"1987 Black Monday" Replay: Reversal of group trading, liquidity shock, what happened next?

The "1987 version of Black Monday" was staged again yesterday, with a global financial market crash, filled with words like circuit breaker, bear market, and historical records.

The Nikkei 225 and TOPIX index both plummeted by over 12%, triggering circuit breakers multiple times during the session; Taiwan's stock market saw its largest drop since 1967, while South Korea experienced its biggest decline since 2008. The Dow Jones fell over a thousand points, matching the largest drop in two years with the S&P. Platforms like Futu and Fidelity issued warnings of trading malfunctions.

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

Back then, Asian stock markets plunged, with the Nikkei index falling by 14.9%, the Hang Seng index plummeting over 40%, and the New Zealand stock index even dropping by 60% at one point. The U.S. market also descended into chaos, with the Dow plunging by 22.6% in a single day, and the S&P 500 index dropping by 30%, wiping out around $1.71 trillion in global stock markets.

Apart from the similar alarming levels of decline, the triggers for the two crashes were also alike, with arbitrage trading and program trading experiencing a "major reversal." Drawing lessons from history, what will happen next? Will the Federal Reserve intervene again to "rescue the market"?

"1987 version of Black Monday"

Looking back at the trend of the U.S. stock market in 1987, on October 14, the U.S. government announced a larger-than-expected trade deficit, leading to a depreciation of the U.S. dollar and a downturn 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, intensifying the decline in U.S. stocks and setting the stage for the turmoil in the following week.

When the market opened on Monday, October 19, panic set in as sell orders far exceeded 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 of the S&P 500 component stocks had not opened for trading; The Wall Street Journal reported that out of the 30 Dow Jones component stocks, 11 were unable to open for trading.

At the same time, with significant arbitrage opportunities between stock index futures and stocks, a group of trading institutions engaged in arbitrage trading. As the stock market continued to plummet, a large number of hedging positions further shorted index contracts in the stock index futures market, which in turn continued to drive the index down.

At the close, the Dow Jones index 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:

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

Arbitrage and program trading unwinding trigger

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

At that time, the US stock market had been in a bull market since 1982, and people thought it was time for a correction. The current bull run in US tech stocks, fueled by the AI boom, has also left investors feeling uneasy.

Next is the reversal of group trading. In the stock market crash of 1987, "program trading" was considered one of the culprits. Trading programs in investment portfolios sold stocks, leading to a domino effect.

Part of the recent stock market plunge is due to the narrowing of the US-Japan interest rate differential, triggering a reversal in "arbitrage trading." The Bank of Japan unexpectedly raised interest rates last week, while the Fed signaled a rate cut after its meeting last week. The Fed's September rate cut was almost fully priced in, and the once popular "sell yen, buy dollars" arbitrage trade lost its appeal, prompting investors to exchange their dollar assets back to yen.

Meanwhile, the week before the crash in 1987 also saw the occurrence of "Triple Witching Day" - the simultaneous expiration of stock options, stock index futures, and stock index options contracts, leading to severe instability in the final few hours of trading on Friday and continuing into Monday.

Finally, the analysis attributes this significant decline to "collective hysteria," where investors' herd mentality exacerbates the downturn every time the market plunges.

Will the Fed intervene again to "rescue the market"?

Taking a lesson from history, what actions might the Fed take?

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

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

At the same time, then-Fed Chairman 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, regulatory authorities introduced circuit breakers for the first time to prevent market crashes caused by program trading. Trading would immediately halt in case of abnormal declines or rises in the stock market.

How will the sharp decline end?

Analysts believe that the worst-case scenario could be a repeat of 2008, but this seems unlikely. While some large US banks collapsed last year due to misjudgments on government bonds, banks now have much lower leverage ratios, and the banking system is less affected by liquidity crises as most risks are now borne by private credit. Massive losses are possible, and private funds may face difficulties, but it will take time and is unlikely to trigger a similar systemic crisisIdeally, the stock market's excessive volatility will gradually calm down like it did in 1987, without causing a larger scale of trouble. It is expected that this calming process will be slower than in 1987. The AI frenzy may lead to further stock price declines, even though NVIDIA's stock price has doubled this year despite a 30% drop from its peak in June. However, the market is closer to normal levels now, with the Nasdaq 100 index up only 6% year-to-date and the S&P index up less than 9%.

The father of the "bond vigilantes," Yardeni, believes:

The danger of a major market decline is that a crash could self-reinforce and evolve into credit tightening. It is conceivable that this arbitrage trade unwinding could evolve into some kind of financial crisis, leading to a recession.

However, he emphasizes that he personally does not predict that this outcome will ultimately materialize