An overview on what happened and why by Forbes

Forbes giving an insight behind the stock market crash of 1987 in a world where investors relied on corporate image and insider trading.

The American business report on the night of Black Monday

This is a video clip of the first 10 minutes of the Nightly Business Report episode from Black Monday, October 19, 1987. This video is interesting as it shows the media's reaction and the public reaction to the market crash.

Investment Advisor Kenneth W. Brown predicting the crash months before it happened

This is a video clip from the Nightly Business Report with Paul Kangas on July 31, 1987. An Investment Advisor Kenneth W. Brown predicted the 1987 Stock Market Crash. He called it an October Massacre.

The many theories and causes of the crash

With macroeconomic events many experts and economists have their own reasons and opinion of why such events happen and this week I am going to discuss the various causes and their counter arguments. 

Program trading by institutional investing companies was a cause of the crash.
However other markets such as Australia and Hong Kong, where program trading was not widespread, also crashed. These may have been in reaction to the program trading in the U.S. but economist Richard Roll says that the crash began in Hong Kong and struck the U.S. after other markets had already descended by considerable amounts.

A senior fellow with the National Centre for Policy Analysis of Dallas and the Brady Commission argued that the early blames for the crash was to do with the failure between the stock markets and derivatives markets to activate in sync with each other. This can happen as the options and futures rely heavily on the changes and volatilities in the stock prices market.

Illiquidity played its part during the crash as large amounts of sell orders were trying to be processed it was difficult to find buyers and this led to termination in trading for many listed stocks. This heightened the price drop as investors had overestimated the amount of liquidity. It does not explain why so many people tried to sell so much stock at the same time. This could be to do with human nature and panic settling in the market

Analysts concur that the stock prices were overvalued around the time of the crash with Price/Earning and Price/Dividend ratios being too high. Though this does not explain the trigger of the crash as they were also historically high in the period 1960-1972 and no crash occurred then.

A reason for investors leaving the stock market could of been to do with the growing attraction of the bond market as long term bond yields had started the year at 7.6% and had grown to 10% by the summer. This offered a more stable, lucrative alternative to the stock markets for investors.

Another possible reason was the announcement on October 14^th of the large U.S. trade deficit where investors may have predicted a fall in the dollar on foreign exchange markets. However this does not explain crashes in other countries.

With these arguments still in contention for debate, program trading took a lot of the blame in the public eye and next week I will discuss the aftermath and the Government intervention that followed the crash.

Origins

The U.S. Securities and Exchange Commission, SEC, that had been set up after the great depression had worked effectively at preventing crashes and fraudulent practices throughout the stock market and had even convinced cautious investors back into the markets in the 1960s and 70s. The problems were they could lead the horse to water but couldn’t make it drink i.e. they could bring the investors to all the information about companies but couldn’t make them invest in the best ones. 

Investors could be easily persuaded by the public image of a company and not the value. The SEC tried to prevent this by making all companies announce what assets they had if any but investors would believe that these companies had limitless potential and so consistently backed them. This continued into the 80s even though there were regular bumps and insolvencies, where companies did not reach their financial goals and expectations. Conglomerates and hostile takeovers were popular in this “new economy” and it was said that companies “would grow exponentially rather than incrementally simply by picking up other companies”.

The market kept rising through the 80s and SEC were unable to stop these conglomerates and there became a huge dependence on program trading, which is computerised trading set to occur when index prices rise or fall to a certain level which can create very volatile situations.

At the start of 1987, the SEC started investigations into insider trading, news of which began to unnerve investors, even though some investors may have been aware of this insider trading.

Bonds or even junk bonds became a more attractive proposal than the corruption being publicised in the stock markets. This led to a huge departure from the market and the program trades began to take control with their stop loss features being activated. These were settings that would automatically sell stocks if their prices fell to a certain level. With a vast number of stop loss features sending orders to the NYSE computer (designed order turnaround, DOT) it made the system freeze and lag. This left every investor effectively blind. Then panic set in with more and more people selling stock even though they were unaware of what losses were made and if the order would happen quick enough to keep up with falling prices.

The New York Times, above, sums it up well what happened as it led the Dow Jones to fall by 508.32 points which was 22.6% and $500 billion disappeared.

In my next posts I’ll discuss the different causes and what Government intervention was taken to stop history repeating itself.