On Oct. 19, 1987, the Dow Jones Industrial Average tanked 23% or 5,200 points in today's terms
It's been three decades since Black Monday, the most disastrous single day in U.S. stock market history, and investors should be forgiven for wondering if Wall Street learned any lessons from that cataclysmic day.
On Oct. 19, 1987 the Dow Jones Industrial Average DJIA, -0.06% tanked 508 points, a fall of nearly 23%, in a chaotic, daylong selling frenzy that ricocheted around the world. The S&P 500 SPX, -0.06% shed more than 20% of its value. At today's market heights, a percentage fall of that magnitude would knock more than 5,200 points off the DJIA.
The crash was blamed on a number of factors, but at heart, it was the growing complexity of the market that seemed to overwhelm participants and set the stage for the calamity. Computerized trading, then in its infancy, combined with new hedging strategies that used relatively newfangled stock-index futures contracts were all part of the picture.
Since then, financial markets have been transformed by the march of time and technology and regulatory change.
"It's a much, much more complex system than it was in 1987. That doesn't mean it's better or worse, but it is certainly infinitely more complex," said Nicholas Colas, co-founder of DataTrek Research.
Among the most profound changes, the stock market has become more fragmented.
In 1987, the New York Stock Exchange, along with the Nasdaq, ruled the roost. Now, the human specialists once at the center of trading have been all but displaced by algorithms and computers. Buying and selling equities takes place across a vast ecosystem made up of numerous exchanges, dozens of so-called dark pools, where trading occurs outside of the public eye, and several electronic communication networks, or ECNs.
"That should be healthy in that it allows for a lot more computational power and it's also less susceptible to having everything focused in one location and one market," Colas said, in an interview. "It doesn't always work that way but that's the idea."
Fragmentation is a relatively new development, ushered in by the Securities and Exchange Commission's Regulation National Market System, or Reg NMS, in 2007. Proponents argue the rule has driven down trading costs by boosting competition. But critics charge it has resulted in a much more disjointed market that favors speed above all and is ripe for trouble.
Thirty years ago, human specialists on the NYSE and Nasdaq market makers were criticized after being overwhelmed by an avalanche of orders and hobbled by a slow tape. But the rise of electronic markets, and high-frequency trading, hasn't dispelled concerns the market could suffer another structurally related meltdown.
In the current system, many market makers have no customer obligations, which can exacerbate down drafts, said Joseph Saluzzi, co-founder and co-head of trading at Themis Trading and a prominent critic of high-frequency trading.
Without those obligations, they're more likely to disappear when the situation turns volatile, Saluzzi said. In the 2010 "flash crash," when major indexes collapsed only to recover within minutes, the downturn was blamed in part on market makers contributing to the selling frenzy, driving prices of stocks precipitously lower, he said.
The chief worry is that the current market system has never faced a crisis scenario on par with Black Monday, Colas said. How it would perform is simply unknown.
"The markets now are less transparent than they were then. It was obvious you could get a handle on what was going on," said Charles Geisst, professor of economics and finance at Manhattan College and author of "Wall Street: A History."
"Now with the alternate trading platforms and everything else, it would be much more difficult to figure that type of phenomenon out," he said.
Also, there were no exchange-traded funds in 1987. Since their introduction in 1993, they now hold nearly $4.2 trillion in global assets, according to research firm ETFGI, and accounted for nearly a third of all U.S. trading in terms of value in 2016, according to Credit Suisse. ETFs are securities that track an index or other basket of stocks or securities, much like a mutual fund. But unlike a mutual fund, whose net asset value is calculated at the end of each day, ETFs trade like a stock. The popularity of low-cost, index-tracking ETFs has exploded as investors embrace passive investing.
Some investors fear that a sharp selloff could be accelerated as index-tracking ETFs attempt to keep up with a downturn. Colas said ETFs also present an unknown, but in a Friday note offered some reassurance.
He said during major market dislocations, mutual-fund managers have to sell to meet anticipated redemptions, but don't know exactly how much cash they will need since redemption orders can come any time until the market closes at 4 p.m. Eastern. That can lead them to over sell, he said, while ETFs, in contrast, go through a real-time creation/redemption process which means they only sell exactly what they need to meet demand.
Wall Street and regulators also instituted a circuit-breaking system for indexes and individual stocks that is designed to slow down a selloff by halting or even stopping trade as heavy losses mount. But while they could mitigate the pace of a decline, it isn't clear that they would be able to significantly ameliorate a 1987-style meltdown, market watchers said.
So, could Black Monday repeat? Critics charge that fragmentation and liquidity concerns resulting from market structure changes make an eventual rerun a near certainty.
"We don't know when that day is going to be, it could be tomorrow, or next year, or two or three years from now," Saluzzi said. "But when it happens, it's going to be really, really ugly."