The 1987 Stock Market Crash – Can It Happen Again?
On Monday, October 19, 1987, stock markets around the world dropped dramatically, with stock owners losing huge amounts of money in a short period of time. The fall in stock prices started in the Hong Kong markets and spread westward to Europe, hitting the United States markets after the other markets had already experienced significant declines. The Dow Jones Industrial Average (DJIA) fell 508 points to 17,38.74, which was a 22.6% decline. This eclipsed the October 28, 1929, drop of 12.82% to become the largest single-day percentage drop in stock prices in the history of the stock market. The day became known as “Black Monday.” What were the causes, what changes came about because of the crash, and can it happen again?
Leading Up to the Crash
By early 1986, the rapid recovery from the recession of the early 1980s was starting to slow. In August 1987, the DJIA peaked at 2,722 points, which was a 44% rise for the year. The collapse of OPEC in early 1986, which led to crude oil prices dropping by more than 50% over the year, also led to further uncertainty in the markets.
During the 1980s, the stock market had been posting strong gains. Stock prices outpaced earnings, resulting in elevated price-earning (P/E) ratios and causing many financial commentators to view the markets as overvalued. Stock prices had been buoyed by the influx of new investors, such as pension funds, into the stock market. Changing tax laws that allowed firms to deduct interest expenses associated with debt issued during a buyout increased the number of companies that were potential takeover targets and pushed up their stock prices. In the months leading up to the crash, the macroeconomic outlook had become somewhat clouded as interest rates started to rise globally and a decline in the U.S. dollar was leading to concerns about inflation.
The morning of Wednesday, October 14, news organization reported two stories that would negatively impact the stock market. First, the Ways and Means Committee of the U.S. House of Representatives had filed legislation to eliminate tax benefits associated with financial mergers—thus reducing the value of stocks that were potential takeover candidates. Secondly, the Commerce Department announced the trade deficit was significantly above estimates, resulting in a drop in the dollar and increased interest rates. By the end of that Wednesday, the market dropped 3.8%, then dropped another 2.4% the next day. The market was now down 12% from the August 25 all-time high.
Leading to further uncertainty in the market, on Thursday, October 15, Iran hit the American owned supertanker, the Sungari, with a Silkworm missile off Kuwait’s main oil port. The next morning, Iran hit another ship, the U.S. flagged MV Sea Isle City, with a missile. On the morning of October 19, two U.S. warships shelled an Iranian oil platform in the Persian Gulf in response to Iran’s mill attack on the Sea Isle City.
On Friday, October 16, the London markets were unexpectedly closed when hurricane-force winds swept through Great Britain and parts of Europe. The DJIA dropped another 4.6% on record volume. Treasury Secretary James Baker spoke out with concerns about the falling prices. By the end of the week, the S&P 500 index was down over nine percent. The nearly record one-week decline would set the stage for the havoc that would unfold the following week.
“Black Monday” – October 19, 1987
At the open of the New York Stock Exchange on Monday, October 19, there was a large imbalance in the number of sell orders relative to buy orders, which resulted in a delay in the opening of the market. When the market did open, it was significantly lower, resulting in portfolio insurer’s models prompting them to sell into the decline. The record trading volume overwhelmed the stock clearing system, resulting in trade execution being reported more than one hour late, which reportedly caused confusion among traders. By the end of the day, the DJIA had fallen 508 points to 1,738.74, a 22.61% one-day decline—the worst in the history of the market.
By the end of October, stock markets in Hong Kong, Australia, Spain, the United Kingdom, Canada, and the United States had all fallen over 20%. New Zealand’s market suffered the most damage, falling about 60% from its 1987 peak, and it would take years for it to recover.
As a result of the market crash, in December 1987, a group of 33 prominent economists from around the world met in Washington, D.C. The group predicted further economic decline, reminiscent of the Great Depression after the 1929 stock market crash. The dire predictions didn’t come to pass, and economic growth resumed throughout 1987 and 1988, with the DJIA reaching it pre-crash high of 2,722 points in August 1989.
Causes of the Crash
In hindsight, there are many explanations for the 1987 stock market crash, such as overvaluation, program trading, illiquidity, and market sentiment. One of the new innovations at that time was portfolio insurance, where institutional investors would short sell a stock index on the futures market to limit any downside risk if the market dropped. Portfolio insurance is designed to allow institutional investors to enjoy the benefits of a rising market yet protect their stock portfolio during falling markets.
The growth of the use of computers on Wall Street allowed stocks and futures to be traded based on algorithms programed into the computer, called program trading. In program trading, the computer executes buy and sell orders of stock or futures at a rapid rate. Many blame program trades as one of the agents that deepened the crash as computers were selling stocks while the market fell. Roughly half the trading on that day was by a small number of institutions with portfolio insurance that was implemented through program trading. Congressman Edward Markey, who had warned about the potential dangers of program trading, stated, “Program trading was the principal cause.” The Presidential Task Force on Market Mechanism gave the greatest importance to portfolio insurance in causing the crash.
Changes That Resulted From the Crash
In order to calm the financial markets, the day after the crash, Federal Reserve Chairman Alan Greenspan said, “The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.” Out of the public’s eye, the Fed was encouraging the banks to continue to lend to financial institutions. During the week of October 19, the ten largest New York banks nearly doubled their lending to securities firms. The response of the Federal Reserve was seen as important in healing financial markets to allow return to normal functioning.
As a result of the crash, regulators stepped in and overhauled trading-clearing protocols to bring uniformity to the markets. To allow exchanges to step in and halt trading during instances of exceptionally large price decline, rules known as “circuit breakers” were developed. To prevent another major crash, the New York Stock Exchange can temporarily halt trading when the S&P 500 stock index declines seven percent, 13 percent, or 20 percent, in order to give investors “the ability to make informed choices during periods of high market volatility.”
Is the Stock Market Set up for Another Crash?
Since 1987, we have had one major decline in the stock market and a few minor corrections. In the 2008-2009 Great Recession, during which the stock market was down nearly 50% by March 2009 from its October 2007 peak, it would take until 2013 before the market would recover to its 2007 peak. The 2007 to 2009 price decline in stocks was a crash in slow motion when compared to the sudden drops experienced in 1987.
The “circuit breaker” rules introduced in 1988 have come into use only one time since then; this was during the late October 1997 mini-crash when the market dropped over 7% in one day. The drop of 350 points triggered a 30-minute halt on the stock, options, and index futures markets. After trading resumed, prices continued to plunge to reach the 550-point circuit breaker point. Once again, the markets closed for a 30-minute halt, and since it was near the end of normal market closing time, the markets didn’t open until the next morning. The next day, Tuesday, October 28, the markets opened down before rallying sharply. Apparently, the circuit breakers did their intended task and gave the market trades a few minutes to break the cycle of panic selling.
So, the answer to the question is yes, the stock market can crash again as it has done more than once since 1987. However, the next one will probably take longer to play out than the 1987 crash. To quote the adage, “History seldom repeats; however, it often rhymes.” The bottom line is, if you are a stock investor, even with markets at record highs, a little caution is always warranted.
Metz, Tim. Black Monday: The Catastrophe of October 19, 1987, and Beyond. William Morrow and Company, Inc. 1988.
Carlson, Mark. A Brief History of the 1987 Stock Market Crash With a Discussion of the Federal Reserve Response. Financial and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C. November 2006.
Geisst, Charles R. Wall Street: A History. Updated Edition. Oxford University Press. 1997.