"1987 Black Monday" Reenactment: Group Trading Reversal, Liquidity Shock, What Happened Next?

Author: Zhao Ying, Wall Street Watch

"1987 version of Black Monday" was replayed yesterday, with global financial markets experiencing a crash-like drop, filled with terms like circuit breaker, bear market, and historical records.

The Nikkei 225 and the TOPIX both plummeted over 12%, triggering circuit breakers multiple times during the session; Taiwan's stock market recorded its largest drop since 1967, while South Korea saw its biggest drop since 2008. The Dow Jones fell over a thousand points, and the S&P 500 recorded its largest drop in two years, with firms like Futu and Fidelity warning of trading failures.

The last time global markets experienced such a painful ordeal was during the stock market crash on October 19, 1987.

At that time, Asia-Pacific stock markets plunged, with the Nikkei index dropping 14.9%, the Hang Seng index crashing over 40%, and the New Zealand stock index even falling by 60% at one point. The U.S. market also fell into chaos, with the Dow dropping 22.6% in a single day and the S&P 500 plummeting 30%, resulting in approximately $1.71 trillion evaporating from global stock markets.

In addition to the similar shocking magnitude, the triggers for both crashes were also alike, with arbitrage trading and program trading experiencing a "reversal." Looking to history, what will happen next? Will the Federal Reserve step in again to "rescue the market"?

"1987 Version of Black Monday"

Looking back at the U.S. stock market performance in 1987, on October 14, the U.S. government announced a trade deficit larger than expected, leading to a depreciation of the dollar and a downward trend in the market.

On Friday, October 16, the U.S. House of Representatives proposed legislation to eliminate certain tax benefits related to financing mergers and acquisitions, exacerbating the decline in the stock market and laying the groundwork for the turmoil that followed in the next week;

On Monday, October 19, as the market opened, people panicked to see that sell orders far outnumbered buy orders. Due to the significant disparity, many market makers did not even provide quotes in the first hour.

The U.S. SEC later pointed out that by 10:00, 95 S&P 500 component stocks had not yet opened; The Wall Street Journal noted that 11 of the 30 Dow Jones component stocks could not be traded.

Meanwhile, as a significant arbitrage opportunity emerged between stock index futures and stocks, a number of trading institutions engaged in arbitrage trading. As the stock market continued to plunge, a large number of hedging positions further shorted index contracts in the futures market, which in turn continued to drive the index down.

By the close, the Dow Jones index had plummeted by 22.76%, marking the largest drop since 1929.

Before the market opened on Tuesday, October 20, the Federal Reserve issued a brief statement and announced "emergency rate cuts of 50 basis points + quantitative easing" to rescue the market:

The Federal Reserve today reaffirms its role as the nation's central bank and confirms its willingness to act as a source of liquidity to support the economy and the financial system.

The market stabilized on the same day the Federal Reserve made its statement, with U.S. stocks continuing to decline in the morning session. Trading was suspended at the Chicago Board Options Exchange and the Commodity Exchange at noon, but resumed in the afternoon, followed by a rebound.

On October 21, the market began to recover some of its losses.

Arbitrage and Program Trading Liquidation Trigger

Similar to 1987, the "Black Monday" of 2024 was also triggered by a perfect storm.

At that time, the U.S. stock market had been in a bull market since 1982, and people believed it was time for a correction. Now, the AI boom has pushed this wave of tech stocks higher, leaving investors feeling "cold as a cicada in winter."

Secondly, the reversal of collective trading, during the 1987 stock market crash, "program trading" was considered one of the culprits, as trading algorithms sold stocks, creating a domino effect.

The recent stock market crash partly stemmed from the narrowing of the U.S.-Japan interest rate differential, leading to a reversal of "arbitrage trading." The Bank of Japan unexpectedly raised interest rates last week, while the Federal Reserve signaled a rate cut after its meeting. The September rate cut by the Fed was almost fully priced in, and the previously popular "sell yen, buy dollars" arbitrage trading lost its appeal, prompting investors to exchange their dollar assets back for yen.

At the same time, the Friday before the 1987 crash also experienced a "triple witching day"—the simultaneous expiration of stock options, stock index futures, and stock index options contracts, which led to severe instability in the last few hours of trading on Friday and extended the turmoil into Monday.

Finally, analysts attributed this significant drop to "mass hysteria," as investor herd mentality tends to exacerbate declines during market downturns.

Will the Federal Reserve Step In Again to "Rescue the Market"?

Looking to history, what actions will the Federal Reserve take?

In response to the 1987 market crash, the U.S. implemented "emergency rate cuts," established circuit breakers, and provided liquidity to rescue the market.

To mitigate the decline in financial markets and prevent spillover effects on the real economy, the Federal Reserve quickly took action to provide liquidity to the financial system, injecting tens of billions of dollars into the economy through quantitative easing policies.

At the same time, then-Federal Reserve Chairman Alan Greenspan announced an "emergency rate cut of 50 basis points," lowering the federal funds rate from over 7.5% on Monday to around 7% on Tuesday.

Additionally, regulators introduced circuit breakers for the first time to prevent market crashes caused by program trading. Trading would be halted immediately in the event of abnormal declines or increases in the stock market.

How Will the Major Drop End?

Analysts believe the worst-case scenario could be a repeat of 2008, but this seems unlikely. Although some large U.S. banks collapsed last year due to missteps in betting on government bonds, the leverage of banks is much lower than before, and the banking system is less affected by liquidity crises since private credit has taken on much of the risk previously borne by banks. Huge losses are possible, and private funds may also face difficulties, but this will take time and is unlikely to trigger the same systemic crisis.

The ideal scenario is that excessive volatility in the stock market will gradually subside, similar to 1987, without causing broader troubles, and this calming process is expected to be slower than in 1987. The AI frenzy may lead to further declines in stock prices; even after a 30% drop from June's peak, Nvidia's stock price has still doubled this year. However, the market is now closer to normal levels, with the Nasdaq 100 index up only 6% year-to-date and the S&P index up less than 9%.

Yardeni, the father of the "bond vigilante," believes:

The danger of a market crash lies in the possibility that the plunge could become self-reinforcing and evolve into a credit crunch. It is conceivable that this liquidation of arbitrage trading could turn into some form of financial crisis, leading to a recession.

However, he emphasized that he personally predicts that such an outcome will not ultimately materialize.