14
1 Running Head: 1929 AND 1987 STOCK MARKET CRASHES 1929 and 1987 Stock Market Crashes Aisha Khalifa Near East University

The Causes of the 1929 Crash

Embed Size (px)

DESCRIPTION

stock market crash

Citation preview

Page 1: The Causes of the 1929 Crash

1 Running Head: 1929 AND 1987 STOCK MARKET CRASHES

1929 and 1987 Stock Market Crashes

Aisha Khalifa

Near East University

Page 2: The Causes of the 1929 Crash

21929 AND 1987 STOCK MARKET CRASHES

The 1929 stock market crash :

It began on Thursday, October 24, 1929. 12,894,650 shares changed hands on the

New York Stock Exchange-a record. To put this number in perspective, let us go back

a bit to March 12, 1928 when there was at that time a record set for trading activity.

On that day, a total of 3,875,910 shares were traded. As we can see, Wall Street was a

very, very busy place, as were markets worldwide. A big problem not mentioned so

far in all this was communication The ticker tape machine had gone through great

amounts of perfections since its early applications in the 1870s-80s by Edison and

others. Even at telegraphic speed, the volume was having an effect on time. Issues

were behind as much as one hour to an hour and a half on the tape. Phones were just

busy signals on hooks .

It was causing crowds to gather outside of the NYSE trying to get in the

communication. Police had to be called to control the strangest of riot masses; the

investors of business. It is not yet noon. The habit of lunch eased the panic somewhat

and New York paused for a breath. There were rumblings of bargain grabbing to

come in the afternoon, so maybe something could be salvaged. And it did comeback

to regain much of the losses. For example, a stock like Montgomery-Ward opened at

83 and dropped to 50 and recovered to 74. This was typical for the big name

companies. On Friday, the mixture of margin call bargains combined with sells that

were waiting from the late tickers on Thursday led to a bit of a gain. The trading was

about 6 million shares. There was a short session on Saturday, which brought

everything back to the level of Thursday.

The Causes of the 1929 Crash:

Page 3: The Causes of the 1929 Crash

31929 AND 1987 STOCK MARKET CRASHES

While there have been many suggested explanations for the Crash, no one can fully

account for it. Here are some of the explanations proposed :

1 .Stocks were Overpriced: Many people believe that stocks were overpriced and the

crash brought the share prices back to a normal level. However, some studies using

standard measures of stock value, such as Price/Earnings ratios and Price/Dividend

ratios, argue that the share prices were not too high .

2 .Massive Fraud and Illegal Activity: A number of people believe that fraud and

illegal activity was one of the causes of the 1929 Crash. However, evidence revealed

that there was probably very little actual insider trading or illegal manipulation .

3 .Margin Buying: Margin buying is another scapegoat for the cause of the Crash.

However, it is not the main reason because there was very little margin outstanding

relative to the value of the market (the margin averaged less than five percent of the

market value) .

4 .Federal Reserve Policy: The new President of the Federal Reserve Board Adolph

Miller tightened the monetary policy and set out to lower the stock prices since he

perceived that speculation led stocks to be overpriced, causing damage to the

economy. Also, starting from the beginning of 1929, the interest rate charged on

broker loans rose tremendously. This policy reduced the amount of broker loans that

originated from banks and lowered the liquidity of nonfinancial and other corporation

that financed brokers and dealers .

5 .Public Officials' Repeated Statements: Many public officials commented that the

stock prices were too high. For example, the newly elected President of the United

States, Herbert Hoover, publicly stated that stocks were overvalued and that

Page 4: The Causes of the 1929 Crash

41929 AND 1987 STOCK MARKET CRASHES

speculation hurt the economy. Hoover's statement suggested to the public the lengths

he was willing to go to control the stock market. These kinds of statements

encouraged investors to believe that the market would continue to be strong, which

could be one of the causes of the Crash.

The 1987 stock market crash :

The Stock Market Crash of 1987 or "Black Monday" was the largest one-day market

crash in history. The Dow lost 22.6% of its value or $500 billion dollars on October

19th 1987. 1986 and 1987 were banner years for the stock market. These years were

an extension of an extremely powerful bull market that had started in the summer of

1982. This bull market had been fueled by low interest rates, hostile takeovers,

leveraged buyouts and merger mania. Many companies were scrambling to raise

capital to buy each other out. The business philosophy of the time was that companies

could grow exponentially simply by constantly acquiring other companies. In a

leveraged buyout, a company would raise a massive amount of capital by selling junk

bonds to the public. Junk bonds are bonds that pay high interest rates due to their high

risk of default. The capital raised through selling junk bonds would go toward the

purchase of the desired company. IPOs were also becoming a commonplace driver of

market excitement. An IPO or Initial Public Offering is when a company issues stock

to the public for the first time. “Microcomputers” now known as personal computers

were become a fast growing industry. People started to view the personal computer as

a revolutionary tool that would change our way of life, while creating wonderful

business opportunities. The investing public eventually became caught up in a

contagious euphoria that was similar to that of any other historic bubble and market

Page 5: The Causes of the 1929 Crash

51929 AND 1987 STOCK MARKET CRASHES

crash. This euphoria made investors, as usual, believe that the stock market would

“always go up”.

