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18/10/2008 | Shades of Black Monday

Oxford Analytica Staff

For seasoned market participants, financial crises are actually quite common. The present panic may be a ‘once in a century’ event, other crises have equally washed away billions in wealth and challenged modern financial capitalism to its core.

 

One such crisis occurred on October 19 1987, more commonly known as Black Monday. The S&P 500 stock index alone lost roughly 20%, sending the efficiency of markets and human rationality into question.

Like the current crisis, the financial practices that precipitated Black Monday were innovative, and at the time hailed a new era of technological know-how capable exacting higher financial returns. Just like today, Black Monday was also precipitated by a rapid increase of asset prices -- outpacing earnings growth, sending price to earnings ratios to new heights. Stock market investment became increasingly commonplace among pension funds, as the latter moved away from fixed-income instruments to gain the perceived premium held in equities, due to changes in investment regulations. Naturally, the increased demand pushed prices up further. When increasingly dour economic data began to emerge just before the crisis, particularly the growing US trade deficit and the weakening of the dollar, such high asset prices suggested a bubble had been in the marking.

A major component in the sudden crash was the use of computerised trading systems. Technological advancements allowed traders to set programmatic trades, where computers would make rapid trades of large amounts of stocks at determined prices levels. As prices started to decline, the mathematical models interacted with the declines in such a way that drove prices down even further. This was exacerbated by the fact that the trading technology was not sophisticated enough to handle the huge orders that were coming in. Gathering correct price information became almost impossible in such a rapid environment. Given information greases the wheels of the market, the information deficit sent investors panicking. Market liquidity was further constrained in derivatives markets particularly as increased margin calls, some as high as ten times the normal daily amount, prevented many investors from entering into new contracts.

Although today’s crisis is much more severe, now and the likely long-term, the global financial system is not in completely uncharted territory. Like before, increasingly innovative risk management techniques, especially the use of sophisticated mathematical models to price risk, came up against a different reality than expected (or, speaking more plainly, up against reality) once markets turned south. The novel practice of packaging local mortgage debts and selling them off to global investors was thought to spread risk more effectively while providing higher rates of return. However, global finance quickly ignored the intricacies of local housing markets. Increasingly advanced technology and more powerful computing power facilitated these practices, just like it had done in the 1980s. 

The way finance is done will be rethought, with some practices surviving and others thrown out. Yet finance as a way of organising global and local economies will continue to persist. Recent government efforts to stem a complete financial meltdown have provided some needed confidence to markets, sending share prices up. Despite loud calls for a major rethink of finance, finance will likely survive just as it has done following other crises and, in a few decades’ time, another crisis will probably rear its head.

Oxford Analytica (Reino Unido)

 



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