Running Head: 1929 AND 1987 STOCK MARKET CRASHES 1
1929 and 1987 Stock Market Crashes
Aisha Khalifa Near East University
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:The 1929 stock market crash
It began on Thursday, October 24, 1929. 12,894,650 shares changed hands on the New York Stock Exchange-a record. To put this number in perspective, let us go back a bit to March 12, 1928 when there was at that time a record set for trading activity. On that day, a total of 3,875,910 shares were traded. As we can see, Wall Street was a very, very busy place, as were markets worldwide. A big problem not mentioned so far in all this was communication The ticker tape machine had gone through great amounts of perfections since its early applications in the 1870s-80s by Edison and others. Even at telegraphic speed, the volume was having an effect on time. Issues were behind as much as one hour to an hour and a half on .the tape. Phones were just busy signals on hooks It was causing crowds to gather outside of the NYSE trying to get in the communication. Police had to be called to control the strangest of riot masses; the investors of business. It is not yet noon. The habit of lunch eased the panic somewhat and New York paused for a breath. There were rumblings of bargain grabbing to come in the afternoon, so maybe something could be salvaged. And it did comeback to regain much of the losses. For example, a stock like Montgomery-Ward opened at 83 and dropped to 50 and recovered to 74. This was typical for the big name companies. On Friday, the mixture of margin call bargains combined with sells that were
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waiting from the late tickers on Thursday led to a bit of a gain. The trading was about 6 million shares. There was a short session on .Saturday, which brought everything back to the level of Thursday :The Causes of the 1929 Crash While there have been many suggested explanations for the Crash, no one can fully account for it. Here are some of the explanations :proposed Stocks were Overpriced: Many people believe that stocks were .1 overpriced and the crash brought the share prices back to a normal level. However, some studies using standard measures of stock value, such as Price/Earnings ratios and Price/Dividend ratios, argue .that the share prices were not too high Massive Fraud and Illegal Activity: A number of people .2 believe that fraud and illegal activity was one of the causes of the 1929 Crash. However, evidence revealed that there was probably .very little actual insider trading or illegal manipulation Margin Buying: Margin buying is another scapegoat for the .3 cause of the Crash. However, it is not the main reason because there was very little margin outstanding relative to the value of the market (the margin averaged less than five percent of the market .value)
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Federal Reserve Policy: The new President of the Federal .4 Reserve Board Adolph Miller tightened the monetary policy and set out to lower the stock prices since he perceived that speculation led stocks to be overpriced, causing damage to the economy. Also, starting from the beginning of 1929, the interest rate charged on broker loans rose tremendously. This policy reduced the amount of broker loans that originated from banks and lowered the liquidity of nonfinancial and other corporation that financed brokers and .dealers Public Officials' Repeated Statements: Many public officials .5 commented that the stock prices were too high. For example, the newly elected President of the United States, Herbert Hoover, publicly stated that stocks were overvalued and that speculation hurt the economy. Hoover's statement suggested to the public the lengths he was willing to go to control the stock market. These kinds of statements encouraged investors to believe that the market would continue to be strong, which could be one of the causes of .the Crash
:The 1987 stock market crash
The Stock Market Crash of 1987 or "Black Monday" was the largest one-day market crash in history. The Dow lost 22.6% of its value or $500 billion dollars on October 19th 1987. 1986 and 1987 were banner years for the stock market. These years were an extension of
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an extremely powerful bull market that had started in the summer of 1982. This bull market had been fueled by low interest rates, hostile takeovers, leveraged buyouts and merger mania. Many companies were scrambling to raise capital to buy each other out. The business philosophy of the time was that companies could grow exponentially simply by constantly acquiring other companies. In a leveraged buyout, a company would raise a massive amount of capital by selling junk bonds to the public. Junk bonds are bonds that pay high interest rates due to their high risk of default. The capital raised through selling junk bonds would go toward the purchase of the desired company. IPOs were also becoming a commonplace driver of market excitement. An IPO or Initial Public Offering is when a company issues stock to the public for the first time. Microcomputers now known as personal computers were become a fast growing industry. People started to view the personal computer as a revolutionary tool that would change our way of life, while creating wonderful business opportunities. The investing public eventually became caught up in a contagious euphoria that was similar to that of any other historic bubble and market crash. This euphoria made investors, as usual, believe that the stock .market would always go up
:The Causes of the 1987 Crash
According to Facts on File, an authoritative source of current-events information for professional research and education, the 1987
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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 oneday 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 :Derivative securities -1 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 [also known as the Presidential Task Force on Market Mechanisms, which was appointed to investigate the causes of the crash], concluded that the failure of stock markets and derivatives markets to operate in sync was the .major factor behind the crash :Computer trading -2 In searching for the cause of the crash, many analysts blame the use of computer trading (also known as program trading) by large
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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 :Illiquidity -3 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 :U.S. trade and budget deficits :4 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
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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 :Investing in bonds as an attractive alternative :5 Long-term bond yields that had started 1987 at 7.6% climbed to approximately 10% [the summer before the crash]. This offered a .lucrative alternative to stocks for investors looking for yield :Overvaluation -6 Many analysts agree that stock prices were overvalued in September, 1987. Price/Earnings ratio and Price/Dividend ratios were too high [Historically, the P/E ratio is about 15 to 1; in October 1987 the P/E for the S&P 500 had risen to about 20 to 1]. Does that imply that overvaluation caused the 1987 Crash? While these ratios were at historically high levels, similar Price/Earnings 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
Similarities and differences between 1929 and 1987
:stock market crashes The October 1929 crash was marked by a few up days and many down days, whereas the October 1987 crash occurred primarily in just one day. Despite this difference, on closer examination, we find
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that these two stock market crashes have much in common. In both crashes the underlying dynamic that caused the demand for risky assets to decline as the price of those assets declined (which is the opposite of the usual relationship between price and demand) was essentially the same. Uncovering the parallels between these two crashes provides valuable insight into the current market crash. The October 1987 crash, and, in particular, the instability created by the widespread use of portfolio insurance, offers a paradigm for how and why markets crash. But how could a crash caused by portfolio insurance help to explain the crash in October 1929, which occurred half of a century before portfolio insurance was created? While portfolio insurance did not exist in 1929, a practice much older than portfolio insurance did: the widespread investment strategy of purchasing risky assets using borrowed funds. Both purchasing portfolio insurance and buying stock on margin follow the same basic strategy: the purchase of both a risky asset and a put on that .risky asset
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:References Carlson, M. A. (n.d.). A Brief History of the 1987 Stock Market Crash With a Discussion of the Federal Reserve Response. SSRN Electronic Journal SSRN Journal. Galbraith, J. K. (1988). The Great crash, 1929. Boston: Houghton Mifflin. Klein, M. (2001). The Stock Market Crash of 1929: A Review Article. Business History Review Bus. Hist. Rev., 75(02), 325-351. Levy, H., & Yoder, J. (1991). The formation of stock return volatility expectations after the 1987 stock market crash. Economics Letters, 35(4), 441-444. Limmack, R., & Ward, C. (1990). The October 1987 stock market crash. Journal of Banking & Finance, 14(2-3), 273-289.