Can there be a stock market crash?

A friend told me recently that although he believes in the possibility of short term market fluctuations (which is reasonable for him to believe considering market efficiency inevitably causes fluctuations in the short term), he feels that it is impossible for the stock market to just crash anytime without any reason. Well, it seems unlikely that any stock market crash may happen anytime soon, considering current economic trends such as a bullish US market with controlled inflation and interest rates.

However, he has never experienced a real stock market crash before, and admittedly he also said that he isn't too familiar with the stock market behaviours. Allow me to explain the 1987 stock market crash, also known as the Black Monday, October 19, 1987. The extent of damage was tremendous. From 13 to 19 October 1987, the Dow Jones Industrial Average "Dow" went down by 31 percent, which translates into a decline of US stocks by $1 trillion. On October 19 itself, the Dow dropped by 22.6 percent. Only the combined fall of October 28 1929 and the following day which together constituted the Crash of 1929 (Great Depression) have approached the October 1987 decline in magnitude. Nobody actually really knows what could have triggered this crash to such an extent as there were no major news or events that occurred prior to the crash. Economists have provided some reasons for the crash, but none of them would have the ability to cause the market to crash to such an extent. The most important reason given was that the US decided to prop up the dollar and restrict inflation faster than the Europeans owing to a monetary policy dispute during the G-7 industrialised nations meeting. This caused the dollar-backed Hong Kong stock exchange to collapse, hence resulting in a crisis of confidence. (But note that this problems spreads from Hong Kong to Europe and then to the US, which doesn't explain why the US market is particularly so badly affected.) Another major reason was the Great Storm of 1987 which caused traders in London to be unable to reach their offices in time, hence resulting in panic. However, these do not sufficiently explain what causes an entire US stock market to decline 1/3 in value in just the span of one week? What power is at work?

First, we have to understand that most of the investment money belongs to institutional financial managers, be it pension funds, REITS, banks, insurance companies, brokerage firms or unit trusts. In the 1980s, many such financial institutions used programme trading to carry out their investment decisions. Programme trading is a large-scale, computer-assisted trading of stocks or other securities according to systems in which decisions to buy and sell are triggered automatically by fluctuations in price. This means that once the programme detects for example a 10% drop in the S&P index, the programme AUTOMATICALLY sells off 50% of its stocks, and such massive selling usually comes in the billions. On top of that, a new innovative financial instrument known as index arbitrage was introduced. This is a form of speculation (it is also known as a futures contract) whereby for a little money down you can buy units of an index of stocks for a fixed price in the future. (Something like buying a call or put option) During the crash of 1987, many institutions which used programme trading sold $2 billion of their stocks and $4 billion in S&P 500 contracts. This massive selling drove the S&P 500 contracts far below the price of the basket of S&P 500 stocks. Hence, the programme traders then started buying the contracts which is at a lower price and sold a like-kind pool of S&P 500 stocks to take advantage of the price discrepancy. However, this puts additional selling pressure on the individual stocks in S&P 500 and before you know it, these stocks dropped in prices in another round of frenzy selling. The point to note is although the companies in the S&P 500 index might have excellent business economics and the overall business climate was optimistic, their stock prices plummetted to ridiculous levels because of programme trading on indices which resulted in swift and tremendous fluctuations. (Talking about market efficiency...)

And the thing is that programme trading still exists in today's brokerage firms and financial institutions. (Although I'm not sure how affected Singapore's financial institutions are by programme trading) Hence, there is still a likelyhood the stock market may just crash one day. While it takes one major event to affect stock markets worldwide temporarily, it just takes a concept like programme trading to devastate these stock markets' traders permanently. I'm not speculating on a stock market crash, don't get me wrong and in fact there is no reason for me to do so since everything seems fine up to now. However, what I'm trying to point out is that there is always a buying opportunity for value investors to take advantage of the stock market's whipsaw prices. At the same time, if you feel that options trading or technical buying is relatively safe, think again. People now have programmes that receive news on stock market prices first hand and these programmes also automatically execute their technical buying or selling in an instant. Hence, it is wise to note that it is rather unlikely to beat the market on prices alone, especially since it is becoming far more efficient. All in all, capitalise on the market's inefficiency in understanding a business true value and avoid competing with the market's high efficiency in price trading.