THE STOCK MARKET CRASH OF 1987

The October 1987 crash marked the end of an extremely powerful bull market - in the U.S. and elsewhere across the world - that had started in the summer of 1982. The bull market had been fueled by hostile takeovers, leveraged buyouts and mergers. Companies were scrambling to raise capital to buy each other out. In leveraged buyouts, a company would raise large amounts of capital by selling junk bonds to the public. Junk bonds being bonds that have a high risk of loss, so they pay a high interest rate. The money raised by selling junk bonds, would go towards the purchase of the desired company. IPOs were also becoming a commonplace driver of the markets. “Microcomputers” were a top growth industry. People started to view the personal computer as a revolutionary tool that would change the way of life, and create wonderful profit opportunities.

During 1987 circumstances seemed to change. In early 1987, the SEC conducted numerous investigations of illegal insider trading. This created a wary stance from many investors at this point. Also, due to the extremely strong economic growth, inflation was becoming a concern. The Fed rapidly raised short term interest rates to fight inflation; in April and May by 50 and 25 bp, and in early September again by 50bp (in two quick steps). This had an effect of hurting stocks as well. In September 1987, the economic concerns over the weak dollar, trade deficit, budget deficit, and rising interest rates started to make investors really nervous. Volatility in the market increased dramatically as both good and bad economic information hit the news. A single day point gain record for the Dow was set on September 22 only to be followed by the largest single day point loss on October 6. In retrospect, the Dow Jones index reached a record high of 2,722.4 on August 25, cycled sideways at around 2,600 during September, before finally slipping downwards from early October. During the three days of October 14 - 16 the DJIA fell over 260 points (of which a record 108 points - 4.6% - together with record-breaking volume on Friday October 16) and the S&P500 declined 10 percent, creating a great deal of anxiety over the weekend. Investors wondered what would happen on Monday.

[The following text is taken from Malkiel (2003)]

Critics of market efficiency argue that there are several instances of recent market history where market prices could not plausibly have been set by rational investors and that psychological considerations must have played the dominant role. It is alleged, for example, that the stock market lost about one-third of its value from early to mid-October 1987 with essentially no change in the general economic environment. How could market prices be efficient both at the start of October and during the middle of the month? Similarly, it is widely believed that the pricing of Internet stocks in early 2000 could only be explained by the behavior of irrational investors. Do such events make a belief in efficient markets untenable?

The Market Crash of October 1987

Can the October 1987 market crash be explained by rational considerations, or does such a rapid and significant change in market valuations prove the dominance of psychological rather than logical factors in understanding the stock market? Behaviorists would say that the one-third drop in market prices, which occurred early in October 1987, can only be explained by relying on psychological considerations, since the basic elements of the valuation equation did not change rapidly over that period. It is, of course, impossible to rule out the existence of behavioral or psychological influences on stock market pricing. But logical considerations can explain a sharp change in market valuations such as occurred during the first weeks of October 1987.

A number of factors could rationally have changed investors’ views about the proper value of the stock market in October 1987. For one thing, yields on long-term Treasury bonds increased from about 9 percent to almost 10.5 percent in the two months prior to mid-October. Moreover, a number of events may rationally have increased risk perceptions during the first two weeks of October. Early in the month, Congress threatened to impose a "merger tax" that would have made merger activity prohibitively expensive and could well have ended the merger boom. The risk that merger activity might be curtailed increased risks throughout the stock market by weakening the discipline over corporate management that potential takeovers provide. Also, in early October 1987, then Secretary of the Treasury James Baker had threatened to encourage a further fall in the exchange value of the dollar, increasing risks for foreign investors and frightening domestic investors as well. While it is impossible to correlate each day’s movement in stock prices to specific news events, it is not unreasonable to ascribe the sharp decline in mid-October to the cumulative effect of a number of unfavorable "fundamental" events. As Merton Miller (1991) has written, ". . . on October 19, some weeks of external events, minor in themselves . . . cumulatively signaled a possible change in what had been up to then a very favorable political and economic climate for equities . . . and . . . many investors simultaneously came to believe they were holding too large a share of their wealth in risky equities."

