Viewed on a long-term chart, the '87 crash is but a minor detour on the Dow's inexorable march to 14,000 and beyond. But the events of Oct. 19, 1987, had a major legacy, in terms of both the structure of the market itself and the psychology of market participants. Lesson No. 1 of the crash is that "so much of stock trading is driven by human emotion" rather than economic fundamentals, says Teddy Weisberg, president of Seaport Securities and a 40-year veteran of the New York Stock Exchange. "Day to day, it's human emotion that's driving the trading train,
and when greed turns to fear, it's a freight train." The veritable cattle cars full of sell orders on the day of the crash left the Dow down 508 points, or 22.6% -- the equivalent of about 3,100 points in today's terms. The extent of the damage and the floor's dysfunction amid then record-setting volume prompted the NYSE (now NYSE Euronext ( NYX)) to embark upon a modernization effort that continues to this day. In October 1987, trading was done much as it had been in the prior decades, by handwritten orders submitted via specialists. (To watch a video on what has changed, click here.) These orders were subsequently entered into computer programs that then calculated the prices for individual stocks and major stock proxies alike. In other words, real-time stock prices were unavailable, even for the most sophisticated investors.
Peter Costa, managing director of Eckhart & Co., recalls that in 1987, the "consolidated ticker" typically ran with a delay of 15 to 20 minutes. On both Black Monday and the preceding Friday, the ticker was running with a delay of almost three hours. "It was the sheer volume of order flow we were getting," Costa says. One legacy of the '87 crash is "the fact the NYSE and all equities markets increased their technological bandwidth to accommodate the amount of information flow, specifically on that day," he says. "Now with all the technological upgrades, we can handle 7-8-9-billion-share days without a blip." Well, blips certainly do still occur, such as the rapid-fire 400-point drop in the Dow last February due to a computer error in the calculation of the index. Because technology can't eliminate the influence of human emotions and introduced the concept of computer-driven or "fat-fingered" errors, it's more important than ever for investors to study and understand the market's "worst day, worst week, worst month, quarter and year," says Frank Holmes, CEO and chief investment officer of U.S. Global Investors ( GROW) in San Antonio, Texas. "Understanding probabilities and how you can manage that risk" is crucial to long-term success. Holmes recommends the books
Way of the Turtle by Curtis Faith and The Black Swan by Nassim Taleb to better understand probability-driven trading and the impact of outlier market events, which he notes have reoccurred since 1987 in different forms, including the 1998 Long Term Capital Management crisis, the bursting of the dot-com bubble and more recent upheaval in the mortgage-backed securities markets.
The specific lesson of Black Monday is that central bankers "took too long to open the window" and the resulting "liquidity crisis shut down markets worldwide," Holmes says. Hong Kong's market was closed for a week and Toronto's for a few days after the '87 crash, he recalls. "The message to central bankers with what's taking place in subprime is 'open the window, otherwise we'll shut down the world.'" The aggressive response by the European Central Bank and Federal Reserve to this summer's credit crunch suggests that central bankers are heeding the lessons of '87. The presumed wisdom of policymakers and built-in precautions such as
circuit breakers -- which call for trading halts and potential market closes if the Dow falls by 10%, 20% or 30% on an intraday basis and are a direct response to the '87 crash and a minor repeat in October 1989 -- help explain why most market players believe a repeat of Black Monday is nearly impossible. But not all agree. "Circuit breakers make a lot of sense in theory. If a circuit breaker gets triggered, it forces people to step back and catch their breath," says Weisberg. "One thing it can't deal with is the human emotion. Because all the reasons experts think it will never happen again only reinforce my feeling the chances of it happening again are better today then they were in 1987."