On This Date in History: After a run-up in the Dow Jones industrial average over the past several weeks that put it in positive territory by some 8% for the year, it took a tumble. The Dow gave back about 1.5%, or 165 points to close as session that saw the big board showing a deficit well over 200 before the close. Profits have been up for a large number of companies during the most recent “earnings season” but the Dow took a hit anyway. The general consensus is that China raising its interest rates was the catalyst. With a rise in Chinese interest rates, that economy may slow down and so the dollar got stronger. The dollar rose 1.7% and commodities, including oil, fell. Oil had been up about 13% over the past month, mainly due to a weakening dollar. Since most commodities, including oil, are traded in dollars then when the dollar gets weaker the price of commodities rise. Earlier this year when there was the European fiscal crisis, the dollar rose and oil prices fell. When the crisis seemed to pass, then the dollar got weaker against other commodities and oil prices rose. So, it would appear that, at the current time, the Dow Jones and other indices such as the S&P 500 are responding to currency exchange rates. I think the volatility in the face of positive earnings reports just shows how nervous the investing class is at this time.

However, Wall Street is not as nervous as it was 23 years ago when, on this date in 1987, the Dow Jones industrial average fell 508 points. It became known as “Black Monday,” though its seems that moniker has been used in some form in the past. That represented a decline of over 22% in one day of trading. For a similar shock to happen today, the Dow would have to fall about 2400 points in one day. Back in 1987 on October 19, the S&P 500 fell over 20% so it was a broad sell off of stocks. The date marked the end of a bull market that had driven the Dow from 776 points in August 1982 to a high of over 2700 points in August 1987. There was great concern in the media that we were in the midst of another potential 1929 scenario but the market said otherwise. The very next day, the market had its biggest gain ever when it rose over 100 points and two days later rose 186 points. By 1989, the Dow had recovered all it had lost on that one day and continued to rise for many years thereafter. In comparison, the largest single day point drop for the Dow Jones happened on Sept 28, 2008 when it fell 778 points but that represented only a 7% decline.

So often, we hear that the market is a forecaster of the days to come so many experts thought the crash meant that it was the sign of a new recession. The fallout though turned out to be relatively minimal. Now, it certainly was a recession for the 15,000 folks on Wall Street who lost thier jobs, but the rest of the economy wasn’t overly affected. An easy answer to simply say that the Dow had risen about 300% in 5 years and people simply took their money off the table. That is certainly true and probably was an incentive to sell at the first time of trouble. Still, it’s not totally clear of the cause, though there are numerous opinions. However, there seems to have been a number of factors that had more to do with a changing trading envrionment and new technology than anything else.

It’s as if it was a hiccup in a transition from the old world to the new. The Brady Commission, formally known as the Presidential Task Force on Market Mechanisms, determined that the failure of stock markets and derivatives markets to operate in sync was the major factor behind the crash. Several sources put the blame on the then relatively new practice of using computer programs to initiate trades. The idea is that when certain conditions were met, computers used by large, institutional investors sold large quantities of stocks and a waterfall effect followed suit. Only trouble with this argument is that markets that did not use computers also dove. But, it seems to me that if traders on other markets saw the Dow tanking that maybe panic would set in. Another finger has been pointed at the lack of liquidity of the market. Traders were unable to handle the large number of trade orders that came in and trading was halted for many stocks. While it clearly was a problem it doesn’t explain why so many people decided to sell at once. The bond market at the time featured yields that had risen from 7.6% to over 10% and that provided a nice haven for folks investing in the equity market but those rates did not rise overnight. Perhaps it provided for a nice alternative and may have encouraged nervous investors who found it a lucrative place to park their tidy profits, but it doesn’t explain the everyone overboard scenario.

So, a look at what might have happened in preceeding days that may have caused people to collectively decide the party was over might be useful. Many historians look to consideration by Congress of the Smoot Hawley Act as the cause for the crash in 1929 followed by an extension of doldrums when Herbert Hoover actually signed it. Now, from October 14, 1987 to October 19 1987, the Dow lost about 30% of its value so the decline really started a few days before the bottom fell out. It just so happens that on October 14, 1987 US Secretary of the Treasury James Baker announced that there may be a need to follow a weak-dollar policy as part of a larger scheme to stablize global currencies. That announcment may have influenced foreign investors to pull out of dollar denominated assets. Then, on October 15 the House Ways and Means Committee passed legislation that eliminated tax deductions by corporations on debt used for corporate takeovers. Securities and Exchange Commission economists Mark Mitchell and Jeff Netter pointed exactly to that legislation as the underlying cause of the crash in their 1989 published report.

One this is for certain, investing in markets is not a simple proposition and it becomes more complicated every day. The more we advance in technology, the more new concerns arise and new rules or limitations get considered. The more the world gets intertwined in the business of economics, the more events in other parts of the world affect the markets at home. Then there are the traditional risks of interest rates, exchange rates, market risk and just plain the risk involved with the specifics of any underlying company. The stock market is not for everyone but the more people get involved in markets through their pensions or 401K’s the more markets volatility directly affects individuals. But, most people assume that the market just goes up and their 401K is always going to grow and that is not the case. If you want a guarantee, get a toaster. Better yet, brokers and financial advisors are charged with recommending investments that are suitable to their clients needs, desires and sophistication. I would submit that most folks who lose money have not been advised properly. Many of the former employees of Enron were misled into believing that their company stock was a sure bet. No doubt, many people let their own greed get in the way, preferring to believe that there is a quick way to make a buck as opposed to taking a more prudent way to invest. One thing I found that is wrong with our markets is that so many people see the market as a horse race or a casino. They don’t invest in a company but instead bet that it will go up. Day traders could care less about the company’s long term viability and are more interested in short, quick gains or losses. They get in or get out by buying and selling or selling short and closing out the position. That is especially true of options traders. That attitude has spilled over into commodity markets where people buy and sell contracts to purchase and underlying commodity, like oil, with no intention of ever taking delivery on that contract. The bottom line is we have many examples of the complexities of the markets and it would be wise to learn the rules of the game before you jump into the pool. Its not for the faint of heart.