Causes, consequences, and lessons from the 1987 stock market crash

Black Tuesday)

Stock Market Crash of 1987

The purpose of this report is to discuss in detail the stock market crash of 1987. The stock market is supposed to fluctuate from day-to-day. But this account will delve into some of the less obvious reasons for that dramatic day on Wall Street and also providing additional insights into how and why investors are in the game and why they were so taken aback by that particular market downturn.

This testimony will also examine some of the more immediate consequences that occurred immediately following the events and how those series of events have carried through to the mindset of present day investments and the Federal Reserve Bank's policies and procedures. Then the report will try to ascertain some lessons learned so as to avoid repeating history.

The report also attempts to explain some investor philosophies that are continually occurring throughout history. Unfortunately, investors seem to constantly miss the signs that have lead and will continue to lead to major losses in the free market environments throughout world history.

The lessons learned also touch upon the steps taken by the overseers of the market itself that have the sole purpose of preventing future crashes of the magnitude of 1987's downturn. Some of those fail safes like new circuit breakers and market limits instituted after 1987 are still working to protect investors today.

Defining those measures will provide a new found understanding of the how our market works today. Events such as Black Tuesday and other current events like the Iraq war and the terroristic attacks on September 11, 2001, all have affects on the market and the typical investment strategy. To make things interesting, the report will do a bit of speculation in order to see if s severe market crash is in our immediate future or if the fail safes will suffice to keep the profits rolling in.

Why Do Investors Invest

Before getting into 1987 and Black Tuesday, a broader question may first come to mind. What motivates a person or an organization to buy securities in the first place? Basic economic theory states that money spent in one place can not be spent in another place. In other words, once committed in the securities market, that money is tied up and can not be spent in any different way. So, why don't people just spend their money on gadgets or televisions?

The key to the answer revolves around the fact that people in general want to create savings in order to pass the money into the future. Savings takes into consideration a person's future cash needs. Also, a second motivation is man's innate need to increase wealth. Better put, man likes to raise money in a way that is similar to raising children.

Making money grow often leads to a temporary insanity where the person desiring to raise or grow his money is compelled to get rich faster than is possible. The need for wealth forces an individual into taking a bigger risk than need be. If a person purchases a lottery ticket, his chance of getting rich increases in proportion probability to how many other people are playing and the possible random chances the lottery has built in.

The stock market is not like a lottery. One may be willing to invest with the intent of the big pay off which of course is similar to a lottery ticket purchase, but the sometimes the big payoff is not worth the price of participation. "How a lack of major news or important events prior to the decline could justify a 22% change. The cause was psychological, caused by an old memory. Thus it needed no events or important news to emerge." (Black Tuesday)

Sometimes the market bites.

(Market Crash of 1987)

The Efficient Market Theory

The efficient markets hypothesis proclaims no one in theory can ever beat the market. The main thought in the efficient markets hypothesis is that when it comes to stock or market prices, the market as an entity has already accounted for any and all relevant information. "This is a highly controversial and often disputed theory. Supporters of this model believe it is pointless to search for undervalued stocks or try to predict trends in the market through any technique from fundamental to technical analysis. Academics point to a large body of evidence that is in support of EMH." (Greatest Market Crashes)

Market efficiency has many implications for investors. Because the market is efficient it is very difficult to misdirect the investors for too long because only substantial news should move the price of a stock. But there seem to be exceptions to the efficient markets hypothesis. What the efficient market hypothesis does not take into consideration is an occurrence called speculative bubbles.

Basically, the prices can fluctuate in either direction because of the whims associated to a type of investor psychosis or even lunacy. Why would this have anything to do with the Crash of 1987?

What Is Black Tuesday

As demonstrated by the hourly chart below, Black Tuesday was an intense effort to sell the house. When the Standard and Poorer's 500 Index fell approximately twenty percent in a single day on Tuesday, October 19, 1987, whole fortunes were lost in the blink of an eye. The twenty percent drop was the largest one day drop in the entire history of this or any other stock market performance.

