A quarter century after the worst one-day stock crash in history, measures to prevent a repeat are failing to keep investors from losing confidence in the market.
The 23 percent plunge in the Dow Jones Industrial Average on Oct. 19, 1987, came amid signs of a slowing economy, the threat of higher taxes and concern among individuals that trading was rigged for insiders. Today’s investors have pulled $440 billion from U.S. equity mutual funds since 2008 and sent trading to the lowest levels in at least four years, retrenching after the worst financial crisis since the Great Depression and the May 2010 stock crash, data compiled by Bloomberg and the Investment Company Institute show.
While Procter & Gamble Co. and McDonald’s Corp. are up more than 800 percent since 1987, protections adopted after the crash couldn’t stop unharnessed computer trading from erasing almost $900 billion of value in less than 20 minutes on May 6, 2010, based on data compiled by Bloomberg. E.E. “Buzzy” Geduld, 69, who oversaw about 60 equity traders 25 years ago at Herzog, Heine & Geduld Inc. and now runs investment firm Cougar Trading LLC, says crashes happen when investors become convinced they’ve lost control.
“In 1987 everybody tried to go to the exit at the same time, but the exit door wasn’t big enough,” Geduld said in a telephone interview. “You had literally a panic. Fast forward to 2012. The volumes we can handle are gigantic, but the exit door hasn’t changed in size.”
Individuals are abandoning stocks even after U.S. Federal Reserve Chairman Ben S. Bernanke held interest rates close to zero for a fourth year, valuations for the Dow remain 23 percent below the level at the market peak in October 2007, and exchanges installed safeguards following the so-called flash crash in 2010. U.S. stocks are in the 44th month of a bull market that has restored $9 trillion in share value, data compiled by Bloomberg show.
Average daily volume for U.S. equities was 6 billion shares in the third quarter, the lowest level since at least 2008 and about half the 10.9 billion average in the first three months of 2009. The total has decreased for 12 of the last 13 quarters as investors pulled money from American stock mutual funds for a record fifth year, according to data compiled by Bloomberg and Washington-based ICI.
The retreat from equities has been fueled by memories of 2008, when the Dow slumped 34 percent during the worst economic contraction in seven decades. Europe’s struggle to contain debt turmoil, which pushed daily swings in the Standard & Poor’s 500 Index to twice the five-decade average last year, and mishaps such as Knight Capital Group Inc.’s trading malfunction on Aug. 1 also hurt investor confidence.
“Today when there’s volatility, it scares people to death,” Timothy Ghriskey, 57, the chief investment officer at Solaris Group LLC, which manages about $2 billion in Bedford Hills, New York, said in a phone interview. “What it has taught me is that there’s no such thing as a free lunch. You can theoretically protect yourself on the downside, but when things come unhinged, nothing’s going to protect you.”
Stocks crashed in 1987 two months after the end of a five- year bull market in which the Dow average tripled. The 30-stock gauge was up 37 percent through the first nine months of the year before losing 9.5 percent in the week ended Oct. 16. The decline came amid concern that 10-year bond rates, then at about 10 percent, would increase and speculation that Congress planned to kill tax benefits for leveraged buyouts.
On Black Monday, Japan’s Nikkei 225 Stock Average fell 2.4 percent. By midday, stocks in London were down 10 percent. In New York, 11 of the 30 Dow components didn’t open in the first hour of trading. The Dow went on to fall 508 points, while the S&P 500 tumbled to 224 from 282.
In 1987 panic spread on Wall Street by phone and ticker tape. About $1 trillion in stock-market value was erased in four days, according to a report by a task force led by Treasury Secretary Nicholas Brady in January 1988. It took more than a year to restore it, compared with a week following the retreat on May 6, 2010.
Mike Earlywine, 47, a hedge-fund trader at Ecofin Ltd. whose first job was as a clerk at Salomon Brothers Inc. in New York, witnessed the magnitude of the 1987 plunge on the streets of New York’s financial district.
“We walked out to the exchange and literally people were spilling out,” Earlywine said. “You’re standing there in the street on the sidewalk and people were coming out of the exits and falling over, and guys were literally weeping into guys’ shoulders saying, ‘It’s gone, it’s all gone.’ One guy with tears streaming down his face is trying to comfort the other who’s also got tears on his face.”
The onslaught of selling almost capsized U.S. markets on Oct. 20 and led regulators to eventually adopt coordinated halts across stocks and futures markets to prevent a recurrence, according to David Ruder, chairman of the Securities and Exchange Commission in 1987 and now a professor at Northwestern University’s School of Law in Chicago.
“The most frightening part of that whole week was the thought that the NYSE might have to close because it did not have sufficient demand,” Ruder, a member of the advisory committee formed after the flash crash to make recommendations to the Commodity Futures Trading Commission and SEC, said by phone. “The theory of the circuit breakers was that if there were predetermined stopping points for the market then the market participants would know this wasn’t a panic closing.”
The challenge of handling about 600 million shares a day on Oct. 19 and Oct. 20, more than three times the New York Stock Exchange’s daily average earlier that year, led securities firms to automate trade processing and increase their capacity for volume.