The Causes of the 1987 Crash:

According to Facts on File, an authoritative source of current-events information for

professional research and education, the 1987 crash"marked the end of a five-year

'bull' market that had seen the Dow rise from 776 points in August 1982 to a high of

2,722.42 points in August 1987." Unlike what hapopened in 1929, however, the

market rallied immediately after the crash, posting a record one-day gain of 102.27

the very next day and 186.64 points on Thursday October 22. It took only two years

for the Dow to recover completely; by September of 1989, the market had regained all

of the value it had lost in the '87 crash.

1 -Derivative securities:

Initial blame for the 1987 crash centered on the interplay between stock markets and

index options and futures markets. In the former people buy actual shares of stock; in

the latter they are only purchasing rights to buy or sell stocks at particular prices. Thus

options and futures are known as derivatives, because their value derives from

changes in stock prices even though no actual shares are owned. The Brady

Commission [also known as the Presidential Task Force on Market Mechanisms,

which was appointed to investigate the causes of the crash], concluded that the failure

of stock markets and derivatives markets to operate in sync was the major factor

behind the crash.

2 -Computer trading:

Page 6: The Causes of the 1929 Crash

61929 AND 1987 STOCK MARKET CRASHES

In searching for the cause of the crash, many analysts blame the use of computer

trading (also known as program trading) by large institutional investing companies. In

program trading, computers were programmed to automatically order large stock

trades when certain market trends prevailed. However, studies show that during the

1987 U.S. Crash, other stock markets which did not use program trading also crashed,

some with losses even more severe than the U.S. market.

3 -Illiquidity:

During the Crash, trading mechanisms in financial markets were not able to deal with

such a large flow of sell orders. Many common stocks in the New York Stock

Exchange were not traded until late in the morning of October 19 because the

specialists could not find enough buyers to purchase the amount of stocks that sellers

wanted to get rid of at certain prices. As a result, trading was terminated in many

listed stocks. This insufficient liquidity may have had a significant effect on the size

of the price drop, since investors had overestimated the amount of liquidity. However,

negative news to investors about the liquidity of stock, option and futures markets

cannot explain why so many people decided to sell stock at the same time.

4 :U.S. trade and budget deficits:

Another important trigger in the market crash was the announcement of a large U.S.

trade deficit on October 14, which led Treasury Secretary James Baker to suggest the

need for a fall in the dollar on foreign exchange markets. Fears of a lower dollar led

foreigners to pull out of dollar-denominated assets, causing a sharp rise in interest

rates.

5 :Investing in bonds as an attractive alternative:

Page 7: The Causes of the 1929 Crash

71929 AND 1987 STOCK MARKET CRASHES

Long-term bond yields that had started 1987 at 7.6% climbed to approximately 10%

[the summer before the crash]. This offered a lucrative alternative to stocks for

investors looking for yield.

6 -Overvaluation:

Many analysts agree that stock prices were overvalued in September, 1987.

Price/Earnings ratio and Price/Dividend ratios were too high [Historically, the P/E

ratio is about 15 to 1; in October 1987 the P/E for the S&P 500 had risen to about 20

to 1]. Does that imply that overvaluation caused the 1987 Crash? While these ratios

were at historically high levels, similar Price/Earnings and Price/Dividends values had

been seen for most of the 1960-72 period. Since no crash happened during that period,

we can assume that overvaluation did not trigger crashes every time.

Similarities and differences between 1929 and 1987 stock market

crashes:

The October 1929 crash was marked by a few up days and many down days, whereas

the October 1987 crash occurred primarily in just one day.  Despite this difference, on

closer examination, we find that these two stock market crashes have much in

common.   In both crashes the underlying dynamic that caused the demand for risky

assets to decline as the price of those assets declined (which is the opposite of the

usual relationship between price and demand) was essentially the same.  Uncovering

the parallels between these two crashes provides valuable insight into the current

market crash. The October 1987 crash, and, in particular, the instability created by the

widespread use of portfolio insurance, offers a paradigm for how and why markets

crash.  But how could a crash caused by portfolio insurance help to explain the crash

Page 8: The Causes of the 1929 Crash

81929 AND 1987 STOCK MARKET CRASHES

in October 1929, which occurred half of a century before portfolio insurance was

created?  While portfolio insurance did not exist in 1929, a practice much older than

portfolio insurance did: the widespread investment strategy of purchasing risky assets

using borrowed funds. Both purchasing portfolio insurance and buying stock on

margin follow the same basic strategy: the purchase of both a risky asset and a put on

that risky asset.

Page 9: The Causes of the 1929 Crash

91929 AND 1987 STOCK MARKET CRASHES

References:

Carlson, M. A. (n.d.). A Brief History of the 1987 Stock Market Crash With a

Discussion of the Federal Reserve Response. SSRN Electronic Journal SSRN

Journal.

Galbraith, J. K. (1988). The Great crash, 1929. Boston: Houghton Mifflin.

Klein, M. (2001). The Stock Market Crash of 1929: A Review Article. Business

History Review Bus. Hist. Rev., 75(02), 325-351.

Levy, H., & Yoder, J. (1991). The formation of stock return volatility expectations

after the 1987 stock market crash. Economics Letters, 35(4), 441-444.

Limmack, R., & Ward, C. (1990). The October 1987 stock market crash. Journal of

Banking & Finance, 14(2-3), 273-289.