Cramer unpacks ‘mechanical’ market crashes that have nothing to do with the economy

FAN Editor

CNBC’s Jim Cramer knows all too well that it’s much easier for investors to buy into a big stock market rally than it is to determine the cause of a major sell-off.

“[Big declines] could be the start of a bear market, they could be just the beginning of something unfathomable, or they might actually be a buyable glitch,” he said.

To understand what makes buyable glitches, Cramer took investors back to 1987, when he went through one of the worst sell-offs he’s ever experienced: the one-day crash that has since become known as Black Monday.

On Oct. 19, 1987, the Dow Jones Industrial Average lost 508 points in a single session, which then accounted for 22 percent of the entire index.

“Even as the previous week had been one of the worst weeks in market history, Monday hit fast and it hit hard,” Cramer said, adding that the previous week had “encouraged bargain hunters [who] turned out to be classic bad money in retrospect because these intrepid souls thought they could flip Monday morning into some strength, and that strength never developed.”

The weakness bled into the next day, which became known as Terrible Tuesday because “the market simply stopped functioning” as the Dow slid to its bottom at roughly 1400, Cramer said. The pain only subsided when then-Federal Reserve Chairman Alan Greenspan said the central bank would help stabilize the market.

Three months later, the market retested its lows and held firm, indicating that stocks were likely out of the woods, the “Mad Money” host said. Still, it took nearly 16 months until the averages returned to where they were trading before the crash.

“Black Monday happened because stock traders didn’t understand the power of the futures market, which could flood the stock market with instant unseen supply,” he explained. “These days, we accept that the futures are worth watching, but it wasn’t like that back then because they were relatively new instruments, founded five years before the crash.”

Even though they were new, futures quickly became “the most powerful drivers of stock prices” because of the ease with which money managers could trade in and out of them, Cramer explained. And when some Wall Street salespeople started selling insurance policies that supposedly let investors skirt stock market losses, it only made matters worse.

Rather than letting people evade risk entirely, which Cramer maintains is too good to be true, the insurance policies only accelerated Black Monday’s declines.

“The people who sold these policies were charlatans and mountebanks,” he said. “There’s no magic trick that can get the returns from investing in the stock market without much of the risk. Don’t believe anyone who ever tells you any different.”

Still, the economy was strong before the 1987 crash and it was strong going out of it, which made Black Monday a purely mechanical sell-off, the “Mad Money” host said.

“At the time, we didn’t know that the power of the futures could cause a crash. We figured where there’s smoke, there’s fire,” he said. But “sometimes, crashes have nothing to do with the economy.”

Stocks endured another bout of volatility Friday, with the Dow losing nearly 300 points, the Nasdaq Composite dropping 2.1 percent and the S&P 500 briefly entering correction territory — 10 percent down from its record highs from September.

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