🚦 Black Monday (1987): The panic that shook global markets in a single day
**4/52** Learn from History (Macro Mistakes)
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🚦 This is part of a 52-week series on Macro Mistakes - Designed for those who want to learn from history.
I share lessons from the biggest macroeconomic mistakes made by investors, companies, and countries, helping you avoid similar pitfalls and capitalize on future opportunities. Feel free to catch up on previous emails here if you'd like to start from the beginning!
Dear all,
As we continue our journey through "Macro Mistakes," we arrive at one of the most shocking and sudden market crashes in history: Black Monday, which took place on October 19, 1987.
On that fateful day, global stock markets plummeted, and in just a few hours, over $500 billion in market value vanished.
The Dow Jones Industrial Average fell by an astonishing 22.6%, marking the largest single-day percentage decline in the index's history.
But why did it happen, and could it have been avoided?
The answer, as always, lies in understanding the macro forces at play.
✍ The Story
The lead-up to Black Monday was characterized by a sense of exuberance in the markets.
Throughout 1986 and early 1987, stock prices had surged, driven by a strong economy, corporate profits, and a growing appetite for risk.
By the summer of 1987, the Dow had gained 44% in less than seven months, raising concerns that the market was overvalued.
In hindsight, there were several macro signals that should have warned investors that trouble was brewing:
· Rising interest rates: In 1987, the Federal Reserve raised interest rates multiple times to combat inflation, pushing the cost of borrowing higher. As interest rates rose, the attractiveness of stocks diminished compared to safer investments like bonds.
· Trade deficits: The U.S. was running large trade deficits, particularly with Japan and Europe. These deficits were seen as unsustainable and put pressure on the U.S. dollar, which was weakening against other currencies.
· Inflation fears: Inflation was slowly creeping back into the economy, prompting the Fed to adopt a tighter monetary policy. Higher inflation and rising rates created a macro backdrop of growing uncertainty.
Despite these warning signs, investors continued to pile into stocks, ignoring the broader macroeconomic picture.
❌🚫 The Macro Mistake
So what exactly triggered the crash?
While there isn’t a single cause, many believe that the market was highly vulnerable to a sudden shock due to program trading - a computerized trading strategy that involved large-scale selling of stocks once prices dropped by a certain percentage.
But beneath the surface, the real issue was a failure to account for macro risks:
Monetary tightening: The Fed’s decision to raise rates was aimed at controlling inflation, but it also made borrowing more expensive and tightened liquidity. This reduced the availability of credit, which is a key driver of market expansion. Investors failed to adjust their strategies to account for the risk of higher interest rates.
Valuation bubble: The price-to-earnings ratio (P/E) of stocks had reached unusually high levels in 1987. This is a classic sign of overvaluation, and yet investors were more focused on short-term gains than on the long-term sustainability of their investments. When market sentiment shifted, there was no macroeconomic cushion to soften the blow.
Global interconnectedness: Black Monday wasn’t just a U.S. phenomenon - it affected markets around the world. The crash spread rapidly to other major financial centers, including London, Tokyo, and Hong Kong. This highlights how macro trends - like monetary policy and trade imbalances - can have global repercussions, especially when markets are as interconnected as they were in 1987.
The Lesson
The events of Black Monday remind us of how quickly markets can turn when macroeconomic conditions shift.
What appeared to be a thriving bull market in 1987 was, in fact, fragile and vulnerable to external shocks.
Here are a few key macro lessons we can take away:
Watch for rising interest rates: Central bank policy plays a critical role in determining market direction. When interest rates are rising, it’s a signal that borrowing costs are increasing and liquidity may become constrained. As macro investors, we must adjust our portfolios accordingly - reducing exposure to highly leveraged assets and focusing on sectors that benefit from a tightening cycle, such as financials or consumer staples.
Valuation matters: Even during bull markets, it’s essential to pay attention to valuation metrics. High P/E ratios are a red flag that the market may be overextended. In 1987, many stocks were trading at unsustainably high valuations, and when the crash came, those valuations corrected violently.
Global risks require a global view: The interconnected nature of global markets means that events in one region can quickly affect others. In 1987, the U.S. trade deficit and the weakening dollar had ripple effects on international markets, contributing to the global scope of the crash. Keeping an eye on macro indicators - like currency movements and trade balances - helps us anticipate where vulnerabilities might arise.
While Black Monday was a terrifying day for investors, the immediate economic fallout was less severe than many expected.
Unlike the 2008 financial crisis, the underlying economy in 1987 was relatively strong.
However, the psychological impact on investors was profound, and it took months for the market to regain its footing.
The Federal Reserve, led by Alan Greenspan, acted quickly to inject liquidity into the financial system, ensuring that banks and other institutions had the cash they needed to function.
This quick response helped stabilize markets and prevent the crash from causing a deeper recession.
However, the crash did lead to changes in how markets operated.
Circuit breakers - mechanisms that temporarily halt trading during large market declines - were introduced to prevent another sudden collapse driven by program trading.
This is a perfect example of how macro events often lead to lasting structural changes in the financial system.
🔒 Macro Bonus
For those with a macro perspective, Black Monday was not entirely unpredictable.
The warning signs were there - rising interest rates, overvalued stocks, and trade imbalances.
Investors who recognized these risks could have taken steps to protect themselves, such as moving into cash or hedging their positions.
Additionally, some savvy investors saw Black Monday as an opportunity.
With stock prices plummeting, those who remained calm and kept their focus on long-term fundamentals were able to buy high-quality stocks at bargain prices.
Once again, we see the importance of understanding the broader macroeconomic environment - it allows us to stay one step ahead and turn crises into opportunities.
The lesson of Black Monday is clear: macro risks are always present, even in the most optimistic of markets.
By paying attention to key indicators - like interest rates, valuations, and global economic trends - we can avoid being blindsided by sudden market shifts.
Next week, we’ll examine a different type of macro mistake: The 1973 Oil Crisis and how it reshaped global economies. This event offers valuable insights into how geopolitical factors can have massive economic consequences.
Alessandro
Founder of Macro Mornings
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