May 24: The Stock Market Crash of 1987

by David Jenyns on May 24, 2007

The stock market crash of 1987 is the largest crash in recent United States History. Although there was a minor crash at the turn of the 21st century, it was nothing in comparison to the end of the 1980s. In fact, the 1987 crash is the worst single day in American financial history. There was a 22% loss in the market on October 19, 1987 or Black Monday. That is almost double the 12% loss experienced by investors in 1929 on Black Tuesday.

The 1980s, similar to the roaring 20s, was characterized by a period of financial growth and excess in the United States. The psychology of the time was “spend, spend, spend” and rampant consumerism drove the national economy and stock market to record highs.

1986 and 1987 were record years for the stock market. The bull market that started in the summer of 1982 was being carried through to create record markets 5 years later. The market was being primarily powered by hostile takeovers, leveraged buyouts and what seemed to be merger fever. The most important thing for many companies was to raise capital in order to buy other companies. It was thought that companies would grow exponentially by purchasing other companies. In leveraged buyouts, a company would raise capital by selling junk bonds to the public. Junk bonds are bonds that have a high-risk rate, and therefore a high interest rate. The capital from selling the junk bonds was used toward the purchase of another company.

Another common phenomenon was the use of IPOs. An IPO, or Initial Public Offering, is when a company issues stocks for the first time. The burgeoning computer industry was created with many IPOs in the market and people were investing in personal computers because they saw potential for great profit.

This created an inflated market with lots of stock at low and reasonable prices available for purchase. Even the most timid investor was tempted to get involved in the market.

Unfortunately, the bull market also created an opportunity for many scam IPOs and conglomerates to take advantage of uninformed investors. The SEC had its hands busy trying to keep up with the shady companies. In early 1987, the SEC began investigating illegal insider trading. This created wariness in investors and slowed the market. There was also a fear of inflation due to the strong economic growth that occurred in the previous five years. To compensate, the FED raised short-term interest rates to prevent inflation. This effected stocks negatively as well.

Many large firms began using portfolio insurance as a way to protect against further stock dips. This practice uses futures contracts as an insurance policy on a stock portfolio. If the market crashed, people with futures contracts could profit and stabilize the market by offsetting the losses in stocks.

The use of portfolio insurance worried many common stockholders. They saw it as a sign of an impending market crash. Many experts believe that the common perception during the time was that the market was beginning to resemble the 1929 market. This caused panic, and led people to sell their stocks immediately.

The fear became a self-fulfilling prophecy and as thousands tried to sell simultaneously on October 19, 1987, the market crashed because their simply weren’t any buyers. Within that day over 500 billion dollars left the Dow Jones index. The effect of the US crash affected every country around the world producing a global market crash.

Many people lost millions in a matter of minutes. Most investors didn’t even know why they were selling; they just heard that everyone else was selling and followed suit. Most futures ands stock exchanges were shut down for the day. In some extreme cases, the duress brought on by the loss of massive amounts of money caused some investors to kill their brokers. There were several instances of clients entering brokerage firms and opening fire.

Fortunately, the crash of 1987 did not result in a similar depression. The Federal government stepped in and lowered short-term interest rates to avoid a banking crisis. The market returned to a bull market rather quickly. Companies buying back their undervalued stocks fueled this new prosperity.

The addition of the circuit breakers system is a lasting impact of the 1987 crash. The system prevents stocks from trading if they plummet too quickly. This will prevent any future vertical drops in the market.

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