In October of 1987 the stock market was booming and traders were raking in money hand over fist. But in the blink of an eye, the Dow fell over 22%, or 508 points. The events that followed would lead to new financial regulation, technology and precautions that would look to stop such bleeding in the stock market.
But to many in the industry, the events of the 1987 stock market crash -- epitomized by the infamous moniker Black Monday -- weren't just a computer glitch or a demonstration of a lack of computer power, they were a convolution of factors. A combination of nascent computing technology, an overvalued market and an overzealous and over-bullish trading sentiment, according to experts, remain the main factors of the '87 crash.
As part of our recent "Crash of 87 -- TheStreet Special Report" package, TheStreet spoke with a number of experts who say that it will also be another storm of things that causes the next stock market crash, a combination of factors that could soon present themselves.
"Another downturn is imminent," said David Yoe Williams, who was a young trader in 1987 and is now a principal at investment firm Strategic Gold. "It's happening."
Overall investor sentiment seems to be at an all time high as the markets continue to set new records just about everyday. Still, questions remain about the role and policies of the Federal Reserve and it's unclear as to whether or not the group will need to step in once again as it did in 2008 after the start of the Great Recession. At the same time, new technology such as artificial intelligence is permeating the trading floors, adding another layer of potential uncertainty to the markets despite much of this technology being designed to help traders.
Has Wall Street Learned These Lessons From the 1987 Black Monday Crash?
Markets Getting Ahead of Themselves
In 1987, most managers and traders agreed the market was drastically overvalued. But the bull market was strong and stocks were climbing. Sounds familiar, no?
Investors were living high on the hog until, suddenly, they weren't. Then came an enormous shift in investor sentiment.
They began to sell, "while they still could," the week ahead of Black Monday once they realized just how high valuations had climbed, said Williams.
While 1987 was a "booming year for equities" much like 2017, there were market "anomalies," Marc Faber, editor of The Gloom, Boom & Doom Report, said.
"By the summer of 1987, stocks were drastically overbought. That's not the case today," Faber said.
But drawing similarities is the most accurate means of predicting when the market will change course. According to Scott Nations, president and chief investment officer of NationsShares and author of "A History of the United States in Five Crashes," each market downturn has come after a distinct pattern of events that was "astonishingly similar" to the last.
They all start with a market that has "really gotten ahead of itself," Nations said. Next comes a "new, novel, financial contraption that everyone thinks is the best in the world." Finally, there must be some sort of catalyst, which, for the most part, are "very rare events."
Mark Zandi, chief economist at Moody's Analytics, said the market must be highly valued and vulnerable to a shift in investor expectation ahead of a crash.
That's a move for which some could argue today's market is ripe. "I don't think [today's] market is speculative, but there's a lot of optimism built into this market," Zandi said.
Fed Policy Needs to Adapt
The question to ask moving forward is whether the Fed will be able to pour money into financial systems to keep them from tanking, as the bank has before.
"Are they going to be able to stop it? Or will it turn into Venezuela or Argentina?" Williams asked.
Williams pointed to Japan, too, as a cautionary tale in relying on central banks too heavily.
"The Japanese economy was the envy of the world," said Williams, the trader, of the 1980s. But when the Nikkei fell from highs near 39,000 points, there wasn't much regulators could do to stop the plunge. The Nikkei remains only about half what it once was, even as Japan is the third-largest economy in the world.
"At some point in time, [injecting liquidity] just doesn't work," Williams said.
Under Chairwoman Janet Yellen, the Fed has been very asset-dependent. When the market moves higher, the Fed is more inclined to steadily raise rates. When the market moves lower, they're more likely to refrain from a hike.
But a disconnect between the Fed and investors could topple markets, Zandi said. That rings true today especially, as the Fed plans for gradual rate hikes throughout the coming years while the market has priced in fewer hikes that would top out around 2%, Zandi said.
"That adjustment is going to be very messy," Zandi said, and could be "fodder" for a market crash.
After the "messy" adjustment begins to take hold, "big pools of liquidity" could send the market into a tailspin. Because institutional investors using programmatic trading represent the bulk of the market's liquidity, any trouble they have adjusting their expectations to the Fed's actions could be magnified. If they can't adjust at all, market liquidity could dry up fast.
New Technology, New Mistakes
"We're fooling ourselves if we think we understand how artificial intelligence and finance will operate," Nations said. With AI and machine learning, there's no way to "hit a big red button to make it all stop."
"Humans are unique because we've been wired to constantly assimilate information and respond," Nations said. He added that we're able to think non-linear: "sometimes the best way to get your sell order filled is to shut up for 30 seconds," Nations noted.
But it's unclear if algorithmic trading can make the same "non-logical leap." We don't yet know how creative technology can get.
New technology in 1987 was "supposed to create an environment that significantly reduced risks," Williams said. "But those systems that were in place to limit risk didn't do that."
Even so, "We will not make the same mistakes again," Nations said. "We will make our own brand new mistakes."
That's due in part to the circuit breakers implemented following Black Monday. That version of the big red buttons to which Nations referred were to halt trading when a certain percentage price decline occurred.
But those quantitative measures may not serve their purpose quickly enough to stop technology that is growing rapidly more intelligent today.
"I think technology generally improves the functioning of markets ... It allows for more and better information and reduces transaction costs," Zandi said. "Having said this, there are potential downsides, including greater cyber-security risks, higher odds for flash crashes and complicating things for regulators working to ensure markets are functioning well."
In order to create a system that could stop an AI-induced crash, the Fed needs to "figure out the plumbing" behind the technology, Zandi said. The bank does a good job of understanding cause and effect post-mortem, but "it could be too late" in the case of a quick-moving programmatic trade.
"The more machines take over, the more things move. And fast," Zandi said. "AI could exacerbate potential risk."
"Right now the worst most computers can do is frustrate us," Nations said. "Imagine the next step."
The "Crash of '87 -- TheStreet Special Report" is a series of stories, videos, graphics and other multimedia elements that look at the stock market crash of 1987, also known as Black Monday. TheStreet examines the cause of the crash, reveals some of the hottest stories of the day, and discovers what could cause a similar crash in the future. How can we prevent another Black Monday? Read more about the Crash of '87.
Originally published Oct. 19.