1987 Stock Market Crash

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Economic History of West
Kevin Capuder

U.S. Stock Market Crash in 1987

Ana Barbakadze, Mariam Jakeli

This paper contributes to the overview of U.S. Stock Market Crash of 1987 and it explores the major causes and effects of this crash. According to the Reuters, the crash of 1987 is included in the top five “major stock market crashes” (Narayana). Let us now define this term itself. Stock Market Crash associates with “A rapid and often unanticipated drop in stock prices”(Investopedia). As we can see, this process reflects the decline in stock prices, which likely has a dramatic effect on the global economy. The first biggest occurrence of stock market crash was in 1929, which was followed by the “Great Depression”. The second and not less serious crash was exactly in 1987, which we are going to discuss in the following sections. The next one occurred after ten years, with the epicenter in Asia. The last two vital crashes were in 21st century; one was in 2001 and the other in 2007 (Narayana). All of these crashes damaged the world economy, but the crash of 1987 still stands out. The reason why we chose this crash is that it is characterized as having “the largest one-day decline in stock market values in U.S. history” (Mishkin and White). It is also often compared to the crash of 1929, but it brought much loss to the stock market, for example, in 1929 the Dow Jones index fell by 12.8 per cent, while in October of 1987 it experienced 22.6 per cent decline (Mishkin and White). “ The crash wiped 22.6 percent off the value of the New York Stock Exchange, compared with 12.8 percent on the worst day of the 1929 Wall Street Crash” (Narayana). In the following paragraphs, we will discuss some major causes and effects of this crash and we will also look at the process itself.

First of all, before analyzing the causes of 1987 Stock Market Crash, it is necessary to look at the facts that occurred prior to the crash. The first and the most important lead-to-crash event was the increase in stock prices. It was evident, that prices were increasing with more extent than earnings from per share. This led to the increase of price-earnings ratios, which resulted in overvalued market (Carlson). From the graph below, we can see almost permanent increase in PE until the crash and then severe fall.

Moreover, new investors joined stock market and it led to the increased demand, which also contributed to the growth of share prices (Katzenbach). Another thing that played a role in causing the crash was U.S. trade deficit, which it had been always experiencing. The fact that imports were more than exports resulted in devaluation of the U.S. dollar. For this reason, it was necessary to increase interest rates in the U.S (Winkler and Herman).

This graph shows the decrease in the value of U.S. dollar and it is evident that the falling was sharper after the crash. Apart from this cause, there was one very important thing that played vital part in straining the situation – it was program trading. This was a new mechanism, which was used during the crash quite actively. With the help of “program trading” the process of selling and buying of stocks was faster and easier, everything was done by the computer (Katzenbach). There were two strategies of “program trading”: The first one is the “portfolio insurance”. Generally investors are not buying just a single stock but they are creating the portfolio where is included noticeable number of stocks. As the prices of stocks are not stable and are changeable, it is kind of difficult to control the total profit and loss. It is hard for investors to think of new strategies to regulate their own trading. “Portfolio Insurance” had exactly this function. It helped investors to minimize losses in case of falling market (Carlson). The second strategy is “Index Arbitrage”, which enabled investors to profit from playing with the “value of stocks in an index and the value of stock-index futures...
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