The Stock Market Crash of 1987: Triggering One of the Most Haunting Declines in the Market’s History

Black Monday (1987) | Author: Roger Hsu | Uploaded June 27 , 2014 | Courtesy of Flickr

It was Monday, October 19, 1987. Stocks plunged 508.32 points, and the world was amazed. Once it hit Wall Street in the United States, it then swept east to Tokyo and then later to London. “There was a panic going on, everybody had to liquidate”(Steve Miller, market maker).  “I saw two grown men crying, they had lost everything”(Al Sherbin, market maker). Millions tried to clear their portfolios and get cash from banks. It was a matter of minimizing losses, not making a profit. At the end of “Black Monday,” over 500 billion dollars evaporated, and it all happened in a single day.1

Companies and governments can sell fractions of their ownership in what is called a Primary Market through investment banks in order to raise funds. Once all stocks have owners, they can be traded in the “Secondary Market,” most commonly known as the Stock Market, or Equity Market. Here investors trade financial assets, the most common of them being stocks, in order to gain a profit. The Stock Market has great influence on the growth of the overall economy. It allows many companies to expand or avoid losing everything by making their business public.2 According to the leading secondary market today, the New York Stock Exchange, there are approximately 1.46 billion stocks traded every day from 2668 companies, which include new, growing companies as well as large, Blue Chip business from all over the world.3 That’s why banks and governments watch carefully the price movement in the Stock Markets, especially in the United States. If something goes wrong in the Stock Market, and prices start declining, a panic may result. People may start selling desperately in order to minimize losses. For this reason, experts tend to associate Stock Market crashes with economic contractions, or more commonly known as “depressions.”4

The 1980s was a boom decade for America in terms of economic expansion. Along with the economic expansion came a Bull market for the major stock indexes. Starting in 1982, prices in the stock market started going up as people increased their investments in the market. 1987 was a particularly productive year for the Stock Market. The number of stock purchases and the prices of securities went up.5 The Market seemed to be robust and healthy… until Friday, October 16. That day, the Dow Jones Industrial Average—an index made up of the 30 biggest industrial companies in the United States—took a fall of 108 points, which represented a 4.6% loss in a single day! A 4.6% loss in a single day is extremely rare, and it certainly represented a sudden sense of fear among vast numbers of investors. But this loss on that Friday was only a prelude to the worst single day of losses ever experienced. Known as “Black Monday,” October 19 was the day the Stock market had its biggest percentage decline in a single day in all history. On that October 19, in just six-and-a-half hours, the Dow fell 508 points, or 22.6% of its value in those few hours.

“Black Monday: Dow Jones” | Author: User:Autopilot | Uploaded March 6, 2009 | Courtesy of Wikimedia Commons

Although this event did not lead to a depression, it is still significant because of the magnitude of the decline and the exposure of the market system’s flaws. As a result, scholars find themselves interested in analyzing the major economic and institutional factors that triggered the 1987 Stock Market Crash, and the ones that worsened it. The main economic factors affecting the market were the 10% decline that occurred on the three days prior to October 19, which was reportedly caused by the U.S. House of Representative’s Ways Means Committee Anti-takeover Tax bill. Furthermore, the main variables that exacerbated the situation were the use of portfolio insurance among many trading firms, and the recent introduction of computer-programmed trading of equities.6

“S&P 500 Index Around the Time of the Crash” | Uploaded November 18, 2017 | Courtesy of Wikimedia Commons
“Seal of The House Committe on Means and Ways” | Created December 31, 1788 | Uploaded on December 2, 2015 | Courtesy of Wikimedia Commons

Senate’s Anti-takeover Tax Bill – U.S. House Committee on Ways and Means: Before the Trigger

According to Carlson, Mitchell, and Netter, the House Committee on Ways and Means signing a document to remove deductibles (purchases that can reduce the amount of tax debt) on October 13, 1987, was the cause of the three-day decline before Black Monday.7 Takeovers are efforts for a company to take control of another one by acquiring a majority of that company’s stock. Because “mergers” and “acquisitions” were treated as capital expenditures, they were deductible. The tax bill removed that opportunity; companies now had to pay for the stocks without getting a tax deduction for it, making takeovers cost more, which increased one’s risk.8 Subsequently, investors reconsidered their risk/reward chances of acquiring companies through merger or acquisition. In other words, the probabilities of a big company trying to buy the majority of stock of some other smaller company was suddenly less attractive.9

