MercoPress. South Atlantic News Agency

Stock market blues: twenty years ago

October 19, two decades ago Alan Greenspan was fresh in the job, only two months before he had been named chairman of the Federal Reserve and that Monday was flying for a bankers conference to Dallas, Texas.

According to Greenspan's latest book "The age of turbulence" when he landed in Texas he asked one of his aides what was happening with the markets because the previous Friday the Dow Jones had lost 108 points, at that time 4.6%. The aide said the stock market had dropped "five, zero, eight" and Greenspan looked satisfied believing the fall had been 5.08 pointsâ€Ã‚¦ "No Mr Chairman, 508 points!" However his terse statement to the markets, "the Fed stands ready to provide all necessary liquidity" is seen as having been effective in controlling the damage from that crash. Two versions of that day and the aftermath follow. Black Monday and the Long Bull MarketOn Monday, October 19, 1987, the value of stocks plummeted on markets around the world. The Dow Jones Industrial Average fell 22 percent to close at 1738.42, the largest one-day decline since 1914, eclipsing even the famous October 1929 market crash. The Brady Commission (a presidential commission set up to investigate the fall) the SEC, and others blamed various factors for the 1987 debacle -- including a negative turn in investor psychology, investors' concerns about the federal government budget deficit and foreign trade deficit, a failure of specialists on the New York Stock Exchange to discharge their duty as buyers of last resort, and "program trading" in which computers are programmed to launch buying or selling of large volumes of stock when certain market triggers occur. The stock exchange subsequently initiated safeguards. It said it would restrict program trading whenever the Dow Jones Industrial Average rose or fell 50 points in a single day, and it created a "circuit-breaker" mechanism to halt all trading temporarily any time the DJIA dropped 250 points. Those emergency mechanisms were later substantially adjusted to reflect the large rise in the DJIA level. In late 1998, one change required program-trading curbs whenever the DJIA rose or fell 2 percent in one day from a certain average recent close; in late 1999, this formula meant that program trading would be halted by a market change of about 210 points. The new rules set also a higher threshold for halting all trading; during the fourth quarter of 1999 that would occur if there was at least a 1,050-point DJIA drop. Those reforms may have helped restore confidence, but a strong performance by the economy may have been even more important. Unlike its performance in 1929, the Federal Reserve made it clear it would ease credit conditions to ensure that investors could meet their margin calls and could continue operating. Partly as a result, the crash of 1987 was quickly erased as the market surged to new highs. In the early 1990s, the Dow Jones Industrial Average topped 3,000, and in 1999 it topped the 11,000 mark. What's more, the volume of trading rose enormously. While trading of 5 million shares was considered a hectic day on the New York Stock Exchange in the 1960s, more than a thousand-million shares were exchanged on some days in 1997 and 1998. On the Nasdaq, such share days were routine by 1998. Much of the increased activity was generated by so-called day traders who would typically buy and sell the same stock several times in one day, hoping to make quick profits on short-term swings. These traders were among the growing legions of persons using the Internet to do their trading. In early 1999, 13 percent of all stock trades by individuals and 25 percent of individual transactions in securities of all kinds were occurring over the Internet. With the greater volume came greater volatility. Swings of more than 100 points a day occurred with increasing frequency, and the circuit-breaker mechanism was triggered on October 27, 1997, when the Dow Jones Industrial Average fell 554.26 points. Another big fall -- 512.61 points -- occurred on August 31, 1998. But by then, the market had climbed so high that the declines amounted to only about 7 percent of the overall value of stocks, and investors stayed in the market, which quickly rebounded. The largest one day crash in history The stock market crash of 1987 was the largest one day stock market crash in history. The Dow lost 22.6% of its value or $500 billion dollars on October 19 th 1987! In order to understand the crash, we must first study the cause. 1986 and 1987 were banner years for the stock market. These years were an extension of an extremely powerful bull market that started in the summer of 1982. This bull market had been fueled by hostile takeovers, leveraged buyouts and merger mania. Companies were scrambling to raise capital to buy each other out, in essence. The philosophy of the time was that companies would grow exponentially simply by constantly purchasing other companies. In leveraged buyouts, a company would raise massive amounts of capital by selling junk bonds to the public. Junk bonds are simply bonds that have a high risk of loss, so they pay a high interest rate. The money raised by selling junk bonds, would go towards the purchase of the desired company. IPOs were also becoming a commonplace driver of the markets. An IPO is when a company issues stock for the first time. "Microcomputers" were also a top growth industry. People started to view the personal computer as a revolutionary tool that will change our way of life, and create wonderful profit opportunities. The investing public was caught up in a contagious euphoria, similar to that of any other bubble and market crash in history. This euphoria made people, once again, believe that the market would always go up. Despite the strong economic growth, SEC was unable to prevent shady IPOs and conglomerates from proliferating. In early 1987, the SEC conducted numerous investigations of illegal insider trading. This created a wary stance from many investors at this point. Also, due to the extremely strong economic growth, inflation was now becoming a concern. The Fed rapidly raised short term interest rates to temper inflation. This, unfortunately, had an effect of hurting stocks as well. Many institutional trading firms started utilizing portfolio insurance to protect against further stock dips. Portfolio insurance is a practice that uses futures contracts as an insurance policy. People that hold the futures contracts can make money as the market crashes offsetting the losses in the stock holdings. After interest rates had risen, many of the large institutional firms started using portfolio insurance all at the same time. The futures market was taking in billions of dollars within minutes, causing the futures market and the stock market to crash from instability. Additionally, common stock holders all wanted to sell simultaneously. The market couldn't handle so many orders at once and most people couldn't sell because there weren't ANY buyers left! Within one day, 500 billion dollars was evaporated from the Dow Jones index. Markets in every country around the world collapsed in the same fashion. When individual investors heard that a massive stock market crash was in effect, they scrambled to call their brokers. This was unsuccessful because each broker had many clients. Many people lost millions instantly. Some unstable individuals, who had lost fortunes, went to their broker's office and started shooting. Several brokers were killed, despite the fact that they had no control over the market action. The majority of investors who were selling didn't even know why they were selling, except that they "saw everyone else selling". This irrational mentality caused the extreme market crash. Most futures and stock exchanges were shut down for the day. Around this time, the Fed started to intervene. Short term interest rates were instantly lowered to prevent a depression and a banking crisis. Remarkably, the markets recovered quickly from the worst one day stock market crash. Unlike the stock market crash of 1929, the market quickly started on a bull run, once again. This was powered by companies buying back their stocks that were undervalued after the severe crash. Additionally, the Japanese Nikkei index was embarking on its own massive bull market. This tremendous momentum helped pull the US stock markets to new heights never seen before. Some benefits came as a result of the 1987 stock market crash. For example, the circuit breakers system was implemented, which electronically stops stocks from trading if they plummet too quickly. This will prevent any future one day vertical drops, like 1987. Once again, the remarkable similarity between all of the market crashes is striking. It seems that after all of the historical market crashes, people would learn to foresee a coming financial disaster. This rarely happens, of course, which is why there is constant opportunity for the smart money to prosper from the irrationality of other people.