to be learned from Black Monday—provided some investing insight that may still be relevant.

Einhorn explained that while the market has a tolerance for “inadvisable economic policies,” that same tolerance is not infinite. He felt that industrial countries must cooperate in terms of economic policy to avoid confrontation.

Templeton noted that human nature is such that there will be periods of enthusiasm and pessimism, bull markets and bear markets, but “if you don’t have borrowed money, you don’t have anything to worry about.”

Schreyer’s lesson was simple: “don’t panic”, In fact, he suggested that investors restructure their portfolios and use the crash as a buying opportunity.

Templeton echoed that suggestion, nothing that “we’re being offered a great opportunity—those who weren’t quick enough to get in on the ground floor when the bull market started in 1982 are being given an opportunity to get in on the ground floor of the next bull market.”

The next bull market wouldn’t happen for a while, though.  Ultimately, the markets recovered, from Black Monday, of course. The Dow ended 1987 with a positive return, opening at 1,897 and closing at 1,939.  But it took two years for the Dow to recoup all of its Black Monday losses and reach its 1987 closing high of 2,722.

The lesson for today’s investor may very well be to expect the unexpected, and plan for its arrival.  To counter market surprises, one must be financially and emotionally prepared for what can be elongated irrationalism.

*The Dow Jones Industrial Average is an index of 30 blue chip U.S. stocks.
*The S&P 500 is made up of 500 common stocks representing major U.S. industry sectors.

After the Crash, Part 1

After the Crash, Part 2

After the Crash, Part 3