Three-Day Decline Prior to the Black Monday: “The Trigger”

According to McKeon and Netter, there are many explanations for 10% decline of October 14-16 that led to the 1987 Crash. However, there is a consensus that this three-day decline revealed some negative information about the market, causing problems in investor psychology leading to many market players all deciding at the same time to liquidate, which is the technical term for selling one’s assets to raise cash. 10

Changes in Investor Psychology: What happened to investors is an example of change in “consumer’s confidence about the future,” which is reflected in what experts call the “Rational Expectation Theory.” This is an economic concept that states that a decrease in consumers’ confidence in a product or service (in this case, investors confidence in markets) will make them spend less and save more. Huang and Wang point out that, “Crashes are typically accompanied by large selling pressures.”11 In this case, because potential investors received information about the market declining 10% between October 14-16, it led them to be less confident that the market would stop declining. So from their perspective, investing in the market presented a risk of losing money higher than the chances of making a profit, consequently causing them to be willing to be sellers of equities rather than buyers.12 As a result, investors were desperate to sell on Friday 16, seeking to reduce losses. But that only created an atmosphere of Panic. There were few buyers of equities and vast numbers of sellers, making values in the Stock Exchange drop further, far below healthy levels.13

Liquidity problem: Huang and Wang point out in their study “Liquidity and Market Crashes,” that there is always some debate on what causes a market crash. However, a lack of liquidity has always been seen as an indicator of a possible Crash, and furthermore a contributor to more severe consequences. A liquid asset is an asset that when sold, has minimal changes in its value.14 The lack of liquidity seems always to be present before a Crash, and during it, it makes the whole trading process more complicated. When there are many buyers and sellers, there is liquidity. Each transaction doesn’t make much of a change in the prices of equities because there are so many people both buying and selling at the same time that the supply and demand remain fairly even. On the other hand, when sellers vastly outnumber buyers, there isn’t enough supply of stock to meet the demand of the sellers, leading to a lack of liquidity, forcing the prices of stock to decline in order to find buyers willing to buy at cheaper prices. When there is a sudden drop in prices, such as the one that occurred on Friday, October 16, many who had previously been buyers decided to sell, making the number of remaining buyers increasingly insufficient. Because there are so fewer buyers, there is also a low quantity of transactions, causing liquidity demand to rise and the supply to decrease.15

Programmed trading: The New York Stock Exchange became fully automated in 1985. Tom Sosnoff, a market maker for the Chicago Board of Options Exchange in 1987, explained that buying a stock required a customer to call a stockbroker to place an order, who then passed the request to a firm’s trading desk, who then made another call to the brokerage booth clerk on the floor of exchange, who then passed the written order to the firm’s floor broker and finally to the specialist who then executed the order.11 In order to make the process easier and faster, computer trading was introduced to trading floors in many Stock Exchanges, eliminating many of those intermediate steps to trading equities. However, the computers were not prepared for the unusual numbers of orders in the case of a panic, and neither were the floor brokers. According to Troy Segal, computers worsened the situation by keeping the execution of orders when the Market was already in unhealthy levels of value, meaning that computers kept liquidating, selling an asset at its current price before its expiration date to make a fast profit or in this case reduce losses, with the market prices already low. As he explained: “To the dismay of the exchanges, program trading led to a domino effect as the falling markets triggered more automated stop-loss orders (liquidation). Since the same programs also automatically turned off all buying, bids vanished all around the stock market at basically the same time.” Because of this reason, exchanges were also busy trying to figure out how to stop this automated trading.17

New York Stock Exchange | August 15, 2008 | Courtesy of Wikimedia Commons

Portfolio Insurance: Michael Lewis mentioned that in 1987, people were using financial tools that had just been created, without fully understanding them. Lewis pointed out that because of how recent the idea was, the majority of investors using portfolio insurance in 1987 were not fully aware of all its drawbacks. Portfolio insurance is a hedging strategy, and hedging is a method of reducing losses by making a second investment in a product correlated to the first one. Portfolio insurance, in theory, creates a zero risk portfolio. It works by making an investment that could provide good returns, while balancing the risk incurred with that investment with options contracts (financial instruments that enable an investor to buy or sell an asset at a fixed price at any point during an agreed time for a premium fee). If the investment loses money, the option contract will offset the loss with a near equal gain, making it possible for the investor to cover the losses. However, it also reduces the amount of potential profit the underlying asset might earn.18