Share prices can be highly sensitive as a result of rational responses to small changes in interest rates and risk perceptions. Suppose stocks are priced as the present value of the expected future stream of dividends. For a long-term holder of stocks, this rational principle of valuation translates to a formula:

r = D/P + g,

where r is the rate of return, D/P is the (expected) dividend yield, and g is the long-term growth rate. For present purposes, consider r to be the required rate of return for the market as a whole. Suppose initially that the "riskless" rate of interest on government bonds is 9 percent and that the required additional risk premium for equity investors is 2 percentage points. In this case, r will be 11 percent (0.09 + 0.02 = 0.11). If a typical stock’s expected growth rate, g, is 7 percent and if the dividend is $4 per share, we can solve for the appropriate price of the stock index (P), obtaining 0.11 = $4/P + 0.07, P = $100.

Now assume that yields on government bonds rise from 9 to 10.5 percent, with no increase in expected inflation, and that risk perceptions increase so that stock-market investors now demand a premium of 2.5 percentage points instead of the 2 points in the previous example. The appropriate rate of return or discount rate for stocks, r, rises then from 11 percent to 13 percent (0.105 + 0.025), and the price of our stock index falls from $100 to $66.67: 0.13 = $4/P + 0.07, P = $66.67.

The price must fall to raise the dividend yield from 4 to 6 percent so as to raise the total return by the required 2 percentage points. Clearly, no irrationality is required for share prices to suffer quite dramatic declines with the sorts of changes in interest rates and risk perceptions that occurred in October 1987. Of course, even a very small decline in anticipated growth would have magnified these declines in warranted share valuations.

This is not to say that psychological factors were irrelevant in explaining the sharp drop in prices during October 1987—they undoubtedly played a role. But it would be a mistake to dismiss the significant change in the external environment, which can provide an entirely rational explanation for a significant decline in the appropriate values for common stocks.

[End]

Fundamentals

Arguably the most careful and most useful academic study on fundamental valuation around the 1987 crash is Siegel (1992). Using long-term interest rate, constant average equity risk premium and consensus Blue Chip survey forecasts of corporate profits, Siegel shows that between 1984 and 1991 the S&P500 generally followed a normal textbook valuation model. The exception is 1987 when a continued increase in the S&P500 contrasts with a declining fundamental value. The October crash eliminated this valuation gap. Interestingly, Siegel's calculations also show that during 1987 the S&P500 remained within the bounds for fundamental value determined by the most optimistic and the most pessimistic corporate profit forecasts. A model that allows a shift in average investor sentiment ('regime shift') from optimists to pessimists could also explain the October crash.

Suggested crash explanations

The common suspects for blame in the 1987 crash are: program trading, borrowing and margin calls, portfolio insurance strategies, and derivatives markets. (See Edwards (1988) for a review of the official 'blame game' studies following the crash.)

To blame program trading or computerized selling related to arbitrage between markets is "like blaming a pipe that conveys water from a high pool into a lower one in the attempt to equalize the level of the two pools." (Rubinstein, 1998) Arbitrage is a fundamental component of the adequate functioning of markets, not a cause of anything. Bertero and Mayer (1990) find no evidence that computer trading explains the severity of market crashes internationally.

Portfolio insurance strategy is also an ad hoc, casual argument that does not fit the crash experience of other countries where and other periods when portfolio insurance did not exist. Occasional crashes of financial markets over time are a general problem, and require a general explanation (Santoni, 1988).

Futures and options markets (in the U.S.) have been blamed as a causal element of the crash due to the perception that futures and options prices led ('Granger caused') cash stock market prices. This has been shown to be merely an artifact of the data, caused by the index effect of non-synchronous trading of individual stocks in the cash market, and stale prices resulting from reporting delays in the cash market trading system that struggled with a record volume of transactions (Kleidon and Whaley, 1992). Bertero and Mayer (1990) also find no evidence that index futures trading explains the severity of market crashes internationally.

