The Crash Put Simply: Oct-87 - How It Happened, Why It Matters, and What We Can Learn from It
The Crash Put Simply: Oct-87
On October 19, 1987, the world witnessed one of the most dramatic events in financial history. The stock market crashed across the globe, wiping out trillions of dollars in wealth and sending shockwaves through the economy. It was a day that changed the course of history and shaped the future of finance. But what exactly happened on that fateful day and why does it matter? In this article, we will explain the causes, effects, and lessons of the 1987 crash in simple terms. We will also compare it with other major crashes in history and see what we can learn from them.
The Crash Put Simply: Oct-87
The Causes of the Crash
The 1987 crash was not a sudden or isolated event. It was the result of a complex combination of factors that had been building up for months or even years. Here are some of the main causes of the crash:
The Global Context: Trade deficits, currency fluctuations, and geopolitical tensions
In the mid-1980s, the world economy was facing several challenges. The US had a large trade deficit with Japan and other countries, which meant that it was importing more than it was exporting. This put downward pressure on the US dollar and made foreign goods cheaper for Americans. To counter this trend, the US government agreed with its allies to intervene in the currency markets and devalue the dollar. This agreement was known as the Plaza Accord and it was signed in September 1985.
However, by 1987, the dollar had fallen too much and too fast. This hurt American exporters and investors who had assets abroad. It also raised fears of inflation and higher interest rates in the US. To reverse this trend, the US government agreed with its allies to intervene in the currency markets again and stabilize the dollar. This agreement was known as the Louvre Accord and it was signed in February 1987.
But these interventions did not work as planned. The dollar continued to decline and interest rates continued to rise. Moreover, there were growing tensions between the US and its trading partners over trade policies and tariffs. There were also geopolitical risks such as the Iran-Iraq war, which threatened oil supplies and prices.
The Market Conditions: Overvaluation, speculation, and leverage
Meanwhile, the stock market was booming. Between 1982 and 1987, the Dow Jones Industrial Average (DJIA), a major index of US stocks, rose from about 800 points to over 2700 points, an increase of more than 200%. This was driven by several factors, such as strong corporate earnings, low inflation, tax cuts, deregulation, and innovation. The market also benefited from the influx of new investors, such as pension funds, mutual funds, and individual savers.
However, the market was also overvalued. The price-to-earnings ratio (P/E), a measure of how expensive a stock is relative to its earnings, was above 20 for the DJIA, well above its historical average of around 15. The market was also fueled by speculation and leverage. Speculation means buying stocks based on expectations of future price increases rather than on fundamentals. Leverage means borrowing money to buy more stocks than one can afford. Both practices amplify the potential gains and losses from stock movements.
One of the most popular forms of speculation and leverage in the 1980s was called program trading. Program trading involved using computer algorithms to execute large orders of stocks based on certain triggers, such as price movements or index levels. Program trading was often used by institutional investors, such as hedge funds or banks, to hedge their portfolios or to arbitrage price differences between markets. Another form of speculation and leverage in the 1980s was called portfolio insurance. Portfolio insurance involved using options or futures contracts to protect against losses from stock declines. Portfolio insurance was often used by institutional investors, such as pension funds or mutual funds, to reduce their risk exposure.
The Trigger Events: Computerized trading, portfolio insurance, and margin calls
On October 14, 1987, the DJIA dropped by 95 points, or 3.4%, its biggest one-day decline since 1914. This was partly due to a report that showed a larger-than-expected trade deficit for August. The report raised concerns about the strength of the US economy and the value of the dollar. It also increased the likelihood of higher interest rates and tighter monetary policy by the Federal Reserve.
On October 15, 1987, the DJIA dropped by another 58 points, or 2.1%. This was partly due to a statement by the US Treasury Secretary that suggested that the US was not concerned about the falling dollar. The statement angered the US allies and undermined the credibility of the Louvre Accord. It also signaled that the US might not intervene to support the dollar or lower interest rates.
On October 16, 1987, a Friday, the DJIA dropped by another 108 points, or 4.6%, its biggest one-day decline since 1929. This was partly due to a wave of selling by program traders and portfolio insurers who were trying to hedge or exit their positions before the weekend. It was also partly due to a rumor that a major takeover deal involving UAL Corporation, the parent company of United Airlines, had collapsed. The rumor sparked fears of a credit crunch and a slowdown in merger activity.
On October 19, 1987, a Monday, the DJIA plunged by 508 points, or 22.6%, its biggest one-day decline ever. This was partly due to a panic reaction by investors who were shocked by the events of the previous week and wanted to get out of the market at any cost. It was also partly due to a breakdown in communication and coordination among market participants and regulators. The market was overwhelmed by a flood of sell orders from program traders and portfolio insurers who were trying to limit their losses or meet their obligations. The market was also hit by a surge of margin calls from brokers who were demanding more collateral from investors who had borrowed money to buy stocks.