Portfolio insurance was a new and popular strategy in 1987, and the basic idea of portfolio insurance is to protect one’s long equity position from market declines by placing a short position to cover that long position’s exposure to declines, either by selling a call option or by buying a put option on that equity (or both–a strategy known as “a collar” trade). When one’s long-side exposure is market-wide, one can accomplish the same portfolio hedge by selling a futures contract on an index of stocks, like a futures contract on the S&P index. Although this didn’t start the panic, it made the situation substantially worse by giving institutional investors a false sense of security.19

Black Monday (1987) | Author: Roger Hsu | Uploaded June 27, 2014 | Courtesy of Flickr

It can be concluded that the main factors creating the Crash were the change in human psychology, which led to desperate selling, and the liquidity problem in collaboration with the panic, which resulted in a rapid devaluation of the market. Furthermore, it was the 10% decline from October 14 to 16 that gave birth to the problems of investors’ perception of the future of the market and the liquidity changes. It is also worth noting the role that the Anti-takeover Tax Bill from the House Committee on Ways and Means had on market sentiment, by changing the rules of the market’s competition and by making the buying of stocks substantially less profitable by eliminating deductibles. Moreover, the biggest decline in the history of the stock market, which was triggered by the three trading days previous to the weekend of Black Monday, reached such high numbers due to the introduction of two new elements in the market. The first element, programmed trading, made the prices fall even more by having computers liquidating under already unfavorable conditions in the market, programs that also turned off purchases at the same time, and exchanges that did not know how to stop it as soon as they noticed it.

  1. “The Stock Market Crash of 1987 | Cancel Crash,” YouTube video, 43:18, posted by Tasty Trade, August 19, 2015, https://www.youtube.com/watch?v=jLfjEMDJubg.
  2. Jansen Cory, Wagner Cory, Investopedia, Dotdash, June 6, 1999, accessed November 9, 2018: https://www.investopedia.com/.
  3. New York Stock Exchange, NYSE, Intercontinental Exchange, 1985, accessed November 8, 2018, https://www.nyse.com/index.
  4. “The Stock Market Crash of 1987 | Cancel Crash,” YouTube video, 43:18, posted by Tasty Trade, August 19, 2015, https://www.youtube.com/watch?v=jLfjEMDJubg.
  5. “The Stock Market Crash of 1987 | Cancel Crash,” YouTube video, 43:18, posted by Tasty Trade, August 19, 2015, https://www.youtube.com/watch?v=jLfjEMDJubg.
  6.  Ryan McKeon and Jeffry Netter, “What caused the 1987 stock market crash and lessons for the 2008 crash,” Review of Accounting and Finance, Vol. 8 Issue 2 (2009): 123-137, https://doi.org/10.1108/14757700910959475.
  7. Swardson Anna, “Senate Approves Tax Revision 74-23,” The Washington Post, September 26, 1982, accessed November 8, 2018: https://www.washingtonpost.com/archive/politics/1986/09/28/senate-approves-tax-revision-74-23/0a068f51-8078-48e7-b177-f2618951eb81/?noredirect=on&utm_term=.f10e695a8aa0
  8. Ray Knight and Lee Knight, University of Akron, “Tax Treatment of Takeover Costs: Supreme Court Responds to Controversy,” 1992: https://ideaexchange.uakron.edu/cgi/viewcontent.cgi?referer=https://www.google.com/&httpsredir=1&article=1064&context=akrontaxjournal.
  9. Carlson Mark, “A Brief History of 1987 Stock Market Crash with a Discussion of the Federal Reserve Response,” Federal Reserve Board, Washington, D.C., November 2006, accessed September 29, 2018: https://www.federalreserve.gov/pubs/feds/2007/200713/200713pap.pdf.
  10. Mitchell Mark and Jeffry Netter, “Triggering the 1987 Stock Market Crash: Antitakeover Provisions in the Proposed House Ways and Means Tax Bill,” William Shwert, University of Rochester, May 20, 2013, accessed September 30, 2018: http://schwert.ssb.rochester.edu/f423/Crash_Tax.pdf.
  11. “The Stock Market Crash of 1987 | Cancel Crash,” YouTube video, 43:18, posted by Tasty Trade, August 19, 2015, https://www.youtube.com/watch?v=jLfjEMDJubg.
  12. Mitchell Mark and Netter Jeffry Netter, “Triggering the 1987 Stock Market Crash: Antitakeover Provisions in the Propose House Ways and Means Tax Bill,” U.S. Securities and Exchange Commission, http://3197d6d14b5f19f2f440-5e13d29c4c016cf96cbbfd197c579b45.r81.cf1.rackcdn.com/collection/papers/1980/1989_0504_TriggeringAntitakeoverT.pdf.
  13.  Ryan McKeon and Jeffry Netter, “What caused the 1987 stock market crash and lessons for the 2008 crash,” Review of Accounting and Finance, Vol. 8 Issue 2 (2009): 123-137, https://doi.org/10.1108/14757700910959475.
  14. Nickolas Steven, Investopedia, Dotdash, April 3, 2018, accessed December 4, https://www.investopedia.com/ask/answers/032715/what-items-are-considered-liquid-assets.asp.
  15. Huang Jennifer and Jiang Wang, “Liquidity and Market Crashes,” Massachusetts Institute of Technology, February 28, 2007, accessed November 115,2018: http://web.mit.edu/wangj/www/pap/HW_070228.pdf.
  16. “The Stock Market Crash of 1987 | Cancel Crash,” YouTube video, 43:18, posted by Tasty Trade, August 19, 2015, https://www.youtube.com/watch?v=jLfjEMDJubg.
  17. Troy Segal, “What Caused Black Monday: The Stock Market Crash of 1987,” Investopedia, January 8, 2018, accessed on November 15, 2018: https://www.investopedia.com/ask/answers/042115/what-caused-black-monday-stock-market-crash-1987.asp.
  18. Ryan McKeon and Jeffry Netter, “What caused the 1987 stock market crash and lessons for the 2008 crash,” Review of Accounting and Finance, Vol. 8 Issue 2 (2009): 123-137, https://doi.org/10.1108/14757700910959475.
  19. “Michael Lewis on the Crash of 1987,” Youtube video, 6:32, posted by BigThink, April 23, 2012, https://www.youtube.com/watch?v=KFa4-SRIhIM.

