High & Low Finance: A Computer Lesson From 1987, Still Unlearned by Wall Street

On one day, the Dow Jones industrial average lost 23 percent of its value. People wondered if that heralded a new Depression. A front page headline in The New York Times asked, “Does 1987 Equal 1929?”

It did not. The next recession, a mild one, was more than two years away.

What it did signify was the beginning of the destruction of markets by dumb computers. Or, to be fair to the computers, by computers programmed by fallible people and trusted by people who did not understand the computer programs’ limitations. As computers came in, human judgment went out.

That process, then in its infancy, gained speed over the next two decades. By 2008, it really did threaten a new Depression. But we’ll get to that later.

The 1987 villain was something called portfolio insurance. It was a product that used stock index futures and options to assure institutional investors that they need not worry if market prices seemed to be unreasonably high.

Portfolio insurance would let them get out with minimal damage if markets ever began to fall. They would simply sell ever-increasing numbers of futures contracts, a process known as dynamic hedging.

The short position in futures contracts would then offset the losses caused by falls in the stocks they owned.

Portfolio insurance did not start the widespread selling of stocks in 1987. But it made sure that the process got out of hand. As computers dictated that more and more futures be sold, the buyers of those futures not only insisted on sharply lower prices but also hedged their positions by selling the underlying stocks. That drove prices down further, and produced more sell orders from the computers. At the time, many people generally understood how portfolio insurance worked, but there was a belief that its very nature would assure that it could not cause panic. Everyone would know the selling was not coming from anyone with inside information, so others would be willing to step in and buy to take advantage of bargains. Or so it was believed.

But when the crash arrived, few understood much of anything, except that it was like nothing they had ever seen. Anyone who did step in with a buy order quickly regretted the decision.

I was then the stock market columnist at Barron’s and I spent most of that October week on the trading floor at Salomon Brothers, then a leading brokerage firm in stock trading. Near the end of that Monday, I remember looking up and seeing dozens of young investment bankers lining the trading floor. There was really nothing for them to see; the ticker tape rolling across the side wall was hours behind actual trading. But many no doubt wondered if their world was coming to an end.

Stan Shopkorn, the Salomon vice chairman and chief equity trader — and a man who had not had a great day — noticed them soon after I did, and loudly suggested they must have something better to do. They didn’t, but they quickly left.

The next day, a Tuesday, the Wall Street establishment effectively came together to stem the panic, although what happened gained little attention at the time. As sell orders forced the New York Stock Exchange to halt trading in stock after stock, word came that the Chicago Mercantile Exchange was threatening to halt trading in stock index futures. With many stocks not trading, there was no way to calculate an accurate value of a stock index. The system threatened to grind to a panic-induced halt.

It was then that Mr. Shopkorn got on the phone with Bob Mnuchin, the head stock trader at Goldman Sachs, and Salomon’s principal competitor. I don’t know who initiated the call, but I heard the result. They agreed to tell their floor traders to tell the stock exchange specialists that Goldman and Salomon would submit buy orders to reopen any stock in the Standard & Poor’s 500. Within minutes, prices began to recover.