Stock Market Crash of 1987 Term Paper

Since institutional investors typically hedge their risks by using asset liability management and derivatives instruments against market risk, it is estimated that institutional investors in a representative stock market such as the London Stock Exchange lost only 10% of the value of their assets in the 1987 crash. In the absence of such hedging the effect of the crash and the resultant liquidity crunch would have been far greater. (Markose, Sheri, n.d.)

Causes of the Crash number of possible reasons for the Crash have put forward by the experts, some of which are discussed below:

Program Trading

Program trading (also called computer trading) involves index arbitrage - which takes advantage of price discrepancies between indexes of stocks and futures contracts by using sophisticated computer models to hedge positions. Program traders or an arbitrageur simultaneously buys a stock in one market and offsets that purchase by selling it in a futures contract of another market; thus earning small but risk free profits. Such trading requires quick execution of orders and simultaneous monitoring of prices in different markets that can be achieved only by high-speed computers. Since large quantities of stocks and futures can be sold or bought through program trading, it is blamed by most people for having caused the stock market crash of 1987. After the crash, many analysts blamed program trading strategies for blindly selling stocks as markets fell, exacerbating the decline. Conversely, some economists have also held program trading responsible for the speculative boom leading up to the peaking of stock values in August 1987. (Koning, Paul 2003 -- "The 1987 Stock...")

Program trading, however, cannot be the major reason behind the crash and was certainly not the trigger behind the decline since selling of large quantities of stocks occurred only after certain conditions had appeared in the market. Moreover, the decline in stock markets was felt globally and even those markets that did not practice computer trading also declined. In fact, some of the markets where no program trading existed declined far more than the U.S. stock markets on October 19. For example, the Hong Kong stock market that had no program trading declined almost 40% as compared to the 20% decline in New York. The argument that other stock markets declined only in reaction to the decline in U.S. market (where program trading was in place) is also unsustainable, since market decline in Hong Kong on October 19 had started earlier before the opening of the U.S. markets.

Portfolio Insurance

Portfolio Insurance is a hedging technique used by institutional investors in an uncertain or volatile market by short selling stock index futures. By doing so, institutional investors and fund managers ensure that they do not lose more than a certain percentage of their holdings. Protecting portfolios on the downside with selling in futures was preferable to reducing the size of the portfolio by selling in the stock market because futures markets are very liquid while several stocks are not, and transaction costs in futures markets are low.

In the wake of the crash of 87 many analysts, including a presidential task force, laid the blame for the decline squarely on portfolio insurance. As evidence, they quoted the fact that portfolio insurance alone accounted for 12% of the selling in stock and index futures markets on October 19, 1987. (Rubinstein, 1998). According to the "blame portfolio insurance" theory, portfolio insurers came to the Monday's opening armed with an overhang of unexecuted sell orders from the accelerating decline of the previous week and placed large sell orders to initiate the decline in the market. From then onwards, as the market declined further during the day, the sell orders by the portfolio insurers kept on increasing to cater for their back log. To make matters worse, other investors who were not familiar with portfolio insurance, saw the declining prices and assumed that the selling was based on fundamentals and joined the queue of sellers; thus perpetuating the vicious circle.

Those who oppose the theory about 'portfolio insurance' being the cause of the crash point to the fact that foreign stock markets around the world fell significantly, even though portfolio insurance was not active in these markets. They also note the volatile behavior of the post-crash market and opine that if the decline were due to the mindless sales of portfolio insurers, it should have recovered to the pre-crash levels in a short period, say, by the end of the year. (Ibid.)

Illiquidity:

Many investors in the New York Stock Exchange, who wanted to sell their stocks on the day of the crash, found great difficulty in doing so. Brokers refused to answer the telephone of their clients, as buyers could not be found to purchase the large amount of stocks that sellers wanted to sell and trading in many common stocks did not start until late in the morning of October 19. Lack of enough liquidity was the problem. However, illiquidity by itself cannot be considered as the fundamental cause for the decline because it does not explain why so many people decided to sell stock at the same time. At best, insufficient liquidity may have had a significant effect on the size of the price drop during the crash. ("The Causes of the Stock Market Crash of 1987," 2004)

U.S. Trade and Budget Deficit

The U.S. trade and budget deficits that rose steadily during the 1980s have also been blamed for the crash. On October 14, 1987, the U.S. Treasury Secretary James Baker announced a large U.S. trade deficit of 3.4% of GDP and suggested the needed for a fall in the dollar on foreign exchange markets. Fears of a lower dollar led foreigners to pull out of dollar-denominated assets, causing a sharp rise in interest rates that had been already rising since early 1987. People such as Morgan Stanley's chief economist Stephen Roach believe that such current account adjustment was "at the heart of the stock market crash of October 1987." (Quoted by Byrne, Rebecca 2004) Others believe that if the large U.S. budget deficit was the cause for the crash stock markets in other countries should not have crashed since large trade deficit in one country is usually good news for its trading partners.

Investing in Bonds as an Alternative:

The difference between the 10-year bond yield and the earnings yield of stocks is often considered as an ominous sign for the stock markets. July 1987, just three months prior to the crash, saw the greatest one-month percentage divergence in bond yields and stock yields in the stock market's history. Specifically, long-term bond yields in the United States that was 7.6% at the start of 1987 had climbed to approximately 10% by mid October. Investing in bonds, therefore, offered a lucrative alternative to stocks for investors looking for high yield and may well have contributed to the crash.

Overvaluation

Overvaluation of U.S. stocks in 1987 is considered another major reason for the crash. For example, the S&P 500 price earnings ratio (P/E ratio), considered a standard measure of market valuation, had reached 19 by the week of the crash, up from 10 only two years before. (Historically, the P/E ratio of U.S. stock market is about 15 to 1). A high PE ratio meant that the average price of a U.S. listed stock had expanded much faster than its corresponding earnings. Without fundamental justification to back them up, stock prices had no choice but to tumble. In a survey just after the crash, 71.7% of individual investors and 84.3% of institutional investors reported that they thought the market was overpriced prior to the decline. Skeptics who do not believe that overvaluation of stocks was responsible for the crash point to various instances in the market's history when the P/E was over 19 (i.e., in the early 60's and the early 70's), yet no stock market crash occurred. (Koning, Paul 2003 -- "The 1987 Stock...")

Specific Events

Although no major political or economic event occurred in the period immediately preceding the crash, some relatively minor developments could have contributed to the negative perception of the stock market. For example, the 'House Ways & Means Committee' made a tax proposal to limit the deductibility of interest expense on corporate debt, especially in takeovers. Between October 13, when the legislation was first introduced, and Friday, October 16, when the market closed for the weekend, stock prices fell more than 10% -- the largest 3-day drop in almost 50 years. The proposed legislation could be partially held responsible for the crash although most of its effect had in all probability been played out in the days before October 19. (Itskevich, Jennifer, 2002)

Mirroring the Crash of 1926?

John Paul Koning, in his paper titled "Explaining the 1987 Stock market Crash and Potential Implications" rejects all the standard explanations for the crash such as program trading, portfolio.....