7-31-02 What *Caused* the *Stock* *Market* *Crash* of *1987*? By Jennifer Itskevich Ms. Itskevich is a student at Rutgers University and an intern at HNN. 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. This was the greatest loss Wall Street had ever suffered on a single day.1 According to /Facts on File /, an authoritative source of current-events information for professional research and education, the *1987* *crash*"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 hapopened 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*.2 Many feared that the *crash* would trigger a recession. Instead, the fallout from the *crash* turned out to be surprisingly small. This phenomenon was due, in part, to the intervention of the Federal Reserve. According to /Facts on File/,"The worst economic losses occurred on Wall Street itself, where 15,000 jobs were lost in the financial industry."3 A number of explanations have been offered as to the cause of the *crash*, although none may be said to have been the sole determinant. Among these are computer trading and derivative securities, illiquidity, trade and budget deficits, and overvaluation. Below we have quoted representative analyses. CAUSE #1: DERIVATIVE SECURITIES /Bruce Bartlett , senior fellow with the National Center for Policy Analysis of Dallas, Texas/: Initial blame for the *1987* *crash* centered on the interplay between *stock* markets and index options and futures markets. In the former people 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*. CAUSE #2: COMPUTER TRADING /Website, University of Melbourne :/ In searching for the cause of the *crash*, many analysts blame the use of computer trading (also known as program trading) by large institutional investing companies. In program trading, computers were programmed to automatically order large *stock* trades when certain *market* trends prevailed. 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*. CAUSE #3: ILLIQUIDITY /Website, University of Melbourne :/ 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. /Bruce Bartlett :/ While structural problems within markets may have played a role in the magnitude of the *market* *crash*, they could not have *caused* it. That would require some action outside the *market* that *caused* traders to dramatically lower their estimates of *stock* *market* values. The main culprit here seems to have been legislation that passed the House Ways & Means Committee on October 15 eliminating the deductibility of interest on debt used for corporate takeovers. Two economists from the Securities and Exchange Commission, Mark Mitchell and Jeffry Netter, published a study in 1989 concluding that the anti-takeover legislation did trigger the *crash*. They note that as the legislation began to move through Congress, the *market* reacted almost instantaneously to news of its progress. Between Tuesday, October 13, when the legislation was first introduced, and Friday, October 16, when the *market* closed for the weekend, *stock* prices fell more than 10 percent -- the largest 3-day drop in almost 50 years. In addition, those stocks that led the *market* downward were precisely those most affected by the legislation. [Ultimately, the legislation was stripped of the provisions that concerned the *stock* *market* before being enacted into law.]4 CAUSE #4: U.S. TRADE AND BUDGET DEFICITS /Bruce Bartlett :/ Another important trigger in the *market* *crash* was the announcement of a large U.S. trade deficit on October 14, which led Treasury Secretary James Baker to suggest the need for a fall in the dollar on foreign exchange markets. Fears of a lower dollar led foreigners to pull out of dollar-denominated assets, causing a sharp rise in interest rates. /Website, University of Melbourne :/ 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? Presumably if unexpected changes in the trade deficit were bad news for one country, it would be good news for its trading partner. CAUSE #5: INVESTING IN BONDS AS AN ATTRACTIVE ALTERNATIVE /The-Adviser.com :/ 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. CAUSE #6: OVERVALUATION /Website, University of Melbourne :/ 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. THE LEGACY OF THE '87 *CRASH* /Bruce Bartlett :/ What the *1987* *crash* ultimately accomplished was to teach politicians that markets heed their words and actions carefully, reacting immediately when threatened. Thus the *crash* initiated a new era of *market* discipline on bad economic policy. ------------------------------------------------------------------------ ENDNOTES 1"The *1987* *Stock* *Market* *Crash*." http://www.arts.unimelb.edu.au/amu/ucr/student/1997/Yee/*1987*.htm 23 July 2002. 2"Key Event: 'Black Monday'*Crash* of *1987* Rocks *Stock* Markets." _Facts on File World News CD-ROM_. Facts on File News Services. http://www.facts.com/cd/v00066.htm 23 July 2002. 3/Ibid./ 4"Triggering the *1987* *Stock* *Market* *Crash*: Antitakeover Provisions in the Proposed House Ways and Means Tax Bill?" /Journal of Financial Economics/, vol. 24, no. 1 (September 1989), pp. 37-68. ------------------------------------------------------------------------ Comments ------------------------------------------------------------------------