Markets & Finance

Flashback: How the Bull Crashed Into Reality


A five-year, $2 trillion surge has stopped—and the search is on for ways to curb volatility

Editor's Note: Here's a look at the issues that investors and market pros faced at the time of the Oct. 19, 1987, stock market crash. The following is the text of the cover story that was published in the Nov. 5, 1987, print edition of BusinessWeek magazine.

Forget trying to explain Bloody Monday. Don't bother forecasting the days ahead from the chart books. There are no precedents. Black Friday, 1929? On Oct. 19, 1987, the Dow Jones industrial average fell nearly twice as far. Precious few stocks gained, just a handful of gold issues. Stunned, market pro Laszlo Birinyi of Salomon Brothers sighed: "We've escaped all the historical parameters."

With the escape from history came the end of an era. The 5-year-old bull market had enriched Americans by almost $2 trillion. It turned obscure corporate takeover artists into celebrities while making some investment bankers crooks and greenhorn MBAs millionaires. The bull market gave birth to program trading and led to the most massive restructuring of U.S. industry in decades.

When the market collapsed on Oct. 19 the cataclysm was mind-numbing. Crowds poured into local brokerage offices, fistfights erupted in trading pits, mutual fund investors jammed the telephone lines to their fund managers. Panic selling drove prices down to crazy levels, distorting values beyond recognition. Take CBS: From its previous close of 195, it plunged to 150. "That's like buying the company for its cash value and getting the whole network for free," marvels Harvey P. Eisen, Integrated Asset Management's president. "Deal stocks," those of companies involved in takeovers or recapitalizations, took the biggest hits as arbitrageurs dumped them to meet margin calls.

PURE FEAR

On its charge upward, the bull market had set new records every few days. On the way down, the Dow took giant steps, almost 10 points at each flicker of the quote screens. The 30-stock average lost 508 points, 23% of its value, on volume of 604.3 million shares in 6.5 hours of pure fear. The previous share volume record was what now seems a measly 338 million, set the prior trading day, Oct. 16. Salomon estimates that $4.46 billion in cash fled the market in Oct. 19's free fall. All this moved Securities & Exchange Commission Chairman David Ruder to order an immediate review of the market's reversal. The goal: to find ways to dampen volatility.

Healing has already begun. The Dow recouped 102 points, or 5.9%, on Oct. 20, and 187 points—10.2%—on Oct. 21. The gains heartened many who had feared that Monday's crash would trigger an avalanche of selling from investors having to meet margin calls and from mutual fund managers raising cash to redeem shares. But the bargain hunters, both professional and individual, could not resist the blue chips.

IBM, which finished Black Monday at 104, down 72 from its high just two months earlier, seemed to scream: Steal Me! "People whom I haven't heard from in years are coming out of the woodwork to buy stocks," said Minneapolis stockbroker David Ginter. "Never before have they bought blue chips. Now they're getting incredible buys." They were hunting dividends, too. General Motors fell to 50, turning the $5 payout into a juicy 10% yield. Buyers jumped for it. By Oct. 21 it hit 62.

After the crash, among the biggest buyers were dozens of companies repurchasing their own shares on the cheap. Among them: USX, Citicorp, Pacific Telesis, Honeywell, United Technologies, and McGraw-Hill, publisher of BusinessWeek. Salomon estimated that buybacks of a collective 262 million shares on Oct. 19 and 20 were worth about $9.2 billion. "It should give people courage to hang on," says William D. Witter, a New York money manager. "Don't ask Wall Street what the company's worth, ask the companies." Ironically, the Oct. 20 rise—as high as 200 points in the early afternoon—was the Dow's biggest one-day advance. That record took a fall the very next day.

But many individual investors found little solace. Smaller issues, which suffered only half the Dow's loss on Oct. 19, got whacked again the next day. The NASDAQ Composite lost 9% after dropping 11.5% on Bloody Monday. The Amex Market Index sank 8.6% after Monday's 12.7% rout. They recovered somewhat on Oct. 21.

The debacle also severely tested the global financial system's limits. To soothe the panic and prevent a spate of brokerage house failures, Federal Reserve Board Chairman Alan Greenspan quickly pumped so much money into the financial system that three-month Treasury bill yields dropped about 0.75 percentage points. For a fleeting moment, the T-bill yielded less than 5%. The government bond market, which had pushed yields as high as 10.4% on Oct. 19, staged a spectacular turnaround. After stocks crashed, the Fed bought bonds, and unnerved investors made a swift flight to quality. Yields on 30-year Treasuries fell to 9.4% the next day. Metals, usually another safe haven in stormy markets, this time fell as many traders liquidated holdings to raise cash.

The crash's intensity renewed criticism of program trading. Such trading, in which millions of dollars worth of stocks are traded in tandem with stock-index futures, was controversial even as it fueled the market's five-year climb. John J. Phelan Jr., chairman of the New York Stock Exchange, estimated that program traders accounted for 20% of the volume on Bloody Monday and surely exacerbated what he called a "financial meltdown." The next morning the New York Stock Exchange tried to dissuade member firms from engaging in such trading by asking them not to use the automatic order entry system that allows them to order trades in thousands of shares of hundreds of stocks at a time. Even the Reagan Administration now is searching for ways to bridle the practice. The frenzy certainly exposed the frailties of the system. The Big Board said its computer system mostly kept up, but many customers waited hours to find out if their orders had been executed—and at what price. Another concern is mundane but critical: Will back offices be able to process the blizzard of paper produced by the trading volume?