(Black Tuesday)

There was also a less dramatic but just as serious ripple effect felt in markets all over the globe as they also crashed. The crash was so severe that many of the major stocks had to be pulled off the trading floor many for the first times in their history. When all was said and done, the United States stock market nose dived a full twenty-nine percent. In hindsight, the crash was eventually blamed on index derivatives and dynamic trading strategies.

The severity of the crash took the world by surprise. The odds of such a catastrophic event can only be compared to an earthquake off of the Richter scale. Miraculously, the aftermath was relatively controlled. Surprisingly, not one stock clearing houses collapsed in the light of the catastrophic event.

Details of the crash

Is it important to review the causes of the crash? Like a Monday morning quarterback, seventeen years have understanding the 1987 market crash the basis for a better understanding of how the market will work in this new high-tech global economy. Black Tuesday is the most significant financial event of the 20th century and can be compared to the Great Depression in scope and sensationalism.

Several first help Black Tuesday gain so much recognition. First, the fact that the market fell as fast and as furious as it did was unprecedented. Also in the realm of firsts was how the market only took one day to have such as complete fall. Throughout history, analysts usually received some fair warning of a future collapse but this particular day baffled even the most seasoned investors and market watchers.

Most unbelievably, even with all of the latest technology and an accurate account of all the days prior and the actual day's event, there really has never been a viable solution to what actually happened. In other words, no one really knows for sure what happened on October 19th.

Market Recovery

Investors should be prepared for sell-offs. Sell-offs like the market crash of 1987 occurs for many reasons. There is no sure way to tell or predict what the market's recovery period will be based on the type of sell off. Some sell-offs have included speculative bubbles, a lack of confidence in the economy, a potential recession, increased inflation, war, or simply "just because." There are formulas that can show what happened but the fact is that recovery is variable.

How quickly do markets recover from devastating days like that of Black Tuesday? Historically, United States stock market sell-offs have shown that investors are working on the assumption that a market will regain a certain former price level. That is not guaranteed.

The other note to mention is that unfortunately bubbles seem to be occurring on a more frequent level as history is an excellent barometer of things to come. "While large asset price fluctuations are by no means a new phenomenon, a distinctive feature of the last two decades is that prolonged build-ups and sharp collapses in asset markets have taken place amidst a decline in consumer price inflation and a more stable macroeconomic environment in most of the industrialized world." (Unknown, "Asset Prices and the Business Cycle") Technically, could we consider the fallout of the Enron debacle a bubble?

Experts have confirmed that immediately after the Crash of 1987, it only took a few days for a few stocks to recover to original levels prior to the crash. The important observation was that the overall market took months to recover to the original pre-crash level prices. Although months sounds bad, there have been some worst case scenarios for stocks waited years to move back to a pre-crash level.

As the baby boomer generation prepares for retirement, investors should re-read the historical ledgers and investors should avoid get rich quick notions and move into the market for the long haul. Recovery and profits can be associated to patient investing over time which creates a situation of reduced market volatility.

(Black Tuesday)

Future Trends

What were future repercussions of Black Tuesday on investors? Only three-year later a new speculative bubble became apparent. Around 1990, a new era of computer firms promising the world started the dot.com era.

The dot.com era is another example of stock price growth that so far exceeds corporate earnings that the corporate earning's growth could never support the necessary revenues to meet investor expectations.

A good example of the missed investor realty can be demonstrated by a comparison of the Yahoo stock from the 1990's and ten years later. "Yahoo jumped $19.44 to $124.94 by the close of regular trading a day after the company reported stronger-than-expected earnings. Other Net stocks are riding Yahoo's wave: Amazon.com was up 6% at $35.06, Priceline.com jumped 10% to $35.62, and Lycos gained 6% to $44.25. America Online rose 3% to $57.44. The run-up comes after yesterday's sell-off, sparked by anticipation of Yahoo's earnings report. Yahoo's stock yesterday hit its calendar year low."(Jim Hu and Evan Hansen, Better-than-expected earnings boost Yahoo shares)

Today Yahoo's common sells for under $40 a share and no one today would even venture how the stock reached over a $100 only a decade ago. Like 1987, the dot.com era showed that a frenzied speculative bubble showed how irrational investors can be and will continue to be in the future.

