October 19, 1987. By afternoon of that fateful Monday, stock market specialists and financial experts faced the horror of a Dow Jones that has seen losses of up to $500 billion in value.Despite the
October 19, 1987. By afternoon of that fateful Monday, stock market specialists and financial experts faced the horror of a Dow Jones that has seen losses of up to $500 billion in value.Despite the lessons learned from the Great Depression and the preceding Stock Market Crash of 1929, what mistakes did the American financial experts make that led to the crash, which has been dubbed as “Black Monday” in history circles?
Over-Optimism for the Market
The conditions that led to the 1987 crash is similar to the factors that led to the 1929 crash. The US economy was enjoying a 5-year bull run. The technology of the personal computer had contributed significantly to the bullish attitude towards the US economy, in addition to the popularity of company mergers and acquisitions. At this time, the market introduced program trading – a form of trading controlled by computers, which react to pre-programmed market trends by selling or buying.
From 1982 until 1987, firms rapidly grew by buying small-time businesses within their niche and turning them into subsidiaries or absorbing them into their organization. In order to finance their acquisitions, companies sold junk bonds to the public, who earn money on high interest rates the firms add to their payment of the bonds.
Many companies also went public at this time period through initial public offerings. IPOs give investors from the public sector the chance to purchase stocks in a company that was previously privately owned. This is another method of raising capital, but this time to fuel a company’s own growth.
All of these factors led to a high trading volume in the market, fueled by investors who, at a moment’s speculation, can easily decide to pull the plug on their own investments and burst the growth bubble that the economy was going through.
Federal Reserve Actions
The Federal Reserve’s actions during the days immediately leading to the 1987 crash contributed to the market meltdown as well. Stock investors, who were previously bullish about their own investments, became reserved as a result of investigations launched by the SEC on fraudulent IPOs. Stock investors were further discouraged when the Reserve raised interest rates – a move that was intended to hedge the economy against inflation that rapid growth can bring. Investors and their institutions started to introduce methods to protect themselves from possible declines in the market.
By October 19, 1987, the Federal Reserve’s interest rates went up to an uncomfortable rate, causing investors and institutions to attempt to protect themselves from losses by selling a significant portion of their holdings. Program trading caused several other investors to sell in response to the massive amount of sell orders. As a result, the market became flooded with sell orders that total $500 billion, and resulted to a crash.
Fortunately, the Federal Reserve intervened immediately by lowering the interest rates and restoring confidence in the market almost instantaneously. By the next day, the market had recovered significantly as companies reacquired stocks they sold during the crash.