October 19th, 1987

Today is the 22nd anniversary of Black Monday, when stocks around the world crashed one after the other on October 19, 1987. The Dow fell almost 23% and continued downward over the next week. A year later, however, it was almost back to 1987 levels. I consider Black Monday a shot over the bough, that is, a telling glimpse into the greatest problems of modern finance. Here are the lessons we should have learned from 1987:

1. Markets are not efficient, nor are they rational. There was no trigger to the 1987 crash. Some say the crash was caused by program trading and portfolio insurance, which turned a bad day into a terrible day. Others argue it was caused by high interest rates, which made bond yields more attractive than stocks. Another theory is that a wide spread between S&P futures and the market caused arbitrageurs to sell equities and buy futures. However, a paper by Yale's Bob Shiller showed that the most powerful driver was a general fear in the market that stocks were overvalued. Even to this day, the 1987 crash is perhaps one of the greatest examples against the EMH because there was absolutely no significant news driving the market.

2. Markets are contagious. It is difficult to diversify in a crisis. The crash in the US precipitated declines around the world. Stocks in Hong Kong, Australia, and other markets fell by more than 40%. Other asset classes also fell. It is very similar to the contagion we saw in financial markets last fall.

3. Pundits are lagging indicators. After the crash, many pundits proclaimed a new age of austerity after the prosperous 1980s. The OECD trimmed down growth forecasts, even though economically little had changed. The Instititute of International Economics brought 33 of the most famous economists around the world together, including numerous Nobel prize winners, to assess the global economy. The group of 33 economists gathered in Washington and proclaimed that the next few years "could be the most troubled since the 1930's."

The most interesting thing about their proclamation is their reasons of why. The economists argued the fundamental problem was "existing imbalances." They argued America must narrow its budget and trade deficits while Germany and Japan must do more to stimulate growth. 22 years later, budget and trade deficits have widened, Germany and Japan still rely on exports, and yet the world experienced some of the most prosperous 2 decades in its history. Plus ca change, plus c'est la meme chose.