Can it happen again?
The question undoubtedly will be asked by many investors and regulators about the crash of 1987 as it marks its first anniversary next Wednesday.
Unfortunately, the answer is not entirely reassuring.
Most market watchers agree that a close repeat of the Oct. 19 disaster--in which the Dow Jones industrial index nose-dived 508 points in one day--is highly unlikely soon under prevailing market conditions. Stocks simply are no longer overvalued by historical standards as they were last summer, a key precondition leading to the crash, these experts say. The investor euphoria of last spring and summer--in retrospect, a telltale sign that the market was overheating--has been replaced by malaise and uncertainty.
But while the chances of another crash appear slim in the near term, they’re much greater over the long haul if a high level of investor speculation returns to the market, experts say. Indeed, major crashes have occurred about once every 60 years, and nothing has been done to diminish the laws of supply and demand that lead to those cycles.
“Markets have crashes from time to time,” says Merton Miller, a University of Chicago finance professor who chaired the Chicago Mercantile Exchange’s official study of the crash. “A stock market crash is not like a space shuttle crash. It’s not something you could prevent if you are more careful.”
“You pay a price for unregulated markets and for free markets,” says New York Stock Exchange Chairman John J. Phelan Jr. “You’ve got to take bumps that come along.”
Further, while another 500-point one-day slide may be highly unlikely, market watchers haven’t ruled out a long, slow decline in stock prices somewhat reminiscent of 1930-32, when the Dow Jones industrial index--after regaining half of its loss following the crash--then lost nearly 90% in a gradual two-year slump.
Experts also warn not to dismiss chances of a different financial crisis--one that could start in an overseas stock market or bank and spread worldwide.
In any event, many experts agree that a second collapse could be far more devastating to the U.S. and world economies because it would more likely hurt citizens in their pocketbooks, homes and jobs. Last October’s crash merely wiped out the stock profits of the previous year.
Disagree on Cause
“Another crash would be so devastating” and could hurt foreign investment, international trade and other key aspects of the world economy, says James C. Meyer, chief securities regulator in Tennessee and outgoing president of the North American Securities Administrators Assn., an organization of state regulators.
To be sure, there is wide disagreement on what is going to happen to the market and economy. Experts still can’t agree on what caused the crash.
Blame for the tumble has fallen variously on a failure of market mechanisms and regulation; the growth of computerized program trading; rising interest rates; high budget and trade deficits; a breakdown in international cooperation to back the dollar, and proposed tax law changes that would have discouraged corporate takeovers.
But amid this disagreement, most experts agree on at least one thing: The record ascent of the Dow between 1982 and 1987 was a key precondition for the crash.
When the Dow hit its all-time high of 2,722.42 on Aug. 25, 1987, stocks in the blue chip Standard & Poor’s 500-stock index were trading at a price-earnings ratio (stock price divided by earnings per share) of more than 20, a level that had also been topped in 1929 and 1962, just before the two other biggest market downturns this century, writes Norman G. Fosback, president of the Institute for Econometric Research, a Ft. Lauderdale, Fla., investment newsletter publisher.
The price-earnings ratio is a common measure of a stock’s relative value, compared to other stocks and other investments; a high ratio indicates that the stock may be overvalued.
Similarly, in 1987, the dividend yield (dividends as a percentage of stock prices) on issues in the S&P; 500 stood at 2.6%--the lowest in history, Fosback says. That compared to a yield of close to 10% for long-term Treasury bonds, a factor that undoubtedly lured some money away from equities into bonds.
Difficult to Pull Out
But today, the price-earnings ratio on the S&P; 500 stands at a much more reasonable level just above 12, while the dividend yield has risen to 3.7%, Fosback notes.
Another factor lessening the likelihood of another crash soon: Many investors learned from last October that it is not easy to bail out of stocks when the bottom falls out. Institutional investors with “portfolio insurance,” a computerized trading strategy using futures and options to limit losses in a market downturn, found that it didn’t work as well as they thought. In the heat of the panic selloff, few buyers came forward.
“No one any longer is naive enough to believe that the futures market adds additional liquidity during times of stress,” says Robert G. Kirby, a Los Angeles money manager and member of the Brady Commission, one of some dozen official groups that studied the crash.
Proposals for Reform
Some experts also cite reforms and proposed reforms that, while not preventing another crash, could at least lessen its force. These include a proposal by the NYSE and Chicago Mercantile Exchange--home of stock index futures trading--to close stock, futures and options markets for one hour if the Dow falls 250 points in one day and for two hours if the decline reaches 400 points.
