I was at the center of the October 19, 1987 stock market crash, when the U.S. equity market dropped 20% in a single day. The second chapter of my book, A Demon of Our Own Design recounts my experiences during the 1987 Crash and provides an explanation of what went wrong.
The essence of the problem was a programmatic positive-feedback strategy, namely, the dynamic hedging program of portfolio insurance, coupled with the time disintermediation between the speed of the index futures market in Chicago and the more deliberate pace of those in the equity market in New York.
This is not so different structurally from what we have now with the time disintermediation between the ETFs and the underlying cash markets in the less liquid markets — which is not observed when we have two-way flow — coupled with various positive-feedback strategies such as volatility targeting and various flavors of what are essentially momentum strategies. Or other structural issues within the current financial system.
So, below is an edited version of Chapter 2 of A Demon of Our Own Design.
(If you have arrived here by going to my blog rather than to this post specifically, you need to click on the post to see the excerpt.)
Excerpts from A Demon of Our Own Design, Chapter 2: The Demons of ‘87
Richard Bookstaber
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Portfolio insurance was commercially developed by two Berkeley finance professors, Hayne Leland and Mark Rubinstein. With John O’Brien, their marketing partner, they founded a management company, LOR, in 1981 to sell their technique. Within a few years it was programmed for action in the computers of some of the largest investment firms in the world. At the start of each day LOR sent their portfolio manager clients hedging instructions based on their runs of the Black-Scholes model. The managers did the hedging themselves.
In practice, the equity manager initiated a hedge against his equity portfolio, usually using the S&P 500 futures contract as the hedging instrument. … As the portfolio increased in value and moved above the floor price, the hedge was reduced, allowing the portfolio to enjoy a greater fraction of the market gain. As the portfolio declined in value, the hedge was increased, so that finally, if the portfolio value fell well below the floor price, the portfolio was almost completely hedged. Thus the portfolio was hedged when it needed it, and was free to take market exposure when there was a buffer between its value and the floor value defined by the exercise price.
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Since the basic option technology for portfolio insurance was well known, other firms followed LOR into the market to provide this hedging advice. I spearheaded the effort at Morgan Stanley.
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This activity engulfed segments of the firm that rarely related to one another. I was in the Fixed Income Division marketing an equity product to investment banking clients and then managing the resulting programs as a fiduciary in Morgan Stanley Asset Management. I ran programs for some of the firm’s blue chip clients, including Chrysler, Ford, and Gillette. This strategy was considered to be at the leading edge of market innovation; rather than buying an existing security, portfolio insurance was ushering in the brave new world of creating synthetic instruments on the fly through dynamic trading strategies.
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The equity market was ripe for the promise of portfolio insurance, because there was much to insure. From 1982 to its pre-Crash peak in August 1987 the Dow Jones Industrial Average went on a bull run that nearly tripled the index. The U.S. economy cooperated providing five years of uninterrupted economic expansion. By 1987 the market was moving forward at an exponential rate; from the start of the year to late August the Dow rose more than 40 percent.
By mid-October, though, the promise of portfolio insurance began to look like a very good idea. From the close on October 16th, the market seemed like it came from a totally different world. The Dow had already fallen nearly 500 points from its August high of over 2700, washing away nearly half the year’s gains. And then decline became free fall. The week preceding the 19th, the market dropped 4% on two separate days: On Wednesday, October 14ththe Dow dropped by a one-day record 95 points, and on Friday the 16th a new record was set with a drop of more than 100 points.
On the trading floors at Morgan Stanley, equity trading turned into a spectator sport. Throughout the latter part of that week, fixed-income traders and salesmen filtered down the stairs from the 32nd floor to the equity trading floor, standing around to watch the frenetic scene. The equity markets benefited from the built-in structure of having listed exchanges for stocks, futures, and options, and usually were much calmer than the fixed income markets, where every bond the desk purchased had to be taken out to many clients to find a new home. The crowds watching this train wreck amplified the crisis mentality. This finally led Anson Beard, the head of the Equity Division for Morgan Stanley, to post signs declaring that “Unauthorized Personnel Loitering in the Trading Area are Subject to Immediate Dismissal.” That took care of the riffraff, but the firm’s Managing Directors still found their way to the floor.
And if they were on the floor on Monday, the 19th, they got an eyeful. The open of the futures market at 9:00 a.m. that day started a cascade of selling. A half hour later, the New York Stock Exchange opened to an apparently insatiable demand to sell stocks as the NYSE tried to keep pace with the selling of S&P futures in Chicago. The imbalance of buying and selling demand was so severe that many stocks did not even open, and the rapid decline in the price of the stocks that did, coming on the heels of the previous week, left most investors frozen in their tracks… By the end of the day the market had suffered its worst one-day percentage drop in history, down over 22 percent. The S&P futures fared even worse. The program trading that normally linked the futures’ intraday prices to the S&P cash market could not keep up with the selling demand in the futures pit, so the futures dropped even further – nearly 29 percent. Overnight the panic spread around the globe to other equity markets. In the 18-hour period after the New York market open, wealth equal several years worth of global GDP was wiped from the face of the earth.
