Stock Market Crash of 1987
The Stock Market Crash of 1987 is a good follow-up to our article on the Stock Market Crash of 1929. Some historians argue that there were similarities between the two crashes, and we tend to agree. We also think that there were some distinct differences between the two crashes. That being said, let's take a look at what was happening in the stock market 25 years ago.

The Stock Market before October 1987

In the first half of 1987, the U.S. dollar experienced a steep decline in value relative to other world currencies. This made U.S. goods and services less expensive, and resulted in increased exports. The increase in exports provided U.S. companies with a strong earnings outlook, and the commensurate rise in stock market valuations.

In fact, most of 1987 was marked with one stock market record after the other. There had been a great deal of corporate restructuring in the years proceeding 1987, and American companies were promising strong future earnings growth. International investors also took notice of the improvements in the U.S. market outlook, and the rate of foreign investment doubled between 1986 and 1987, driving stock prices upward. By August, the Dow Jones Industrials was up over 800 points, which translated into a 41% rise in value.

In September 1987, the economic concerns over the weak dollar and rising interest rates started making investors nervous. Volatility in the market increased dramatically as both good and bad economic information was in the news. A record single day point gain for the Dow was set on September 22nd, only to be followed by the largest single day point loss on October 6th. During the three days of October 14th through 16th, the Dow fell over 260 points and the S&P 500 declined 10%. The volatility of the market created a great deal of anxiety over the weekend. Investors were left wondering what would happen on Monday.

October 19, 1987 - Black Monday

On Monday October 19, 1987, the stock market plummeted right from the opening bell. No one was looking to buy stocks that day, and the problems in the stock market soon spread to the futures market. The technology advances in the stock exchanges began to kick in, and these computerized systems accelerated the decline.

Program trading was a new tool, and was introduced to take advantage of rapid market movements. On Black Monday, program trading moved millions of shares, and clients as well as investment houses were left wondering what their actual market positions were like for most of the day.

Portfolio insurance professionals also contributed to the stock market crash of 1987 through their electronic trading systems. As these computerized systems analyzed the event of the days prior to Black Monday, they flooded the market with sell orders early on Monday.

Portfolio insurance and program trading were intended to help investors take advantage of short-term market fluctuations. Unfortunately, these two systems, along with a lack of investor confidence, drove the Dow Jones down 508 points. This was a 22% decline in value in just a single day. Investors in the stock market would lose over $500 billion on Black Monday.


What Caused the Stock Market Crash of 1987?
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

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

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.

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:
Website, University of Melbourne:

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.

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

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

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

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.