Leverage in general, or, in this case, buying stocks with borrowed money or on margin certainly makes investors more sensitive to declines in the value of their investments. On October 19, margin calls in the U.S. were about ten times the average size (Carlson, 2007). However, large institutional investors were generally accommodated with extended credit lines from the banking system. Only the emergency margin calls to retail investors frequently ended with liquidation of positions, adding limited selling pressure in the markets.

Origin of the crash ('the shock')

A difficulty with much of the discussion on financial market crashes seems to be that many analyses do not sufficiently distinguish between the origin of the crash ("the shock") and the magnitude of the market decline ("accelerators"). Computer trading (portfolio insurance), derivatives arbitrage (futures, options), lack of liquidity (not sufficient buyers) most likely contributed to the overall size of the market crash, operating as accelerators in the price decline. In addition, recent economic theories on crashes and information cascades or avalanches focus on the rationality of herding behavior of individuals when selling and buying in an environment of uncertain, not transparent, and, especially, asymmetric information (Lee, 1998; Gennotte and Leland, 1990).

However, the origin of the crash must be found in the reason why so many stock owners decided to sell stocks that fateful Monday October 19. Unfortunately, we will never know. We know that market confidence had already weakened during the weeks and even months before the crash (see the general but gradual decline in market prices during this period). Despite the fact that newspapers continued to report bullish comments from some market analysts, gradually more and more investors became aware of the likely downward correction in market prices that was to come.

Whether it was the Iranian crisis, the Asian and European stock market sell offs, interest rate and exchange rate fears, or rational herding behavior, the fact is that many investors ultimately scrambled for the perceived safety of liquidity and as such engineered a classic 'bank run' on the stock market; i.e. its liquidity providers. Market prices collapsed, as usual overreacting to some degree due to well known imperfections in the market system, before finally finding a new consensus at a lower fundamental value.

Literature

• * Malkiel, B.G., "The Efficient Market Hypothesis and its critics," Journal of Economic Perspectives, vol.17 (1) Winter 2003: 59-82.
• * Siegel, J.J., 'Equity risk premia, corporate profit forecasts, and investor sentiment around the stock crash of October 1987,' Journal of Business, vol.65 (4) 1992: 557-70.
• * Bertero, E. and C. Mayer, 'Structure and performance: Global interdependence of stock markets around the crash of October 1987,' European Economic Review, vol.34 ( ) 1990: 1155-80.
• * Rubinstein, M., 'Comments on the 1987 stock market crash: Eleven years later,' 1998.
• * Kleidon, A.W. and R.E. Whaley, 'One market? Stocks, futures, and options during October 1987,' Journal of Finance, vol.47 (3) July 1992: 851-77.
• * Carlson, M., 'A brief history of the 1987 stock market crash with a discussion of the Federal Reserve response,' Federal Reserve Board FEDS 2007-13.
• * Lee, I.H., 'Market crashes and informational avalanches,' Review of Economic Studies, vol.65 ( ) 1998: 741-59.
• * Gennotte, G. and H. Leland, 'Market liquidity, hedging, and crashes,' American Economic Review, vol.80 (5) December 1990: 999-1021.
• * Santoni, G.J., 'The October crash: Some evidence on the cascade theory,' FRB St Louis Review, May 1988: 18-33.
• * Edwards, F.R., 'Studies of the 1987 stock market crash: Review and appraisal,' Journal of Financial Services Research, vol.1 ( ) 1988: 231-51.

Internet

• * Lowrisk.com, 1987 Crash - 10 year anniversary link
• * Sniper Market Timing, Stock market crash 1987 - Black Monday - 19.10.1987 link
• * Motley fool, 1987 revisited, 1987 timeline: http://www.fool.com/features/1997/sp971017crashanniversary1987timeline.htm
• * CNBC, Remembering the crash of 1987: http://www.cnbc.com/id/20910471
• * CBC Archive of reports: http://archives.cbc.ca/IDC-1-73-1883-12455-11/politics_economy/twt/