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This Post Has 16 Comments

  1. Avatar

    This article was very interesting since I am a Finance major who wants to learn more about the stock market. I always wondered how stocks became so computerized, which is kind of funny because reading this article explains that the process becoming automated made it worse for the stock market at one point. It’s also interesting reading about the domino effect and how one thing led to another which started people to panic and try to save their investments when they’re actually killing them. It’s terrifying thinking about how people can lose years worth of investments in a single day in the stock market.

  2. Avatar

    I really liked reading this economic explanatory article on the stock market crash. It is very unfortunate about how much loss of money and other situations that occurred in this time, but this article was very well written and it made it enjoyable to read about such an event.I really liked the introduction into the writing by how you included the two guys because it makes the reader already feel interested and sorry for the men in their situation.

  3. Avatar

    I recall the stock market crash of 1987, and I thought this article detailed it very well. The writer was able to explain the importance of the stock market in most economies, specifically, the American economy. He was also able to make a connection between depressions and stock market crashes, and I was very impressed by this explanation. Additionally, I enjoyed reading the authors description of how the stock market impacts the growth and development of businesses as well as the overall economy. One thing that stood out to me from the article was the picture of two men crying; it was a sad sight indeed. The thought of taking such great financial losses is terrifying to me, and I can sympathize with their loss.

  4. Avatar

    I love how informative this article was, it did a great job explaining all the aspects of the stock market crash and all of the ripple effects it had in the financial area. I am not very familiar when it comes to finance, but this article does a great job on explaining these type of things so people like me can understand. The stock market crash didn’t just affect people financially, it affected people emotionally too, so many people suffered.

  5. Avatar

    This was a great, well written article! I, personally, am not familiar with many specifics when it comes to the stock market but this crash is one that I have been made aware of and told of since I can remember. This article did a great job of informing me of all the specifics regarding this stock market crash. There was a lot of research that was in the article and I think it was interesting how it actually had an impact on our stock market today.

  6. Avatar

    This is such a great and knowledgeable article! When it comes to stock markets I honestly do not know anything. I really loved how to author broke down how the crash came to be all the factors. I always loved talking about the stock market class so this was able to clear up so many things. Very well written article!

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