1987 Stock Market Crash, History and Lessons
The 1987 stock market crash refers to the selloff that occurred on “Black Monday,” October 19. It was the largest single-day decline in the history of the US stock market–the Dow Jones Industrial Average (DJIA) lost 22.6%. While it was a massive decline, it was short-lived.
In August of 1987 the DJIA peak at 2,722 and drifted a bit lower. Troubles began in mid-October. On October 14 the DJIA dropped 3.8% and another 2.4% on October 15. On October 16 the DJIA fell 4.6%, which was a Friday. The Eastern markets were the first to open on Monday (Sunday in the US) and experienced massive selling. The selling continued during the London session followed by US session.
While the selloff shook investors, and the regulators and economists who tried to make sense of it, by early 1989 the DJIA reclaimed its 2,272 high. The decline was swift and relatively brief compared to other historical crashes (like 1929) that lasted much longer.
The crash is often blamed on “program trading” or computer programs that sold stock in mass. Others blame conflicts that were taking place during this time between Iran and US. There were also some pricing differences between New York and Chicago which caused traders to buy in one market and sell in the other. This coupled with the program trading, and portfolios trying to hedge, created a financial storm. These all may have contributed to the crash. Articles in the Further Reading section below discuss the political and economic climate of the late 80’s in more detail.
Lessons From ’87 Crash
Ultimately, the cause of a crash or selloff doesn’t matter much. The lesson is that selloffs happen with regularity. When trading, risk management is important…especially if short-term trading and a significant decline could decimate the account. If long stocks and prices start to fall, get out at a pre-determined level or with a pre-determined method. While prices may eventually recover, they may not do so within the timeframe you require. The crash of 1987 started with several smaller declines which would have gotten short-term traders out of most of their long positions before the major selloff on Black Monday.
Investors holding long-term positions need to continually take inventory of how stocks are valued and consider whether they will hold their stocks through a significant decline, should one arise. One factor to consider is that when stock prices are high relative to the earnings those companies produce there is a greater risk of a significant and sustained crash. In 1987 stocks were not priced that high relative to earnings, leading to a fairly quick recovery. Following the ’87 crash, stock prices moved higher into 2000. By 2000, stocks were valued at insanely high levels, leading to a larger and longer crash.
This shows that while Price to Earnings ratios provide some insight into whether stocks are overvalued or undervalued by historical standards, the ratio is a not a timing indicator as stocks can stay over or undervalued for long periods of time. It also shows that even when stocks are seemingly priced low or fairly, significant selloffs can still occur.
What P/E does help with is assessing whether to hold an investment if stock prices start declining (the chart above is a Schiller P/E ratio, which also considers inflation). If stocks are undervalued already, it is more likely that eventually stocks will return to average or overvalued and can be sold for a profit. If stocks are excessively overvalued, then there is a greater risk that the stock may never reach its prior highs, or will take many years, even decades, to recover the losses it sustains during a crash.
When dealing with individual stocks, the prospects of that company must also be assessed. A fair (or in some cases High) P/E in a stock with stable or rising earnings is more attractive than a stock with a temporarily nice P/E where earnings are in a long-term decline. Price is not the only factor to consider; the future of earnings must also be considered.
Long-term investment is not to be confused with short-term trading. Short-term traders should always cut losses swiftly and mechanically per their strategy, regardless of how they think the stock is valued. Longer-term investors may hold stocks through declines if they believe in the future prospects of the company, and they purchased the stock at a reasonable price which will likely be surpassed (could take months or years) after the crash ends and prices begin to rise again. As mentioned, paying an excessively high price for a stock could mean the price never recovers its former glory or lofty price.
Shorter-term traders can trade in the trending direction regardless of value but must exit losing trades quickly, especially if in a volatile or highly speculative asset. Such an approach greatly reduces the chances of being caught in the major portion of a market crash.
Further Reading on the 1987 Crash
Cancel Crash – A TastyTrade documentary on the 1987 crash, as told by the traders who were there.
Black Monday – The Federal Reserve Bank of Chicago provides a detailed fundamental view of the events leading up to the ’87 crash.
Below, is a PBS broadcast from the day of the crash.
Articles On Other Stock Market Crashes
By Cory Mitchell, CMT
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