Ebook What Caused the 1987 Stock Market Crash and Lessons for the 2008 Crash
On Monday October 19, 1987, the U.S. equity market suffered its largest single-day percentage decline in history. The S&P 500 index fell by 57.86 points, a decline of 20.46%. The Dow Jones Industrial average suffered a similar decline, falling by 508 points, 22.6% of its value.
The NASDAQ fell by 46 points, 11.35% of its value (although many of the dealers stopped trading early, limiting the reported decline). An important, but often forgetten, factor in this decline was the 10.12% decline in the S&P 500 in the three trading days prior to October 19.
Mitchell and Netter (1989) argue that this three-day decline was an important contributing factor to the crash in fact, they describe the decline as a “trigger.” In this paper, we review this argument, provide simple descriptive evidence supporting the argument and suggest how October 1987 is different from the market decline in late 2008. We report data that the drop in the stock market immediately proceeding the October 19, 1987 crash that others have shown was very large in historical terms remains one of the largest declines over the next 20 years. Additionally, we document the unprecedented level of volatility since August 2008 and show how it is different from 1987.
The October 19, 2007 market crash of more than 20% did not seem to be related to any fundamental news. However, Mitchell and Netter (1989) argue that the three-day decline preceding the crash was a large enough decline that it became the fundamental news and that shook the market. The theoretical model of Jacklin, Kleidon, and Pfleiderer (1992) (among others) shows how a surprise significant drop in the market could have provided information to the market that would directly lead to a crash. In this paper, we present evidence that even 20 years later, the magnitude of the market decline immediately preceding the 1987 is still a significant outlier – only one three-day period in the 20 years after 1987 had as large a market drop.
Jacklin, Kleidon, and Pfleiderer’s model suggests that the sharp market decline preceding the 1987 crash revealed the effects of new investment strategies by investors that had not been fully anticipated by the market (they build on Grossman’s (1988) model of the effects of imperfect information about portfolio insurance). This revelation to investors of the extent of dynamic hedging caused investors to dramatically revise downward their stock valuations. Other explanations of the 1987 crash include liquidity problems (the Presidential Task Force (1988) --The Brady Report) in trading when volume increased tremendously (perhaps as the result of portfolio insurance trading), or changed investor psychology or some combination of all the theories. However, each of the theories is consistent with the effects of a large downward market movement directly preceding the crash that was significant and unexpected, triggering the October 19 crash.
The paper proceeds as follows. In Section 2, we examine possible reasons for the 1987 crash, providing a general discussion on what causes large market movements, and reviewing the Mitchell and Netter work on the 1987 crash. In Section 3, we examine trading volume and market volatility since the 1987 crash, including the extraordinary market events of the Fall of 2008. We conclude in Section 4.
Download
PDF Ebook What Caused the 1987 Stock Market Crash and Lessons for the 2008 Crash
Posted in :