The NYSE also imposed stiffer capital requirements for specialists after the 1987 crash and restricted use of a system that delivered trade requests directly to specialists to limit disruption from index arbitrage in volatile markets. Nasdaq Stock Market mandated that its market makers quote on the Small Order Execution System after individual investors couldn’t get through to brokers who didn’t answer phones on Black Monday.
The NYSE and futures operator Chicago Mercantile Exchange approved separate curbs on intraday price moves in 1988. The focus was on mechanisms that would slow or briefly halt their respective market when trading became disruptive, Leo Melamed, the CME’s former chairman, said in a phone interview. They were later made uniform across equity-index futures and securities.
The plunge in May 2010 didn’t trigger those circuit breakers. The Dow average fell 9.2 percent, most of it between 2:30 p.m. and 3 p.m., after aggressive selling of so-called E- mini S&P 500 futures by a mutual fund company caused a flight of liquidity. As equity market makers and other providers of bids and offers withdrew, trades in individual stocks took place at prices including fractions of 1 cent and $99,999.99.
While the flash crash wasn’t caused by high-frequency traders, their habit of buying and selling rapidly led to the sudden removal of liquidity, kicking off a related plunge in stocks, a report by the SEC and CFTC said on Sept. 30, 2010.
Curbs instituted after that crash, which halt stocks when they move 10 percent in five minutes, will be updated in February when the broad-market triggers adopted following the 1987 rout are overhauled. Amid increased automation, exchanges and brokers are also debating the benefits of so-called kill switches that would shut off a firm’s trading if it exceeds a certain level of activity or breaches pre-set parameters.
Both plunges accelerated as selling pressure in the futures market seeped into stocks. “From an economic viewpoint, what have been traditionally seen as separate markets — the markets for stocks, stock index futures, and stock options — are in fact one market,” the Brady Report said. “To a large extent, the problems of mid-October can be traced to the failure of these market segments to act as one.”
As equities tumbled 25 years ago, Wall Street tickers couldn’t keep up and back offices worked into the night for months to cope with record volume on the New York Stock Exchange and Nasdaq.
Within the exchange there was scant information about what was causing the selloff, according to Kenneth Polcari, a managing director in ICAP PLC’s equities unit. Traders at the NYSE could only see scrolling headlines, not full stories, he said in a phone interview.
“Customers were calling and entering orders an hour earlier than usual,” said Polcari, who worked at William Latham & Co. in 1987. “You could feel from the minute you picked up the phone that this would be a different kind of day. You could tell it from their voices, you could see it in their orders. Instead of 10,000 shares in GE or Coke or Johnson & Johnson, it was, ’Sell 150,000 — sell, sell, sell.’”
Some clerical people at Salomon Brothers didn’t go home for days, according to James Leman, who oversaw a trading floor support staff of more than 100 for equities and fixed income in the firm’s One New York Plaza headquarters. People slept on cots in their offices or got hotel rooms so they could process the surge in trade tickets and resolve problems with transactions that had missing information, no time stamps or incorrect terms, he said.
“The records were manual,” said Leman, managing director at consulting firm Westwater Corp. in New York. “We had paper tickets and paper floor reports. There was no PC, no e-mail. We were living on computer runs coming out of a mainframe computer.”
The NYSE, predominantly a market run by and for humans in 1987, is now an automated exchange with so-called designated market makers overseeing trading in their assigned stocks. There are four main market makers on the exchange’s trading floor, including Getco LLC, one of the largest automated trading firms, compared to more than 50 specialists at the time of the crash.
Nasdaq has since shifted from a phone-based dealer market to an exchange that matches buy and sell orders electronically. Both NYSE Euronext and Nasdaq OMX Group Inc. are public companies that each own three U.S. securities exchanges and have branched beyond equities into options, futures and technology services. CME Group Inc. is the world’s largest exchange company by market value.
Regulators should require brokers to be able to handle a certain multiple of trading, perhaps 10 times the normal volume, to limit disruptions that could worsen a panic, according to Geduld of Cougar Trading. They should also mandate that high-frequency firms have sufficient capital to complete transactions during the day if the market closes, he said. Firms need the “capacity and financial wherewithal to withstand a crazy day,” Geduld said.
More than 19 billion shares traded in the 2010 flash crash on dozens of different venues, including platforms known as dark pools and among brokers matching orders away from exchanges. The number of market makers on the NYSE had fallen to five from 25 since 2000 as the business of providing liquidity became dominated by hundreds of automated traders across markets with less stringent rules about when they must buy and sell.
Both routs proved to be buying opportunities. Within 10 years of the 1987 crash the Dow average had quadrupled and investors were enjoying the biggest bull market ever. After falling 999 points on May 6, 2010, the gauge ended the day down 348. The Dow rose 6.5 percent through the end of the year.
“Twenty-five years later we’re still talking about the impact of technology on the markets and what kinds of solutions could be created to try to soften the movements,” Ken Leibler, president of the American Stock Exchange in 1987, now a consultant, said in a phone interview.
“With high-frequency trading, there are tremendous amounts of trading done, but now it’s done in thousandths of a second,” he said. “The problem is similar today to what it was back then. The solutions are also likely to be ways to halt trading.”
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