The increased volatility in the US Stock markets over the past few weeks has scared investors, now may be a good time to look at what happened in the 1987 market crash.



In the days between October 14 and October 19, 1987, major indexes of market valuation in the United States dropped 30 percent or more. On October 19, 1987, a date that subsequently became known as "Black Monday," the Dow Jones Industrial Average plummeted 508 points, losing 22.6% of its total value. The S&P 500 dropped 20.4%, falling from 282.7 to 225.06.

The 1987 crash may have marked the end of a five-year 'bull market that had seen the Dow rise from 776 points in August 1982 to a high of 2,722.42 points in August 1987. Unlike what happened in 1929, however, the market rallied immediately after the crash, posting a record one-day gain of 102.27 the very next day and 186.64 points on Thursday October 22. It took only two years for the Dow to recover completely; by September of 1989, the market had regained all of the value it had lost in the '87 crash.

Like today, many investors feared that the a stock market crash would trigger a major recession. Instead, the impact from the crash turned out to be surprisingly small. This phenomenon was due, in part, to the intervention of the Federal Reserve. The worst economic losses occurred on Wall Street itself, where 15,000 jobs were lost in the financial industry.

Numerous explanations have been offered as to the cause of the crash, although no one theory has been said to have been the sole determinant. Among these are computer trading and derivative securities, illiquidity, trade and budget deficits, and overvaluation. Below are some of the major theories of what happened.

1: DERIVATIVE SECURITIES

Initial blame for the 1987 crash centered on the relationship between stock markets, index options and futures markets. In the former, investors buy actual shares of stock; in the latter they are only purchasing rights to buy or sell stocks at particular prices. Thus options and futures are known as derivatives, because their value derives from changes in stock prices even though no actual shares are owned. The Brady Commission [also known as the Presidential Task Force on Market Mechanisms, which was appointed to investigate the causes of the crash], concluded that the failure of stock markets and derivatives markets to operate in sync was the major factor behind the crash.

2: COMPUTER TRADING

Many analysts blame the use of computer trading (also known as program trading) by large institutional firms. In program trading, computers were programmed to automatically order large stock trades when certain market trends prevailed. With a large decline in the market, analysts believe that program trading caused more selling. However, studies show that during the 1987 U.S. crash, other stock markets which did not use program trading also crashed, some with losses even more severe than the U.S. market.

3: ILLIQUIDITY

During the Crash, trading mechanisms in financial markets were not able to deal with such a large flow of sell orders. Many common stocks in the New York Stock Exchange were not traded until late in the morning of October 19 because the specialists could not find enough buyers to purchase the amount of stocks that sellers wanted to get rid of at certain prices. As a result, trading was terminated in many listed stocks. This insufficient liquidity may have had a significant effect on the size of the price drop, since investors had overestimated the amount of liquidity. However, negative news to investors about the liquidity of stock, option and futures markets cannot explain why so many people decided to sell stock at the same time.

4: U.S. TRADE AND BUDGET DEFICITS

Another important trigger in the market crash was the announcement of a large U.S. trade deficit on October 14, which led then Treasury Secretary James Baker to suggest the need for a fall in the dollar on foreign exchange markets. The fear of a lower dollar led foreigners to pull out of dollar-denominated assets, which then caused a sharp rise in interest rates.

One belief is that the large trade and budget deficits during the third quarter of 1987 might have led investors into thinking that these deficits would cause a fall of the U.S. stocks compared with foreign securities (this was the largest U.S. trade deficit since 1960). However, if the large U.S. budget deficit was the cause, why did stock markets in other countries crash as well? (Unexpected changes in the trade deficit were bad news for one country; it would be good news for its trading partner.)

5: INVESTING IN BONDS AS AN ATTRACTIVE ALTERNATIVE

Long-term bond yields that had started 1987 at 7.6% climbed to approximately 10% [the summer before the crash]. This offered a lucrative alternative to stocks for investors looking for yield.

6: OVERVALUATION

Many analysts agree that stock prices were overvalued in September, 1987. Price/Earning ratio and Price/Dividend ratios were too high [Historically, the P/E ratio is about 15 to 1; in October 1987 the P/E for the S&P 500 had risen to about 20 to 1]. Does that imply that overvaluation caused the 1987 Crash? While these ratios were at historically high levels, similar Price/Earning and Price/Dividends values had been seen for most of the 1960-72 period. Since no crash happened during that period, we can assume that overvaluation did not trigger crashes every time.

In looking at today's market, many of the cause of the 87 crash are not present. Bonds are not at attractive levels, stocks are not overvalued and computer trading has evolved significantly over the past 20 years. Emotional fear is in the market. Once the fear subsides, it will be back to business as usual.