History of 1987 Stock Market Crash
7 min read
Ask questions about this lesson and get instant answers.
On October 19, 1987 the stock market in the U.S. along with the associated futures and options market crashed with the S&P 500 stock market index falling about 20 percent (A considerably large percentage fall). The causes of concern were the severity and swiftness of the market decline and the weakness of the trading systems as they were stretched and came close to breaking in extreme conditions. This was of course exuberated by the decline in the prices. There was also a considerable lack of uncertainty in obtaining information.
This article gives a brief on the background of the crisis, the events that led to it and the actions taken by the Federal Reserve to help calm down the markets and restore investor sentiment.
Firstly let us look at the market conditions that prevailed before the crash. Prior to the crash the stock market had posted very healthy gains. Price increases outpaced earnings growth resulting in over-valuation and inflated price-to-earnings ratios. Two other factors that contributed to price trend increase had been the influx of new investors notably pension funds and favorable tax treatments given to finance corporate buyouts. The market was also employing the use of program trading strategies. There were broadly two strategies that were used: Portfolio Insurance and Index Arbitrage. Very briefly a program trading strategy is one that employs computer models to trade large amounts of stock when certain conditions have been met.
Portfolio insurance method involves computing optimal stock-to-cash ratios at various market prices and limit losses investors face in a declining market. By buying stock index futures in a rising market and selling them in a falling market, portfolio insurers could provide protection against losses from falling equity prices without trading stocks. As portfolio insurers did not continually update the analysis about the optimal portfolio of stock and cash holdings there were concerns that this could lead to many investors selling stocks and futures simultaneously.
Index Arbitrage strategies involve exploring the arbitrage opportunities between the value of the stocks in an index and the values of the stock-index-futures contracts.
In the months that led up to crash the macro-economic outlook became less certain with interest rates rising globally. This increase in interest rates was due to a growing U.S trade deficit and a decline in the value of the dollar leading to concerns about inflation.
The timeline of the crash is as follows:
Wednesday, October 14 – Friday October 16 1987
On Wednesday two events precipitated the decline in the stock market. The first was the filing of legislation by the Ways and Means Committee of the US House Of Representatives to eliminate tax benefits associated with financing mergers. Second the Commerce Department announced that the Trade Deficit for August was notably above expectations. This resulted in a decline in the value of the dollar and increase in the interest rates. On Thursday the decline continued which was primarily attributed to anxiety especially among the pension funds and institutional investors. The decline continued on Friday as anxiety was augmented by technical factors, primarily relating to many stock index options expiring on Friday and the difficulty into rolling over the positions into new contracts for hedging purposes. More investors sold futures contracts as a hedge against the falling stocks which led to a price discrepancy between the value of stock index in the futures market and the value of stocks on the NYSE, which was taken advantage of by Index Arbitrage traders causing a further downward pressure on the NYSE. By the end of the day on Friday, markets had fallen considerably, with the S&P 500 down over nine percent for the week which left the Portfolio Insurers with an overhang and the models suggested they should sell more stocks or futures contracts. The futures contracts were already experiencing a heavier than usual volumes.
Monday - October 19, 1987
Due to the imbalance in the number of sales orders relative to buy orders the stock market did not open for one hour’s time. As a result of this suspension in trading, stale prices were used to compute the index value. The future market on the other hand opened on time and this created a gap in the value of stocks in the cash market relative to the futures market which caused further selling by the index arbitragers. There was an 18 to 23 percent decline in the value of the DJIA, S&P 500 and the Wilshire 500 which caused the SEC to announce that there would be a temporary halt in trading which resulted in a further selling. The selling was highly concentrated with the top ten sellers accounted for 50 percent of non market-maker volume in the futures market, and many of these institutions were providers of portfolio insurance.
Tuesday - October 20, 1987
The Federal Reserve acted in response to this crisis by infusing more liquidity into the system so that banks could serve their margin calls due to decline in the values of futures prices. Still, trading on Tuesday continued to be significantly impaired. Over the course of the day, about seven percent of stocks, including some of the most active, reportedly were closed for trading by the specialists as order imbalances made maintaining orderly markets difficult. On October 20, two CME clearinghouse members had not received margin payments due to them by noon, which started rumors about the solvency of the CME and its ability to make these payments. These rumors proved unfounded but nevertheless reportedly deterred some investors from trading. Bid-ask spreads widened, and trading was characterized as disorderly. Later in the afternoon, there was a sustained rise in financial markets as corporations announced stock buyback programs to support demand for their stocks. Corporations had started announcing these programs Monday afternoon, but it was not until partway through Tuesday that a critical mass had formed.
Very briefly the factors that contributed to the severity of the crash were:
The prompt action the Federal Reserve in infusing further liquidity into the system by lowering the fed funds rate down to 7 percent from 7.5 percent resulted in a further lowering of short-term interest rates thus reducing the cost of borrowers through open-market operations. Fears of counterparty risk had also caused reluctance on behalf of the holders of government securities to lend them as freely as they did which might have further impacted liquidity. The Federal Reserve temporarily liberalized the rules governing lending of securities from its portfolio by suspending per issue and per dealer limits on the amount of loans as well as the requirement that the loans not be made to facilitate a short sale. There were also a variety of supervisory efforts to ensure the soundness of the financial system. The Federal Reserve placed examiners in major banking institutions and monitored developments. This action was taken in part to identify potential runs as well as to assess the banking industry’s credit exposure to securities firms through loans, loan commitments, and letters of credit. Monitoring efforts by the Federal Reserve went beyond the banking industry and included stepped up daily monitoring of the government securities markets and of the health of primary dealer and inter-dealer brokers. These latter efforts also involved keeping in close touch with officials from a variety of agencies and institutions such as the Securities and Exchange Commission, National Association of Securities Dealers, New York Stock Exchange, and the Treasury Department. Finally, in an effort to facilitate settlement and clearing of transactions and loans by settlement banks to brokers and dealers, the Federal Reserve extended Fed wire hours on several occasions. The response of the Federal Reserve, and other regulators, appears to have contributed to improved market conditions. Reflecting the additions of reserves through open market operations and the reduction in the federal funds rate, other short-term interest rates declined. The liquidity support likely contributed substantially towards a return to normal market functioning. Within a few days, some measures of market uncertainty, such as the implied volatility on the S&P 100 declined, although they remained elevated compared to pre-crash levels.