QuantitativeExhaustion

Revisiting October 1987 Stock Market Crash

Education
SP:SPX   S&P 500 Index
S&P 500 comparison to VXO (implied volatility of OEX options) -- former VIX -- during the stock market crash of October 1987.

What caused the crash of 1987?

According to a 2006 Federal Reserve paper, a combination of circumstances made the crash possible. In the five years preceding the crash, stocks were supported by new entrants into the market (pension and 401(k) plans), which drove up prices. The Dow bottomed out at 776 in August 1982 and marched up to a high of 2,722 in August 1987.

Equities were also boosted by favorable tax treatments given to the financing of corporate buyouts, which "increased the number of companies that were potential takeover targets and pushed up their stock prices." These buyouts benefitted from lower interest rates. However, in the months leading up to the crash, interest rates were rising globally and concerns about inflation caused fears of further interest rate increases in the U.S. as well.

Two fuses were lit in the days before the crash. On Wednesday October 14, there were reports that legislation had been proposed in Congress to eliminate tax benefits associated with financing mergers, and separately, the U.S. trade deficit was revealed to be worse than expected, which caused the value of the dollar to dive and raised expectations that the Fed would increase interest rates.

Once these fuses were lit, other conditions added fuel to the fire. The increase in computer "program trading" strategies added to the magnitude of the losses, as did the impact of margin calls and the inability for investors to gather information in the chaotic environment. The combination of all these factors led to that historic and frightening day of trading.

http://www.cbsnews.com/8301-505123_162-5...

The aggregated implied volatility of at the money options on the S&P 100 ( OEX )© soared from 36.37% (Friday, 16.10.1987) to 150.19% (Monday, 19.10.1987). The intra day high - and therefore the all time high since inception of this indicator - was at 152.48%!

Some possible reasons for the stock market crash of 1987 and for the rapid psychological shift of the market participants:

- Anti-takeover legislation

-Rapidly increasing short term US interest rates (the annualized yield of 3M US Treasury Bills increased from 5.30% on 20.01.1987 to the high print of the year: 7.19% on 14.10.1987 - an increase of 189 basis points)

-Rapidly increasing long term US interest rates (the yield of 30Y US Treasury Bonds increased from the low print of the year: 7.29% on 09.01.1987 to the high print of the year: 10.25% on 19.10.1987 - an increase of 296 basis points)

-Weakening US dollar (=falling against most major foreign currencies)

-Deteriorating US current account deficit

-Escalating US government debt

-Very high price-earnings-ratios (P/E)

-Very low dividend yields

-Very bullish investor sentiment figures (= too much optimism by investors)

-Deteriorating "market breadth" (e.g.: weak Advance-Decline-Line)

http://www.sniper.at/stock-market-crash-...
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