Capital Perspectives: Black Monday 30 years later.
This past Thursday marked the 30th anniversary of Black Monday when the Dow Jones industrial average plummeted 50 points to finish the day down 23 percent. While a few shrewd (or lucky) investors made fortunes that day, most others lost their shirts. To put the severity of event into context, an equivalent percentage drop today would shave 5,365 points off the Dow in a single session. What was to blame? The political and economic backdrop leading up to that dark day included: (1) Fear of war with Iran, (2) Concerns about the Fed increasing interest rates given inflationary pressures, (3) A weak dollar associated with deteriorating macroeconomic fundamentals and (4) The -year Treasury yield had increased from 7 percent to percent over the course of the year, making bonds relatively more attractive. But perhaps most importantly, stocks had gone on a multi-year bull run without a meaningful setback and valuations had simply become stretched. The price level of the S&P 500 exceeded 20x what was earned by constituent companies that year, an exceedingly high number in the context of the much higher interest rates of the day. The high valuation levels were at least in part due to excessive risk taking brought on by the promises of a security blanket called portfolio insurance. Portfolio insurance is the primary culprit for what made Black Monday worthy of its name. While slightly more complicated, portfolio insurance amounted to placing a stop loss order on a portfolio such that computers would dump stocks because shares had declined by a preset amount. Since portfolio insurance had become so widely adopted by institutional investors, lots of computers were programmed the same way, creating a vicious cycle that was accentuated by panicked selling by humans. The legacy of Black Monday is still apparent in modern financial markets. From a market structure standpoint, the prospect of single-day collapse is much reduced. Reason being, after Black Monday the New York Stock Exchange installed circuit breakers whereby after a 7-percent drop trading is suspended for 15 minutes, and in the event of a decline of 20 percent, trading ceases for the day. The most important legacy of Black Monday among financial historians though is that it introduced or unveiled a greater degree of moral hazard in financial markets than was previously understood. The term moral hazard describes instances where economic actors (i.e. individuals or institutions) do not have to wear the full weight of their losses. While the convulsion drew parallels with Black Tuesday of 1929, which ushered in the Great Depression, the Crash of 7 was not proceeded by a prolonged economic downturn. The actions of the new Fed chair, Alan Greenspan, in the wake of the event that amounted to committing to stabilizing markets and promising accommodative monetary policy likely helped prevent the financial market distress from infecting the real economy. However, the perception that a new monetary policy paradigm had emerged helped set the stage for an increased likelihood for speculative bubbles to emerge prospectively. This perception of a Greenspan Put aided the ensuing stock market recovery after Black Monday, which turned out to be the greatest bull market in American history. Of course, the bull run reached unsustainable heights and culminated in the bursting of the tech bubble at the turn of the century. Also, students of financial history oftentimes draw a straight line between the actions of the U.S. central bank in the wake of Black Monday and the excessive risk taking by our financial institutions that fueled another unsustainable increase, this time in housing prices, which eventually resulted in the Financial Crisis. Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com). This column has been prepared by an employee of Meliora Capital, LLC. This column is for information and illustrative purposes only. It is not, and should not be regarded as investment advice or as a recommendation regarding any security mentioned herein. Opinions expressed herein are current opinions as of the date appearing in this material only and are subject to change without notice. Reasonable parties may disagree about the opinions expressed herein. 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