There are many new concerns and current events for investors to consider. The September 11th attack on the United States by terrorists has completing the toppling of an already troubled airline industry. New terroristic threats on the United States have the travel and leisure tourism industries begging for new travelers. The North American Free Trade Agreement (NAFTA) between the North American nations seems to have given the United States' economy a much needed boost but then again the baby boomers are nearing retirement age and unsolved social security and healthcare issues abound.

The internet continues to make our world a smaller and more open economic arena. But that same entrepreneurial nation mentality has emerging nations increasing the demand for oil and other limited resources.

The price of oil has hit record prices per barrel and new highs are expected as the fragile supply chain centered by the OPEC nations is being pushed to its capacity limits because of an unsure future. The war with Iraq, Russia's tax issues and rouge sovereign entities in many oil producing African nations also interfere with oil supplies. Wow, the stock market will continue to be an unsure thing because the issues surrounding our future make investing an iffy proposition at best.

Stock volatility remains unusually low since the 1987 stock market crash. Since 1987, there have been very large increases in overall stock prices. What does that mean? Stock prices have been extremely volatile by historical standards.

Lessons Learned

Alan Greenspan became the Federal Reserve Bank Chief only a few months before the crash of 1987. There were many lessons learned for Mr. Greenspan. His responsibilities are to lead the Federal Reserve, which comprises the Board of Governors in Washington D.C., and twelve regional Federal Reserve Banks, to stop occurrences like the Stock Market "Crash of 1987 from ever happening again. He does this by:

Controlling the nation's monetary policies through influence over the fiscal and credit conditions of the economy

Regulate the banking institutions

Stabilize the financial system

Provide certain financial services to the U.S. government and other financial institutions

The one who seems to have learned the most from the events of the Black Tuesday Crash is the Federal Chairman himself. What he may have learned was that being in the market for the long haul is a better way to go then any get rich quick schemes. The impatient investor should take the lesson learned and move the quick payback thoughts to the back burner.

Therefore, have we seen the last of the big economic booms? There is a definite correlation of the economy in the late 1980's and today. Is there a better indicator of the current United States economic situation than the housing situation caused from constant interest controls by the Federal Reserve Bank and Alan Greenspan?

Similar to the aftermath of the world wide stock market crash in October of 1987, Alan Greenspan and the Federal Reserve Bank used interest rate controls to reinvigorate the United States economy. By lowering rates and creating a massive real estate boom, the economy was allowed to resurge and create new revenue streams for the banks and business sectors which held up the economy. Even with the seriousness of the stock market crash of October 1987, the renewed economic growth created by the new housing boom white washed Black Tuesday out of headlines.

Alan Greenspan and the Fed have used that same formula to beat inflation and to help protect the economy from the serious crash that seems to be looming. But like any medicine, the economy seems to be building some immunity to the cure all interest rate adjustments. In other words, like the crash of 87, something is looming and the same cure has been working but the dosage of medicine keeps going up. Similar to 1987, the United States housing boom is going on strong but there has not been a stock market crash as of yet. Greenspan and the Fed seem to have come up with a formula that works.

The formula that has been working for the Federal Reserve uses three tools: the open market operations which controls all United States banks reserves, the setting of those reserve requirements for banks, and last the setting of the discount rate for lending reserves. Apparently, the Fed has done well by monitoring and then adjusting the interest rates to a point where we have not has a repeat of 1987 or even potentially larger market crashes. The mix of forcing the economy to add liquidity coupled with low interest rates has also avoided any long lasting recession.

Conclusion

In conclusion, the purpose of this report was to discuss in detail the problems associated with the stock market crash of 1987. The stock market is only supposed to fluctuate by a few points in either direction on any given day. But as was demonstrated by this account most investors were taken aback by that particular market downturn. This testimony examined some of the more immediate consequences that occurred immediately following the event the series of events that continue to influence investors today. The report ascertained lessons learned to help create an atmosphere that would not recreate this black mark on history. The lessons learned also touch upon steps taken to prevent future crashes. Some of those fail safes like new circuit breakers and market limits instituted after 1987 are still working to protect investors today. The report did a bit of speculation in order to see if a severe market crash was in our immediate future.