The Effects of the Crash
The 1987 crash had significant and lasting effects on the economy and society. Here are some of the main effects of the crash:
The Immediate Impact: Panic selling, circuit breakers, and liquidity crisis
The crash caused widespread panic and confusion among investors and traders. Many people tried to sell their stocks but could not find buyers or prices. Many people also tried to call their brokers or banks but could not get through or get answers. Many people also tried to access their accounts or statements but could not get information or confirmation.
a certain range for a certain stock or security. These mechanisms were meant to calm the market and restore order, but they also had some unintended consequences. For example, circuit breakers and trading halts disrupted the normal functioning of the market and created bottlenecks and imbalances. Price limits also created arbitrage opportunities and distorted price signals.
The crash also caused a liquidity crisis in the market. Liquidity means the ability to buy or sell an asset quickly and easily without affecting its price. Liquidity is essential for the smooth operation of the market and the efficient allocation of capital. However, during the crash, liquidity dried up as buyers disappeared and sellers outnumbered them. This made it harder and costlier to trade and increased the risk of default or bankruptcy.
The Short-Term Consequences: Regulatory reforms, market volatility, and investor confidence
The crash prompted several regulatory reforms to improve the functioning and stability of the market. These reforms included increasing capital requirements for brokers and dealers, enhancing disclosure and reporting standards for issuers and traders, strengthening oversight and coordination among regulators and exchanges, and introducing new rules and technologies for clearing and settlement systems. These reforms aimed to reduce systemic risk, enhance transparency, and prevent fraud and manipulation.
The crash also increased market volatility and uncertainty in the short term. Volatility means the degree of variation or fluctuation in the price of an asset over time. Volatility is a measure of risk and opportunity in the market. However, too much volatility can be harmful as it can discourage investment and growth. After the crash, the market experienced several sharp swings and corrections as investors adjusted their expectations and strategies. The market also faced several external shocks, such as the Gulf War in 1990-1991, which added to the volatility.
The crash also affected investor confidence and behavior in the short term. Confidence means the degree of trust or belief that investors have in the market or in their own abilities. Confidence is a key factor that influences investment decisions and outcomes. However, too much or too little confidence can be detrimental as it can lead to overconfidence or underconfidence. After the crash, many investors lost confidence in the market and in themselves. Some investors withdrew from the market altogether or shifted to safer assets, such as bonds or cash. Some investors also became more cautious or conservative in their risk-taking or diversification.
The Long-Term Implications: Lessons learned, structural changes, and future challenges
The crash had some lasting implications for the economy and society. Here are some of the long-term implications of the crash:
Lessons learned
The crash taught several valuable lessons to investors, traders, regulators, policymakers, and academics. Some of these lessons include:
Markets are not always efficient or rational. Markets can be influenced by human emotions, biases, errors, and herd behavior. Markets can also be affected by technical factors, such as computerized trading or leverage.
Markets are not always stable or predictable. Markets can be subject to sudden shocks or crises that can have cascading effects across sectors or regions. Markets can also be subject to long-term cycles or trends that can have lasting effects on performance or valuation.
Markets are not always isolated or independent. Markets are interconnected and interdependent with other markets, such as currency markets or bond markets. Markets are also influenced by external factors, such as economic conditions or political events.
Markets are not always self-regulating or self-correcting. Markets may need some form of regulation or intervention to prevent or mitigate problems, such as fraud, manipulation, contagion, or systemic risk. Markets may also need some form of support or stimulus to promote or restore growth, such as monetary policy or fiscal policy.
Structural changes
The crash also led to some structural changes in the market and the economy. Some of these changes include:
The rise of index funds and passive investing. Index funds are funds that track a specific index or benchmark, such as the S&P 500 or the Nasdaq 100. Passive investing means investing in index funds rather than actively picking stocks or sectors. Index funds and passive investing became more popular after the crash as they offered lower costs, higher diversification, and better performance than active funds or individual stocks.
The growth of derivatives and alternative investments. Derivatives are financial instruments that derive their value from underlying assets, such as stocks, bonds, currencies, or commodities. Alternative investments are investments that are not traditional stocks, bonds, or cash, such as hedge funds, private equity, real estate, or commodities. Derivatives and alternative investments became more popular after the crash as they offered more flexibility, customization, and hedging opportunities than conventional investments.
The development of financial technology and innovation. Financial technology or fintech means the use of technology to provide or enhance financial services or products, such as online banking, mobile payments, robo-advisors, or cryptocurrencies. Financial innovation means the creation or improvement of financial instruments or methods, such as securitization, credit default swaps, or high-frequency trading. Fintech and financial innovation became more popular after the crash as they offered more convenience, efficiency, and accessibility than traditional finance.
Future challenges
The crash also posed some future challenges for the market and the economy. Some of these challenges include:
The risk of complacency or overconfidence. Complacency means the state of being satisfied or content with the status quo or the current situation. Overconfidence means the state of being excessively confident or optimistic about one's abilities or outcomes. Complacency and overconfidence can be dangerous as they can lead to underestimating or ignoring potential problems or risks.
