The Next Stock Market Crash Will Be Bigger Than 'Black Monday'
by Martin Hutchinson
the 25th anniversary of Black Monday. On October 19, 1987 the Dow
Jones Industrial Average fell 508 points, or a mind-numbing 22.6%.
How bad was
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.
or percentage terms it was the largest one-day drop ever beating
the 13.6% drop on the worst day of the 1929 crash.
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
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.
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.
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.
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
became very popular, so that by October 1987 tens of billions of
dollars were managed in this way.
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.
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.
All Over Again
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.
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.
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.
the exchanges have loss limits which cut in when the computers go
mad, limiting the losses in the market.
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.
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.
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.
with permission from Money
© 2012 Money