Next Crash Will be Bigger than Black Monday

October 29th, 2012
in contributors

Money Morning Article of the Week

by Martin Hutchinson, Global Investing Strategist, Money Morning

Friday was the 25th anniversary of Black Monday. On October 19, 1987 the Dow Jones Industrial Average fell 508 points, or a mind-numbing 22.6%.

crash-stock-marketSMALLHow bad was it?...

Let's put it this way, if it happened today the Dow would drop 2,965 points on the session to finish at roughly 10,158. You can imagine the depression.  Now you know why they call it "Black Monday," even though it occurred in a sea of red.  In absolute or percentage terms it was the largest one-day drop ever-- beating the 13.6% drop on the worst day of the 1929 crash.

Follow up:

But then again, the 1929 crash was caused only by human beings. The 1987 event, on the other hand, was largely computer-driven. Of such is progress made!For British observers like me, Black Monday was memorable as being the first business day after the Great Storm, the first hurricane to hit the British Isles since 1703.

The relief at not having lost a third of the British Navy, which happened on the previous occasion, made Black Monday seem a minor hiccup. I actually bought some shares as the U.S. markets opened, and was delighted to see that they closed at a higher price than I paid!

There was also the satisfaction of hearing about a rather smug ex-colleague, who had received a large payout from the bank where we had worked (no such payout came my way, alas) and had invested it and margined 50% in the U.S. market.

Alas, blessed by Fortune though he was, he was awakened at 1:30 am London time by a margin call for $700,000. I always felt it was something of a fitting recompense for greed and creepiness to authority.

How the Market Crashed

Of course, those whose trading lives don't extend back to 1987 doubtless feel that it can't happen again.

Well, I have news for you....

The 1987 crash was mostly caused by a primitive computerized trading strategy called "portfolio insurance." The idea behind this was that investors could not lose too much money if they sold futures every time the market dipped, so that further dips would be matched on the short futures position.

This fallacy became very popular, so that by October 1987 tens of billions of dollars were managed in this way.

Needless to say, it didn't work. When the market started falling out of bed the computers started maniacally selling futures, which then traded at a discount to shares, causing arbitrageurs to sell shares to match the futures.

The result was an uncontrollable downward spiral, much more severe than had ever been caused by panic among merely human traders.

There was one saving grace: the computers of those days were very sluggish by modern standards, and the market makers were human, so the disaster proceeded at human speed, taking minutes or even an hour or so for each 100 point drop in the Dow.

Black Monday All Over Again

Needless to say, those limitations no longer apply.

There are very few human traders, and about 80% of trading volume in U.S. stocks is produced by computers trading with each other, within a time span of milliseconds.

Today, computers act as piranhas around large orders, front-running them and making it more difficult to trade in large size than it was 15 years ago. More dangerous, these high-frequency traders are able to place orders that disappear when they are hit, thus depriving the market of liquidity altogether.

That's how in the "flash crash" a couple of years ago stocks traded for $0.01 and $99,999.All this speed and sophistication makes the system much more dangerous.

Even when humans are standing by, and want to pull the plugs out of computers, they physically may not be able to do so before trillions of dollars have been traded and hundreds of billions lost. Knight Capital, an obscure brokerage, lost $390 million in under a minute when it switched on its new computerized trading system a few months ago.

Theoretically the exchanges have loss limits which cut in when the computers go mad, limiting the losses in the market.

In practice, if the selling pressure is great enough, these may simply make it impossible to reopen trading, causing the markets to seize up altogether. That would make all the stocks on the U.S. markets illiquid.

Needless to say, that would cause all the banks systems, no doubt also computer-driven, to send out margin calls to all their leveraged investors. With no liquidity, financial collapse would be more or less inevitable.

Machines have increased human capabilities in all kinds of areas. One of those areas is in causing stock market crashes.

In 1987, machines pushed the frontier of crash size from 13.6% to 22.6%. This time, they are much more capable - and could push the size of the crash frontier much, much further.


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