Worried About Another Black Monday?

30 years ago, the stock market “crashed” on a single day. It was called Black Monday. At the time, I was in high school. I put aside the newspaper from that day thinking it would be a major collectors item in years to come. It hasn’t, but not because it wasn’t a big event.

Black Monday was the name given to the biggest one day drop in the stock market. On October 19, 1987, the Dow Jones Industrial Average plunged 22.6% in one day.

Back then, the Dow was still everything. The NASDAQ was the stock market where also-ran stocks that couldn’t qualify for the NYSE traded. The S&P 500 was known to savvy investors, but your average American still didn’t know much about the stock market beyond what showed up in 45 seconds on the nightly newscast. In fact, many of them didn’t own any stocks, unless they had a 401k account at work. Online trading was still in the future, and discount brokers took orders on the telephone.

Unlike previous crashes, Black Monday did not start a panic. It did not lead to a depression. The drop was serious, and real. For the rest of 1987, the market traded basically sideways. Just like a market will meander up and down in a narrow, sideways, type rang in order to consolidate gains, in this case, it did so to consolidate losses. By 1989, however, the market was headed back up.

Could Black Monday Happen Today?

Regulators, and the stock market itself added some new “features” following the Black Monday crash. The most famous is the so-called circuit breaker that actually shuts down the markets for 15-minutes in the case of a 7% (and again at 13%) drop in the S&P 500 index. A drop of 20% halts trading for the day.

The idea is that such big moves are not driven by fundamentals and instead are the result of panic, or even errors in the system. If people have time to think, the theory goes, then such massive downfalls won’t happen. Whether or not this works has never really been tested since they were adjusted after the “Flash Crash” of 2010.

The problem with all of these measures is the same as always. They are specifically designed to stop what happened last time. Most complex systems like the stock market don’t repeat events in the same way. In other words, whatever causes the next big drop won’t be same as last time.

Do Stock Market Circuit Breakers Really Help

There are some analysts who worry that circuit breakers might make things worse. Consider this scenario. The market is down 6.8%. You are worried that the breakers will kick in leaving you holding positions. So, you sell now to beat the breakers. This becomes a self-fulfilling prophecy as sellers drive the market toward the breaker.

Once the breaker kicks in, everyone waits for the 15 minutes to pass. If the markets come back online and trading proceeds nice and orderly, then the breaker worked as intended, and everyone is happy. However, if the markets resume quick downward movements, then that nervousness about the second breaker gets even bigger driving prices down faster. When that comes back, folks worried about trading ending for the day and being trapped holding positions overnight, race each other to sell before the 20% – Trading Ended for the Day kicks in.

In other words, the breakers may actually cause the next “biggest one day” drop in the markets.

Of course, there is no way to predict the future, and even big one day crashes shouldn’t phase long-term investors. For those who panicked and sold following Black Monday, losses were locked in. For those that stayed invested in their diversified portfolios, they recovered in about a year.

As always, long-term investors are never served well by fear.

What’s Next?

Looking for something else to read? How about the Finance Gourmet Digit review.