The exchange's specialists, whose franchise it is to make orderly markets, were swamped. Trading in many stocks owned by institutions often shut down for short stretches because of order imbalances. By midday on the 20th, that had led to a 50-minute halt in trading on stock-index options and futures in Chicago and New York.

That proved a turning point for the market, says Phelan. Although the market on Tuesday opened strongly, the Dow soon headed south. Had the shutdown not eased the selling pressure, Phelan maintains, the exchange might have had to close altogether. "We came very close to losing it," says a senior Administration economic official.

The stock-index futures market, which grew up in this bull market, hardly turned out to be a place where heroes resided. Local traders—who in practice play the role of specialists to take the public's orders—actually fled the pit at the Chicago Mercantile Exchange, drying up the market for the highly popular futures contract on the Standard & Poor's 500-stock index. The futures contracts, which typically trade at no more than a couple of points higher or lower than the actual S&P 500 index, collapsed, trading at 20- to 30-point discounts.

WASHED OUT

Customers of many mutual fund companies complained they could not reach them by telephone to execute trades. Those who got through dumped equity funds. Fidelity Investments staff logged 200,000 phone calls on Oct. 19—and 280,000 the next day. Like several other fund managers, Fidelity invoked its right to delay payment for seven days, giving portfolio managers time to raise cash. There were substantial redemptions, most of which found their way into money-market funds. Between redemptions and the fall in prices, assets in Fidelity's Magellan Fund—one of the best-known and best-performing—dropped to $7.7 billion on Oct. 20 from $11.5 billion at the end of September.

From a high of 2722 on Aug. 25, the Dow "corrected" 214 points, or 7.9%, by Oct. 13. Few believed the pullback was over, and many market pundits saw it as a way to wash out some of the excessive valuations and euphoria of this most remarkable year in history's biggest bull market. What started as a "severe correction" on Oct. 14 culminated in an outright disaster on Oct. 19, wiping out the year's entire gain of 43%. By the end of trading on the 19th, the Dow had given up half the gain it made since the bottom in August, 1982.

The consensus—often right during the bull market—this time missed the mark. Of the 350 investment advisory newsletters tracked by the Dick Davis Digest, a Miami publication, only about 5% were on target in calling for a steep drop, said publisher Davis. He counted as incorrect those who joined the consensus predicting a 20% market correction—a pullback to the 2200 zone in the Dow. The correct few urged readers to "pull out and step on the sidelines."

It's often said that bull markets climb a wall of worry. And this market had no shortage of worries. Through most of the past two years' phenomenal rise, the bull struggled with a sluggish economy, a record U.S. budget deficit, a monstrous trade deficit, and a falling dollar. This year the market added concerns over rising interest rates, inflation, military tensions in the Persian Gulf, and a proposed round of tax hikes aimed right at Wall Street. But on Oct. 14, when the Commerce Dept. reported August's merchandise trade deficit at $15.7 billion—which was more than expected—the bull finally lost its footing.

Over the weekend, fear spread. One reason: Treasury Secretary James A. Baker III's threat to let the dollar resume its fall against the West German mark. By Monday morning markets around the world were plummeting, with the U.S. market taking the worst bath of all. At the Charles Schwab brokerage office in Stamford, Conn., orders flooded in to sell at any price. "People are afraid they're trapped," said branch manager David T. Hunter III.

WET FEET

Some cooler heads tried to put the loss in perspective. "The market is only back where it started this year," said Aaron Libby, a Washington (D.C.) retiree. "What's so bad about that?" Many saw it as an opportunity to enter the market they had long watched from the sidelines. Jon L. Thume, a Washington firefighter, took $20,000 in savings and opened a brokerage account. "I'm going to get my feet good and wet."

Professional money managers, many of whom had been raising cash for months, started to ease back into the market. And in those stashes are the seeds of the market's recovery. William C. Fletcher, executive vice-president of Boston's Independence Investment Associates, planned to deploy much of the 20% cash in his $3.5 billion portfolio. Peter Anderson, president of IDS Advisory Group, also went shopping. He was prepared to spend up to $400 million from IDS's pension and mutual fund accounts. And Paul Bilzerian, a Florida-based corporate raider, feels the decline will touch off another round of dealmaking, a force that helped drive the bull market. "If the market stays at this level, we'll be doing deal after deal," says Bilzerian.

Is it back up from here? A drop as sharp as this is bound to produce a sharp rebound, but no one's calling for a return to 2700. And no one expects a one-shot bounce either. The market could break down and test the recent lows. But most think if cool heads prevail and there's some visible progress on the budget and trade fronts, stock prices will find equilibrium somewhere between the heady days of summer and the depths of autumn.


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