The risk of complexity or opacity. Complexity means the state of being complicated or difficult to understand or analyze. Opacity means the state of being unclear or obscure or lacking transparency or disclosure. Complexity and opacity can be harmful as they can lead to confusion or miscommunication or information asymmetry.
The risk of contagion or spillover. Contagion means the state of being infected or affected by something else. Spillover means the state of having an impact or influence on something else. Contagion and spillover can be detrimental as they can lead to transmission or amplification of problems or shocks across markets or regions.
The Comparison with Other Crashes
The 1987 crash was not the first or the last major crash in history. There have been several other crashes that have occurred before or after 1987. Here are some of the comparisons between the 1987 crash and other crashes:
The Similarities with the 1929 Crash: Market bubbles, herd behavior, and contagion effects
The 1929 crash was another historic event that occurred on October 29, 1929, also known as Black Tuesday. The 1929 crash marked the end of the Roaring Twenties, a decade of economic prosperity and social change in the US. The 1929 crash also marked the beginning of the Great Depression, a period of economic hardship and suffering that lasted until the late 1930s.
The 1929 crash had some similarities with the 1987 crash, such as:
Market bubbles: Both crashes were preceded by a period of rapid and unsustainable growth in stock prices that created market bubbles. A market bubble is a situation where the price of an asset exceeds its intrinsic value by a large margin due to irrational exuberance or speculation.
Herd behavior: Both crashes were fueled by a phenomenon called herd behavior. Herd behavior means the tendency of individuals to follow the actions or opinions of others without thinking independently or critically. Herd behavior can lead to positive feedback loops that reinforce price movements in either direction.
Contagion effects: Both crashes had contagion effects that spread across markets and regions. Contagion effects mean the transmission or spillover of problems or shocks from one market or region to another due to interconnections or interdependencies.
The Differences with the 2008 Crash: Financial system stability, government intervention, and recovery speed
The 2008 crash was another historic event that occurred on September 15, 2008, also known as Black Monday. The 2008 crash marked the peak of the global financial crisis, a period of severe disruption and distress in the financial system and markets that started in 2007. The 2008 crash also marked the onset of the Great Recession, a period of economic contraction and stagnation that lasted until 2009.
The 2008 crash had some differences with the 1987 crash, such as:
Financial system stability: The 2008 crash was more severe and systemic than the 1987 crash. The 2008 crash involved not only stock markets but also other financial markets and institutions, such as banks, mortgage lenders, insurance companies, hedge funds, and rating agencies. The 2008 crash also threatened the stability and solvency of the entire financial system and posed a risk of a global meltdown.
1987 crash. The 2008 crash prompted the governments and central banks of major countries to take unprecedented and extraordinary measures to rescue and support the financial system and the economy. These measures included bailouts, guarantees, injections, stimulus packages, quantitative easing, and zero interest rates.
Recovery speed: The 2008 crash took longer to recover than the 1987 crash. The 2008 crash caused a deep and prolonged recession that lasted for more than a year and had lasting effects on employment, income, and output. The 2008 crash also left behind a legacy of debt, deficits, and imbalances that constrained growth and stability for years.
The Parallels with the 2020 Crash: Pandemic shocks, central bank actions, and market resilience
The 2020 crash was another historic event that occurred on March 16, 2020, also known as Black Monday II. The 2020 crash marked the onset of the coronavirus pandemic, a global health crisis that infected millions of people and killed hundreds of thousands. The 2020 crash also marked the onset of the coronavirus recession, a period of economic disruption and contraction that affected almost every country and sector.
The 2020 crash had some parallels with the 1987 crash, such as:
Pandemic shocks: Both crashes were triggered by exogenous shocks that were unrelated to the market or the economy. Exogenous shocks mean events or factors that originate from outside the system and are unexpected or unpredictable. The 1987 crash was triggered by geopolitical tensions and currency fluctuations. The 2020 crash was triggered by a novel virus outbreak and lockdown measures.
Central bank actions: Both crashes were met with swift and decisive actions by central banks to stabilize and stimulate the market and the economy. Central banks are institutions that control the money supply and interest rates in a country or region. The 1987 crash led to coordinated interest rate cuts and liquidity injections by major central banks. The 2020 crash led to unprecedented interest rate cuts and asset purchases by major central banks.
Market resilience: Both crashes were followed by rapid and remarkable recoveries in the market. Market resilience means the ability of the market to bounce back or adapt to shocks or changes. The 1987 crash was followed by a V-shaped recovery that saw the DJIA regain its pre-crash level within two years. The 2020 crash was followed by a V-shaped recovery that saw the DJIA regain its pre-crash level within five months.
The Conclusion
The 1987 crash was one of the most significant events in financial history. It was a day that shook the world and changed the course of history. It was also a day that taught us many lessons and left us many challenges. The 1987 crash showed us the power and the peril of the market. It showed us the importance and the difficulty of understanding and managing the market. It showed us the need and the opportunity for learning and improving from the market.
FAQs
What was the biggest drop in stock market history?
The biggest drop in stock market history in percentage terms was on October 19, 1987, when the DJIA fell by 22.6%. The biggest drop in stock market history in absolute terms