QuantitativeExhaustion
Education

Revisiting October 1987 Stock Market Crash

INDEX: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_162-57534843/lessons-from-the-1987-stock-market-crash-25-years-later/

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-of-1987.htm
What a goldmine you have here THX!
+2 Reply
"Cancel Crash" the story of 1987's Black Monday crash, is streaming for free on FuturesMag.com: http://bit.ly/16ep1vy
+1 Reply
QuantitativeExhaustion FuturesMagazine
Thanks !
I'll be taking at look at that.
+1 Reply
nice summary !

but in my view no comparison to today:

- we don't have weakening US$ (we have currency wars)
- we don't have high and/or rising interest rates (interest rates short and long are historically low and not rising yet)
- we don't have very high P/Es
- we don't have a very bullish sentiment (look at AAII, market is not going up with great volume)

- we do have other problems though (massive escalating debts in Europe, US, Japan)

Hence, I can imagine a small correction is overdue, but not a crash as in 1987.
Reply
Nice summary JR. I lived and traded through the 1987 bull market and crash and I appreciate reading over that time window. I would add the following:
1. Capital gains tax rates were changing as of 1988. It was a significant hike in rates. I do recall people talking about when to sell in 1987, at the current low tax rates, or just wait until next year when stock prices were enough higher to cover the higher tax rates. Since stocks weren't up for longer than a year, everyone waited, holding out for long term capital gains that didn't materialize.
2. The tax treatment of real estate had changed in 1986 which encouraged capital to flow out of real estate and into stocks as the passive losses on real estate were no longer deductible and hence made real estate instantly worth-less. The banks that had loaned their capital to investors to buy cash-flow negative properties were a gaping black hole that led to the S&L crisis just one year after the infamous 1987 stock market crash. The real estate crash had started in 1986 and was on the front page of the newspapers in 1988.
3. Sentiment may have appeared extremely bullish, but there were different surveys that showed it was more neutral.
4. Stop loss orders. Simply that once the market went under certain levels there just wasn't anyone left to buy and margin departments sold positions out aggressively to avoid taking losses. Margin departments can have a huge impact on the markets, especially in short time-frames when the market is illiquid.
5. Liquidity providers ran out of cash. Market-makers ran out of cash. The reason why VIX shot up to 150 is because of this issue. I went to the Philly stock exchange right after the crash and learned first hand from the firms directly that they had no ability to execute additional trades to provide the "other side of the trade" coming from the retail and institutional sell orders. This is why we have trading limits - to prevent this problem.
I thank Tradingview again for providing the data to allow you to make the beautiful charts you have made and displayed. Keep up the great work!
Cheers.
Tim
+2 Reply
Hope you're not in agreement because you see some similar actions today.
+1 Reply
snapshot

US Dollar Falling Fast
+2 Reply
snapshot

Investors flee to Gold
+2 Reply
In the days between October 14 and October 19, 1987, major indexes of market valuation in the United States dropped 30 percent or more. On October 19, 1987, a date that subsequently became known as"Black Monday," the Dow Jones Industrial Average plummeted 508 points, losing 22.6% of its total value. The S&P 500 dropped 20.4%, falling from 282.7 to 225.06. This was the greatest loss Wall Street had ever suffered on a single day.1
According to Facts on File, an authoritative source of current-events information for professional research and education, the 1987 crash"marked the end of a five-year 'bull' market that had seen the Dow rise from 776 points in August 1982 to a high of 2,722.42 points in August 1987." Unlike what hapopened in 1929, however, the market rallied immediately after the crash, posting a record one-day gain of 102.27 the very next day and 186.64 points on Thursday October 22. It took only two years for the Dow to recover completely; by September of 1989, the market had regained all of the value it had lost in the '87 crash.2

Many feared that the crash would trigger a recession. Instead, the fallout from the crash turned out to be surprisingly small. This phenomenon was due, in part, to the intervention of the Federal Reserve. According to Facts on File,"The worst economic losses occurred on Wall Street itself, where 15,000 jobs were lost in the financial industry."3

A number of explanations have been offered as to the cause of the crash, although none may be said to have been the sole determinant. Among these are computer trading and derivative securities, illiquidity, trade and budget deficits, and overvaluation. Below we have quoted representative analyses.

