five-year period, the British stock market was up 164 percent; the Swiss,
209 percent; German, 217 percent; Japanese, 288 percent; and Italian, 421
percent.
But rising bond rates, coupled with higher stock prices, spelled trou-
ble for the equity markets. The long-term government bond rate, which
began the year at 7 percent, topped 9 percent in September and continued
to rise. As stocks rose, the dividend and earnings yield fell, and the gap
between the real yield on bonds and the earnings and dividend yields on
stocks reached a postwar high. By the morning of October 19, the long-
term bond yield had reached 10.47 percent despite the fact that inflation
was well under control. The record gap between yields on stocks and the
real yields on bonds set the stage for the stock market crash.The Futures Market
The S&P 500 futures market also clearly contributed to the market crash.
Since the introduction of the stock index futures market, a new trading
technique, called portfolio insurance, had been introduced into portfolio
management.
Portfolio insurance was, in concept, not much different than an oft-
used technique called a stop-loss order. If an investor buys a stock and
wants to protect herself from a loss (or if it has gone up, protect her
profit), it is possible to place a sell order below the current price that will
be triggered when and if the price falls to or below this specified level.
But stop-loss orders are not guarantees that you can get out of the
market. If the stock falls below your specified price, your stop-loss order
becomes a market orderto be executed at the next bestprice. If the stock
gaps, or declines dramatically, your order could be executed far below
your hoped-for price. This means a panic might develop if many in-
vestors place stop-loss orders around the same price. A price decline
could trigger a flood of sell orders, overwhelming the market.
Portfolio insurers, who sold the stock index futures against large
portfolios to protect them against market decline, felt they were immune
to such problems. It seemed extremely unlikely that the S&P 500 Index
futures would ever decline dramatically in price and that the whole U.S.
capital market, the world’s largest, could fail to find buyers. This is one
reason why the stock market continued to rise in the face of sharply
higher long-term rates.
But the entire market did gap on October 19, 1987. During the week
of October 12, the market declined by 10 percent and a large number of
sell orders flooded the markets. So many traders and money managersCHAPTER 16 Market Volatility 275