Wendy Lee Gramm, chairman of the Commodity Futures Trading Commission and a proponent of this “circuit breaker” scheme, argues that it would give time for investors and regulators to assess market activity and obtain new information, while securities firms could use the time to process trades.
Also, to boost their ability to cope with future crashes, major exchanges and markets have improved computer capabilities and imposed new safeguards, such as requiring traders to hold greater financial reserves. These and other changes will allow the markets to process much higher trading volumes, better coordinate trading between markets and obtain better information on who is doing the trading.
Nonetheless, regulators, industry officials and legislators say more needs to be done. Joseph Hardiman, president of the National Assn. of Securities Dealers, which operates the over-the-counter market, says the biggest need is for a unified clearing system to handle payment and settlement of trades. Uncertainty about the financial solvency of traders on Oct. 20, the day after Black Monday, nearly led to a total shutdown of the market itself.
Howard Stein, chairman of the Dreyfus Corp. mutual fund company and another member of the Brady Commission, contends that a top priority should be to consolidate regulation of stocks and stock index futures under one regulatory roof. Those roles are now split between the Securities and Exchange Commission and the CFTC.
Beyond the need for further technical market improvements, worries abound about potential vulnerabilities in the U.S. and world financial system--any one of which could precipitate another market crash or worldwide economic crisis.
Maurice Mann, chairman of the Pacific Stock Exchange, urges more progress to tame the bulging U.S. trade and budget deficits. Other often cited woes include high levels of corporate debt and strains on banks and savings and loans, many of which are insolvent.
Higher interest rates or a recession could trigger a rash of new banking failures and business bankruptcies similar to those in the early 1930s. Many economists say those failures--and not the 1929 stock market crash--were the real cause of the Great Depression.
Others worry about a collapse starting overseas, perhaps in the burgeoning Japanese stock market--the world’s largest--where equity prices didn’t crash nearly as much as in the United States and where prices on average have gained more than 25% this year, double the rise in the American market.
But others--including many regulators and industry officials--minimize the possibility of a financial crisis. They contend, among other things, that the major industrial democracies are well aware of these risks and are committed to coordinate economic policies to thwart a crisis. Policy-makers such as Federal Reserve Board Chairman Alan Greenspan are unlikely to repeat the mistakes of the 1930s, when the Fed reduced the money supply just as bank failures began to rise and the economy began to slow. And the Tokyo market, while overvalued by U.S. standards, is not unreasonably overvalued by Japanese standards, the optimists contend.
Perhaps a more realistic concern might be that the U.S. stock market is due for a sustained and gradual fall, although not as severe as in 1930-32, when the Dow slipped to 41 from 294. Investor confidence will take months to repair, many pessimists contend.
While the Dow has risen more than 24% from its Oct. 19 low to set a new post-crash high of 2,158.96 on Monday, many stocks have not participated in the gain--a sign that the rally is occurring within a bear market, not starting a new bull market, contends Robert R. Prechter, editor of the Elliott Wave Theorist newsletter in Gainesville, Ga. Bull market rallies, he contends, are characterized by investors buying a broad number of stocks.
“It takes years to bring a market back to the point where it can attract new investors again to start a new cycle,” he says.
However, others--encouraged by new post-crash highs--contend that the bear market is already over. Some even suggest that the bear market started, and ended, last Oct. 19.
Ralph Acampora, a widely respected technical analyst for the investment firm Kidder, Peabody & Co. and one of the first market watchers to compare the 1987 crash with the 1929 version, now notes that the similarities are decreasing. Trading patterns of the two periods, while looking similar in the first few weeks following both crashes, now have diverged, Acampora argues.
For example, after October, 1929, the Dow recovered about half of its loss from its pre-crash high by the following April. So far, the Dow has only recovered about 40% of what it lost since its August, 1987, peak, and has taken nearly a year to do so. Also, by the one-year anniversary of the 1929 crash, the Dow had fallen to below the lows of the crash. This time around, the market is still setting new post-crash highs.
Acampora also notes there are differences in the economies as well. Today there are few signs of recession, unlike 1930. And the Fed will stand behind the banking system, which now enjoys federal deposit insurance, unlike in 1930.
“The comparison is not there,” Acampora says. “The mirror image is kind of fuzzy.”
Other experts contend that the 1987 crash may have been a blessing in disguise, laying the groundwork for a more sustained, healthy market.
While trading volume is down, that is partly because institutional and individual investors are not engaging in as much short-term trading that had destabilized prices before the crash, NASD President Hardiman says.
“People are going back to fundamentals,” he says.