$ Introduction.

$ The Cause of the Crash.

$ The U.S. Government’s Reaction.

$ Reform.

$ Impact on the Economy.

$ Introduction

From October 14 to October 19, 1987, the major indices of the United States (Dow Jones, Nasdaq, S&P 500) dropped 30% and more. On October 20, these indices recovered a part of their losses. However, for the next 4 months, they were often subject to fairly large daily variation. It took 1 year and 10 months - until 1989 - for the markets to reach a new high with a gain of 37%.

Here are the details of how the crash affected the Dow Jones (DJIA) and the Standard and Poor's 500 (S&P 500) index:

Impact on the DJIA

The 1987 stock market crash occurred on the so called "Black Monday" - October 19, 1987 - when the DJIA dropped from 2246 to 1738 points, losing 22,6% of it's total value. From the close of trading on Tuesday, October 13, to the close of trading on Monday, October 19, the DJIA dropped by almost one third, indicating a loss in value of all outstanding U.S. stocks of about 1 trillion Dollars.

This crash marked the end of a 5 year "Bull" market that saw the DJIA rise from 776.92 points in August 1982 to a high of 2722.42 points in August 1987.

Fortunately, the markets soon recovered after the crash. The DJIA had a record gain in one day of 102.27 points on October 20, 1987 and 186.64 points 2 days later.

By September 1989, the DJIA had regained all it had lost in the crash.

Impact on the S&P 500

On August 25, 1987, the S&P 500 peakd at 337.89 points. It then started to plunge, accelerating downward into Friday, October 16, when the market closed down almost 5.3% for the day.

On October 19, the S&P 500 dropped from 282.7 to 225.06 points (-20.4%) and declined 21.8% for the month of October.

The Market continued to drop making new lows for the next month and a half. From the market peak to the October lows the S&P 500 lost 35.9% of it's value. It also regained all it's losses 2 years later.

$ The Cause of the Crash

Although a number of people tried to account for the 1987 crash, no one can provide a complete explanation. There were many suspects, but not enough evidence to convict anyone.

Here are some of the main explanations people came up with:

1. Computer Trading and Derivate Securities
   
   In search 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 crash, other stock markets which did not use program trading also crashed, some with losses even greater than the U.S. market.
   
   Some analysts found fault with the use of *index futures or *derivative securities.They claim that these practices increased the variability, risk and uncertainty of the U.S. stock markets. Nevertheless, none of these methods or pracitces existed in previous large and sudden market declines that occurred in 1914, 1929, 1962 or in the early 70's during the oil crisis.

         As a result, we cannot conclude that computer trading and derivatives
           were the major cause of the crash.

    2.  Illiquidity

         During the crash, trading mechanisms in financial markets were not able to deal with such large
           flow of sell orders. Many stocks in the New York Stock Exchange weren't traded until late in
           the morning of October 19 because not enough buyers could be found 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
           their stock at the same time.

    3.  Trade and Budget Deficits

         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 drop 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 the 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 it's trading partner.

    4.  Overvaluation

         Many analysts agree that stock prices were overvalued in September 1987.
        
          *Price/Earning ratios and *Price/Dividend ratios were too high. But 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,                  it can be assumed that over valuations do not trigger crashes every time.

$ The U.S. Government's Reaction to the Crash

The U.S. central bank supplied liquidity through the open market purchase of U.S.
government securities, adding $2.2 billion in non-borrowed reserves.In addition, the Federal Reserve Bank provided help to commercial banks by making the discount window available when they encountered heavy reserve needs.

The Chairman of the Federal Reserve Bank, Alan Greenspan, also reassured the public that the Federal Reserve would serve as a source of liquidity to support the economic and financial system. Interest rates on short-and-long-term financial instruments dropped in order to provide liquidity. For example, the interest rate on three-month *Treasury bills droppen from 6.74% on October 13 to 5.27% on October 30, while the federal funds rate declined by 179 basis points over this interval, and the rate on 30-year *Treasury bonds dropped from 9.92 to 9.03%.

Further, banks increasing lending to securities firms during October 19 - 23 enabled firms to finance the inventories of securities accumulated by their customers sell orders. Partially due to the Federal Reserve and banks assistance, the stock price recovery period was much shorter than the 1929 crash.

$ Reform

Several changes took place in the U.S. financial market after the 1987 crash which were also introduced in other countries:

    1.  The Circuit Breaker System

         So called "circuit breakers" were introduced which is a mechanism by which trading would be
           stopped for 1 hour if the DJIA dropped more than 250 points in one day.

           After trading resumes, it would again be stopped by 2 hours this time if the DJIA dropped
           another 150 points making it a total of 400 points in one day.

           The circuit breakers were installed primarily to prevent extreme changes in the stock market
           and to give the market time to calm down and for brokers and dealers to re-assess the overall
           situation.

    2.  Uniform Margin Requirements

         Uniform *margin requirements is another change that was introduced after the crash.
           It aims to reduce volatility for stocks, futures and stock options.

    3.  Computer Systems

         After the crash, some stock exchanges changed their computer systems in order to improve
           data management effectiveness and increase accuracy, efficiency and productivity.

$ Impact on the Economy

There was widespread fear that this crash would bring on a devastating recession.

However, there was no recession within the next 2 years and there was no instant concern the solvency of the financial system. In fact, fallout from the 1987 crash was remarkably light, partly due to the intervention by the central bank of the U.S., the federal reserve. Also, most of the industries that were not directly tied to the stock markets were not influenced at all by the crash.

In addition, many U.S. corporations announced they would repurchase their own stocks, implying that they felt that the price drop was unnecessary. Moreover, continuous good news about the U.S. economy speeded the recovery from the market collapse.

The worst economic loss occurred on Wall Street itself, where 15,000 jobs were lost in the financial industry.

Ricky Schmidt

July 5, 2003

StockBreakthroughs.com > The 1987 Stock Market Crash