"1987 Black Monday" Reenactment: Reversal of Collective Trading, Impact of Liquidity, What Happened Next?

Original author: Zhao Ying, Wall Street News

“Black Monday 1987” was staged again yesterday, and global financial markets experienced a big dump, with words like circuit breaker, Bear Market, and historical records everywhere.

Nikkei 225 and TOPIX both experienced a big dump of over 12%, triggering circuit breakers multiple times during the trading session; Taiwan’s stock market saw its largest drop since 1967, while South Korea experienced its biggest drop since 2008. The Dow Jones Industrial Average dropped over a thousand points, matching the largest drop in two years with the S&P, and platforms like Futu and Fidelity have issued warnings about trading malfunctions.

The last time the global market experienced such a painful baptism was the stock market crash on October 19, 1987.

At that time, Asia-Pacific stock markets plummeted, with the Nikkei index plummeting by 14.9%, the Hang Seng Index taking a nosedive by more than 40%, and the New Zealand stock index even plummeting by 60% at one point. The US market also fell into chaos, with the Dow Jones Industrial Average plunging 22.6% intraday, and the S&P 500 Index plummeting 30%. About $17.1 trillion of global stock markets were wiped out.

Apart from being equally shocking, the triggers for the two big dumps are also similar: a big reversal in arbitrage and algorithmic trading. Taking a lesson from history, what will happen next? Will the Federal Reserve intervene again to “save the market”?

“Black Monday” 1987 version

Looking back at the performance of the US stock market in 1987, on October 14th, the US government announced a larger trade deficit than expected, and the US dollar depreciated accordingly, causing the market to decline.

On Friday, October 16, the U.S. House of Representatives proposed legislation to eliminate certain tax breaks related to financing and mergers, leading to a further decline in U.S. stocks and setting the stage for volatility in the coming week;

On Monday, October 19th, when the market opened, people panicked as they saw a much larger number of sell orders than buy orders. Due to the significant difference, many market makers even did not provide quotes in the first hour.

The U.S. SEC later pointed out that at 10:00, 95 of the S&P 500 components were still unopened; The Wall Street Journal pointed out that 11 of the 30 Dow Jones components were unable to open for trading.

At the same time, as there is a large Arbitrage space between stock index futures and stocks, a group of trading institutions have carried out Arbitrage trading, and with the stock market continuing to Take a Nosedive, a large number of trap holders further Short index contracts in the stock index futures market, which in turn continues to drive the stock index to Take a Nosedive.

At the close, the Dow Jones Industrial Average experienced a big dump, falling by 22.76%, creating the largest decline since 1929.

On Tuesday, October 20th, before the opening, the Federal Reserve issued a brief statement and announced an ‘emergency rate cut of 50 basis points + quantitative easing’ to rescue the market:

The Federal Reserve today reaffirmed its role as the central bank of the country, confirming its willingness to serve as a source of Liquidity to support the economy and the financial system.

The market also stabilized on the day the Fed made its statement, with US stocks continuing to fall in early trading. The Chicago Options exchange and commodity exchange suspended trading at noon, resumed trading in the afternoon, and then rebounded somewhat.

On October 21, the market began to recover some of the losses.

Arbitrage, Programmed Trading Close Position Detonates

Similar to 1987, the ‘Black Monday’ in 2024 was also triggered by a perfect storm.

The US stock market was in a bull market since 1982 at that time, and people thought it was time for an adjustment, but now the AI boom has pushed this wave of US technology stocks to rise, making investors ‘chilled and unable to speak’.

Then there was a reversal of group trading. In the 1987 stock market crash, ‘program trading’ was considered one of the main culprits, as the trading programs of investment portfolios dumped stocks, leading to a domino effect.

But the recent big dump in the stock market is partly due to the narrowing of the US-Japan interest rate differential, which triggered a reversal in Arbitrage trading. The unexpected rate hike by the Central Bank of Japan last week, coupled with the signal of a rate cut released by the Fed after the meeting last week, has almost fully priced in a rate cut by the Fed in September. The once popular ‘sell yen, buy dollars’ Arbitrage trade is no longer attractive, and investors are beginning to convert their dollar assets back into yen.

Meanwhile, the Friday before the 1987 crash also saw a ‘triple witching hour’ - the simultaneous expiration of stock options, stock index futures, and stock index options contracts, leading to significant instability in the final few hours of Friday trading and carrying over into Monday.

Finally, the analysis attributes this big fall to ‘collective hysteria’. Every time there is a big dump in the market, investors’ herd mentality will intensify the fall.

Will the Federal Reserve intervene again to “rescue the market”?

Taking history as a mirror, what action will the Fed take?

In response to the market crash in 1987, the United States “cut interest rates urgently”, set up a circuit breaker mechanism, and provided Liquidity to rescue the market.

In order to mitigate the market downturn and prevent spillover effects on the real economy, the Federal Reserve took swift action to provide Liquidity to the financial system, injecting billions of dollars into the economy through quantitative easing policies.

At the same time, then Federal Reserve Chairman Greenspan announced an ‘emergency 50 basis point interest rate cut,’ reducing the federal funds Intrerest Rate from over 7.5% on Monday to around 7% on Tuesday.

In addition, regulatory authorities have introduced a circuit breaker mechanism for the first time to prevent market crashes caused by algorithmic trading. Once there is a significant drop in the stock market or a pump situation, trading will be halted immediately.

How will the big drop end?

Analysts believe the worst-case scenario could be a repeat of 2008, but this seems unlikely to occur. Although some large US banks collapsed last year due to misjudgments on government bonds, the banks’ leverage ratio is much lower than before, and the impact of the Liquidity crisis on the banking system is also smaller due to private credit bearing most of the past risks. Massive losses are possible, and private funds may also be in trouble, but this will take time and will not trigger the same systemic crisis.

The ideal scenario is that the stock market’s excessive volatility will gradually ease as it did in 1987, without causing larger-scale trouble. It is anticipated that this easing process will be slower than in 1987. The AI frenzy may lead to further stock price declines, even though NVIDIA’s stock price has doubled this year despite a 30% drop from its peak in June. However, the market is now closer to normal levels, with the NASDAQ 100 index only up 6% year-to-date and the S&P index up less than 9%.

The father of ‘Bond Vigilantes’, Yardeni, believes:

The danger of big dump in the market is that it may self-reinforce and evolve into credit tightening. It is conceivable that this kind of Arbitrage trading may evolve into some financial crisis, and then lead to a recession Close Position.

However, he emphasized that he personally does not predict that this result will ultimately be produced.

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