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21 Oct 2017 (AFR) – Why Wall Street’s ‘Black Monday’ is a red herring

[COMMENT: Here is a good article describing some of the events of the infamous markets crash of 1987 – Black Monday in the US and Black Tuesday in Australia.]

(21 October 2017, AFR, p29, by Patrick Commins)

‘ “By the time we got to the crash, it was clear that equities were very expensive relative to bonds.” Are those the words we are likely to hear in the wake of the next sharemarket crisis? Unless you have been hiding under a rock, you would know that this week marks 30 years since the 1987 Wall St crash. That “Black Monday”,  when the Dow Jones lost 23 per cent in one session, was followed by a “Black Tuesday” in Australia as exchanges around the world tumbled like so many domino pieces. The All Ords that day plunged 25 per cent. In terms of single-session falls, those days were unrivalled.’ <snipped…>

Portfolio insurance was, essentially, a method of hedging against the risk of a downturn in the stockmarket by short-selling index futures. The idea  was that your losses in the physical market would be offset by gains in the futures contracts. This would have been fine, Wilmot notes, except everybody was doing it. This led to a situation in which, as economist Robert Shiller explains, the “initial price decline starts a vicious circle by causing portfolio insurers to sell, causing further price declines, causing portfolio insurers to sell again, and so on”. ‘ <snipped…>

‘Less technically, it’s the common phenomenon where what makes sense and is logical from an individual perspective, when aggregated, is collectively irrational. If only a few people had taken out portfolio insurance, then the 1987 crash wouldn’t have happened. “It’s a classic phenomenon in financial markets, and indeed economic cycles. In the boom phase all the businessmen are investing together, not realising they are going to create excess capacity. Everybody is doing the right thing from their individual point of view, but creating risk from a systemic point of view. You would have had a big sell-off at some point, but the fact that it happened essentially in one day” was down to this effect, Wilmot says. So back to today. There are two obvious lessons for me…’

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