CAUSE #1: DERIVATIVE SECURITIES

Bruce Bartlett, senior fellow with the National Center for Policy Analysis of Dallas, Texas:

Initial blame for the 1987 crash centered on the interplay between stock markets and index options and futures markets. In the former people buy actual shares of stock; in the latter they are only purchasing rights to buy or sell stocks at particular prices. Thus options and futures are known as derivatives, because their value derives from changes in stock prices even though no actual shares are owned. The Brady Commission , concluded that the failure of stock markets and derivatives markets to operate in sync was the major factor behind the crash.

CAUSE #2: COMPUTER TRADING

Website, University of Melbourne:

In searching for the cause of the crash, many analysts blame the use of computer trading (also known as program trading) by large institutional investing companies. In program trading, computers were programmed to automatically order large stock trades when certain market trends prevailed. However, studies show that during the 1987 U.S. Crash, other stock markets which did not use program trading also crashed, some with losses even more severe than the U.S. market.

CAUSE #3: ILLIQUIDITY

Website, University of Melbourne:

During the Crash, trading mechanisms in financial markets were not able to deal with such a large flow of sell orders. Many common stocks in the New York Stock Exchange were not traded until late in the morning of October 19 because the specialists could not find enough buyers to purchase the amount of stocks that sellers wanted to get rid of at certain prices. As a result, trading was terminated in many listed stocks. This insufficient liquidity may have had a significant effect on the size of the price drop, since investors had overestimated the amount of liquidity. However, negative news to investors about the liquidity of stock, option and futures markets cannot explain why so many people decided to sell stock at the same time.

Bruce Bartlett:

While structural problems within markets may have played a role in the magnitude of the market crash, they could not have caused it. That would require some action outside the market that caused traders to dramatically lower their estimates of stock market values. The main culprit here seems to have been legislation that passed the House Ways & Means Committee on October 15 eliminating the deductibility of interest on debt used for corporate takeovers.

Two economists from the Securities and Exchange Commission, Mark Mitchell and Jeffry Netter, published a study in 1989 concluding that the anti-takeover legislation did trigger the crash. They note that as the legislation began to move through Congress, the market reacted almost instantaneously to news of its progress. Between Tuesday, 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 percent -- the largest 3-day drop in almost 50 years. In addition, those stocks that led the market downward were precisely those most affected by the legislation. 4

CAUSE #4: U.S. TRADE AND BUDGET DEFICITS

Bruce Bartlett:

Another important trigger in the market crash was the announcement of a large U.S. trade deficit on October 14, which led Treasury Secretary James Baker to suggest the need 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.

Website, University of Melbourne:

One belief is that the large trade and budget deficits during the third quarter of 1987 might have led investors into thinking that these deficits would cause a fall of the U.S. stocks compared with foreign securities (this was the largest U.S. trade deficit since 1960). However, if the large U.S. budget deficit was the cause, why did stock markets in other countries crash as well? Presumably if unexpected changes in the trade deficit were bad news for one country, it would be good news for its trading partner.

CAUSE #5: INVESTING IN BONDS AS AN ATTRACTIVE ALTERNATIVE

The-Adviser.com:

Long-term bond yields that had started 1987 at 7.6% climbed to approximately 10% . This offered a lucrative alternative to stocks for investors looking for yield.

CAUSE #6: OVERVALUATION

Website, University of Melbourne:

Many analysts agree that stock prices were overvalued in September, 1987. Price/Earning ratio and Price/Dividend ratios were too high . Does that imply that overvaluation caused the 1987 Crash? While these ratios were at historically high levels, similar Price/Earning and Price/Dividends values had been seen for most of the 1960-72 period. Since no crash happened during that period, we can assume that overvaluation did not trigger crashes every time.

THE LEGACY OF THE '87 CRASH

Bruce Bartlett:

What the 1987 crash ultimately accomplished was to teach politicians that markets heed their words and actions carefully, reacting immediately when threatened. Thus the crash initiated a new era of market discipline on bad economic policy.
http://hnn.us/articles/895.html
+2 Reply
United States
United Kingdom
India
Deutschland
France
España
Italia
Polska
Türkiye
Россия
Brasil
Indonesia
Malaysia
Việt Nam
日本
한국
简体
繁體
Home Stock Screener Forex Signal Finder Cryptocurrency Signal Finder Economic Calendar How It Works Chart Features House Rules Moderators Website & Broker Solutions Widgets Stock Charting Library Feature Request Blog & News FAQ Help & Wiki Twitter
Profile Profile Settings Account and Billing My Support Tickets Priority Support Contact Support Ideas Published Followers Following Private Messages Chat Sign Out