WSJ Review of “A First-Class Catastrophe”

Anatomy of a Stock-Market Crash

By Burton G. Malkiel
Sept. 18, 2017 6:48 p.m. ET

WSJ-LogoNew ‘trading toys’ no doubt played a role in Black Monday’s market collapse in 1987. But were there sound financial reasons as well? Burton G. Malkiel reviews ‘A First-Class Catastrophe’ by Diana B. Henriques.

On Monday, Oct. 19, 1987, the U.S. stock market fell by 22.6%—the biggest one-day decline in its history. In “A First-Class Catastrophe,” a chronicle of the Black Monday crash, Diana Henriques, a veteran financial journalist, presents a compelling account of the event itself and offers an analysis of its causes.

In addition to describing Black Monday’s frantic activity, Ms. Henriques presents a narrative history of the seven years preceding the crash. It is rich in interviews and archival research and personalized with vivid descriptions of the actors and conflicts involved. Ms. Henriques uses this history to trace the changes in market structure and portfolio management that, she believes, were responsible for the market collapse. Her writing is so skillful that even mathematical risk-mitigation techniques and arcane turf wars between regulatory agencies are infused with life.

First on Ms. Henriques’s list of changes is the institutionalization of financial markets. By the late 1980s, she notes, no longer were countless individual investors, each with different spending needs and income flows, participating in the stock market. Now a handful of large institutions were dominating trading, and these “titans and their trading toys,” as she puts it, were directing the course of markets, especially when they acted in unison.

The “toys” to which Ms. Henriques alludes include program trading, index arbitrage and, not least, ever more intricate futures contracts. Such contracts involve the obligation to purchase (or deliver) a commodity (or a financial instrument) at a particular price at some specific future time. In the late 1980s, financial futures were increasingly being used by index funds and by institutional investors hedging their portfolios. At the time, trading in the Chicago futures (and options) markets was the most rapidly growing part of the securities business and had begun to overshadow in importance the trading of actual securities in New York.

Meanwhile, the markets in Chicago and New York were being linked by the technique of index arbitrage. Suppose, for example, the value of the S&P 500 index based on New York trading prices was 2400 but the futures price in Chicago was 2350. An arbitrageur could profit by selling short the stocks in New York and buying the futures contract. The sale could be made quickly in a program trade—that is, by entering the trade directly into the markets’ computer systems. In this way, selling pressure that started in the futures market was rapidly transmitted to the cash markets.

The effect of such developments—dominant institutions and newly popular trading techniques—was varied. They made capital more productive, but they also, Ms. Henriques argues, made markets more subject to sudden shifts—and thus, she believes, more in need of centralized regulation. She singles out one other technique—portfolio insurance—for blame. Such insurance involves selling stock-index futures at the first sign of a market decline in order to protect against future losses. If the market declines still further, more sales are made. Portfolio insurance can have exacerbating effects, especially when it is adopted by more and more institutional investors. It is impossible to get out the door when everyone in the room is trying to exit at the same time.

Such was the background to the cascading collapse of stock prices on Oct. 19, 1987. On the day itself, the Dow Jones Industrial Average dropped 9% in the first 90 minutes of trading. Ms. Henriques argues that index arbitrageurs, instead of buying S&P 500 futures, “held back, waiting for even lower prices in Chicago. And by not buying, of course, they helped guarantee that prices in Chicago would continue to fall.” After a brief rally, the Dow “sank under wave after wave of sell orders from all kinds of professional investors.” By mid-afternoon, “the market was falling into history.”

After the crash, commissions were formed to examine the causes of the meltdown and offer recommendations. Ms. Henriques cites approvingly the Brady Commission Report, which emphasized the role played by the financial instruments and trading techniques she has described. The commission called for increased margin requirements, on the theory that, if investors had been required to put up more of their own money for securities or future contracts, the market would have been less volatile. It also called for putting financial markets under the scrutiny of a single regulator.

But the Brady Report should not be taken as holy writ. A Chicago Mercantile Exchange study, for example, concluded that the futures market was a net absorber of selling pressure and that increased margin requirements would have restricted buying and made the decline even worse. A single regulator, it was noted, might also limit financial innovation and the development of helpful hedging techniques.

Ms. Henriques dismisses the idea that there were rational causes—as opposed to structural or technical ones—for a dramatic revision of valuation levels on Black Monday. But such causes are worth considering. The market had rallied sharply during the preceding five years: Valuations were stretched. Price-earnings multiples were over 20 at the same time that interest rates were unusually high, having just risen to over 10%. In addition, Congress had threatened to impose a “merger tax” that would have made merger activity prohibitively expensive and could well have ended the merger boom that had inflated stock prices. What is more, James Baker, the Treasury secretary, had recently threatened to encourage a further fall in the price of the dollar, increasing risks for foreign investors and frightening domestic investors as well.

To be sure, portfolio-insurance trades magnified the decline on Black Monday. But markets all over the world declined just as sharply as the U.S. market, and they didn’t have similar futures markets. Moreover, markets remained below their 1987 summer peak for the next two years. It is unsupportable to claim that the institutional structure of the U.S. market and a lack of unified regulation were responsible for the crash.

Mr. Malkiel is the author of “A Random Walk Down Wall Street.”
Appeared in the September 19, 2017, print edition of The Wall Street Journal as ‘Anatomy Of a Crash.’

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