What caused the stockmarket crash of 1987 – and could it happen again today?

For many people in the UK, October 1987 is infamous for the Great Storm that swept the south of England.

As well as causing widespread disruption and 18 deaths (plus another four in France), the Great Storm left an indelible mark on the reputation of Michael Fish, the UK's top weather forecaster at the time.

Fish has always claimed that his insouciance has been exaggerated, which may be fair. But he certainly didn't see the epic storm coming.

The stockmarket crash of October 1987 came out of the blue for most people too. But what's interesting is that a few forecasters did see it coming.

And at least one of those models suggests something similar could happen today...

How 1987 swept the globe

The 1987 stockmarket crash "Black Monday" is legendary.

On 19 October, the US stockmarket, as measured by the Dow Jones Industrial Average, fell by 22.6% in a single trading session. This still represents the largest single-day stockmarket decline in US history. From the start of the tremors on 14 October the market shed more than 30%.

And while the focus tends to be on the US, the crash was a global one. Apparently, the market that suffered least over the period (in local currency terms) was Austria's it only lost 11%. Tiny New Zealand was the worst, crashing by 60%.

So what caused it? No one can point to the exact trigger. As with most crashes, it's hard to mark the precise tipping point, even in hindsight. We'll go into the most widely accepted and convincing theories in a moment.

However, while it's pretty much impossible to predict exactly when a major market turn might come, it is possible to at least have an idea of how vulnerable a market is.

On that front, while the crash of 1987 was shocking and surprising, it's important to realise that stockmarkets had enjoyed a first half that was equally startling in terms of just how good it was.

As Swiss Finance Institute researchers put it in a 2006 paper on volatility: "The strong market decline followed what for many countries had been an unprecedented market increase during the first nine months of the year." For example, by the end of August that year, the Dow Jones had climbed by 44% in the space of seven months. The FTSE 100, meanwhile, had also gained around 40% from the start of the year, peaking at 2,443 on July 16.

When it comes to markets, of course, what goes up does not necessarily have to come all the way back down again. But you could certainly argue that after that sort of spectacular run, stocks were ripe for a correction, with everyone twitchy and ready to take their profits.

Anyway, here's a short version of how events unfolded. On Wednesday 14 October, global markets started turning down. On Friday 16 October, the Dow Jones ended the day 4.6% lower - which briefly set the record as the largest single-day points drop in the Dow ever seen, until the following Monday.

Come Monday morning, stockmarkets in Asia were tumbling. And the contagion spread across the world, accelerating as it went. In Britain, the aforementioned Great Storm didn't help matters at all.

The storm had struck on the night of Thursday 15th and through Friday 16th. Trains into London were cancelled, and trading had been cut short on the Friday, so by Monday morning, traders were already keen to get out of the market, having seen the weak close on Wall Street.

By the end of the day on Monday, the UK market had fallen by nearly 11% (and by the close on Tuesday, they'd lost a further 12%).

So by the time the US market opened, it was just a question of how far it could fall. The answer was: "farther than anyone would have thought possible". By the end of the day, the US stockmarket had lost nearly a quarter of its value.

(Oh, and in case you're wondering, gold rose by $10 to hit a four-and-a-half year high of $481.70 an ounce on the day.)

What caused the 1987 crash?

There was plenty of geopolitical upheaval around in 1987. The Iran-Iraq war was going on and that week had seen Iran firing missiles at American-owned tankers in the Gulf.

But geopolitical upheaval is a constant in markets. In any given year, scary stuff is happening somewhere. I reckon if you could do a Google search on all of the news reports I've ever heard and read in my life, the phrase "tension in the Middle East" would get by far the most hits significantly ahead of "climate change" and an awful lot higher up than "North Korea".

So what was around that was unusual and market-specific? Slightly more convincing is the argument that international attempts to fix currency rates might have had an impact. At the weekend, then-US Treasury Secretary James Baker threatened to devalue the dollar against the German mark, to help narrow the trade deficit.

Fear of a falling dollar might have persuaded international investors who had become a more important part of the US market to pull their money out.

But one of the most convincing factors blamed for the speed and scale of the crash was a financial innovation known as "portfolio insurance". If you want a comprehensive yet comprehensible explanation of how this worked, I'd advise you to read the relevant chapter of Ed Thorp's A Man for All Markets (a great book you can read my review of it here).

Keeping it short and simple, investors were using computerised trading systems involving derivatives. The idea was that these algorithms would keep you safe by locking in your wins on the way up and hedging against your losses on the way down. But when the system became overwhelmed, they instead created a self-fulfilling doom loop selling begat more selling and so on.

With markets already coming off a huge rally and feeling vertiginous, it didn't take a lot to tip it into danger territory.

All's well that ends well or is it?

In any case, as it was, in the end, despite the terrifying panic on the day, the only portfolio insurance investors really needed was already sitting at the head of the US central bank, the Federal Reserve. Alan Greenspan the Maestro-in-the-making twisted the arms of banks to keep lending on their usual terms.

Within just two days, the Dow had regained more than half of the Black Monday losses. And inside two years, it was back at the highs. There was no economic fallout, and the financial system was essentially unharmed.

(By the way, in December 1987 a group of 33 eminent international economists including five Nobel Prize winners warned in Washington that "the next few years could be the most troubled since the 1930s". So much for experts.)

In effect, 1987 was an explosive, but short-lived setback. Another interesting point and one that makes intuitive sense to me is made by economist Andrew Smithers, who argued that one reason for the quick recovery is that stocks were not especially expensive, even at the 1987 peak.

They may have come too far and too fast (price/earnings ratios were high), but as measured by "Tobin's Q" (an asset-based valuation measure), the level of valuation was not extreme. In other words, the market blew off a lot of froth, but rapidly realised that the post-crash prices were worth paying.

Anyway, that's all very interesting. But there's a particularly pertinent point to be made about 1987 right now.

I mentioned earlier that some market forecasters called 1987 correctly. One specific one was the late Martin Zweig (author of Winning on Wall Street). Algy Hall wrote up a good piece in Investors Chronicle the other day, looking at how Zweig's market-timing model the one that called the 1987 crash has now issued its first "sell" signal in over a decade.

I'll be discussing this in more detail next week in Money Morning, but the main trigger for the shift in Zweig's model is the combination of tightening monetary policy, along with a long-running bull market, and high p/e ratios.

Could we see a similar crash today? The market has more safety nets, but prices can certainly still fall hard. And while I can't put my finger on the precise mechanism, I do suspect that the sheer array of bets being made on low volatility right now have made the market vulnerable to a rapid change in sentiment (I've written more about this in MoneyWeek magazine this week).

Would a 1987-style crash set the scene for an '87-style recovery? It's hard to imagine what the Fed would do if the market fell by anything like 1987-style levels. I'm not sure it would even be allowed.

But one big difference between now and then is that there's little debate as to whether stocks are fundamentally overvalued or not. Indeed, on Tobin's Q, stocks in the US are roughly 70% overvalued right now. So a sharp rally on that basis would seem unlikely.

Another reason to be hanging on to a bit more cash than usual - just in case.

A little light reading

By the way, if you enjoyed this and you've missed the others in the "crash" series, we're building up bit of a collection now. Here are the links to the others:

• The credit crunch of 1966
• 1720: What the South Sea Bubble can tell us about blockchain
• 1920/21: The depression you've probably never heard of