We have already established in this blog that the author agrees with the notion that armed conflicts occupy most of the inherited study of Herodotus prose. And like most historical studies, generally, all macro events are tragedies. In the financial case, the topic of general history, and now more a popular knowledge than a case study, are the crises of 1929 and 2008. What exactly happened, how the events unfolded, causes and effects, are lost within the arrogant lexicon of the financial press. The public knows that they were serious events, so bad, that is the only relevant thing, the fine details are lost sight of. Within the relevant financial events of the 20th century, one of my favorites (not because of the severity, but because of the causes) is the 1987 crash. That's what this blog post is about; we will use as a guide a Federal Reserve's paper, 'A Brief History of the 1987 Stock Market Crash with a Discussion of the Federal Reserve Response', by Mark Carlson as a guide to the facts.
Although it did not have a severe impact on the 'real economy', the stock market crash of October 1987 is remembered as the first with modern overtones. The events are embedded in Ronald Reagan's second term, during which the American public gave him the confidence - with a resounding victory at the polls - to continue the capitalist renewal of the country. We can debate a lot about the actual effect of the so-called Reaganomics, but the fact is that the good momentum led the major US stock indices and other international markets to historical highs. Seen 37 years later, given the phase of the economic cycle, a correction could have been expected at any time.
Structurally, the late 1970s were difficult years in the United States, an environment of high inflation, the end of the Bretton Woods agreement, and social unrest due to the Vietnam War. To abruptly cut the inflationary spiral, the Federal Reserve, whose governing by Paul Volcker, raised interest rates to a historic high of 14% in 1981, triggering a recession but halting the upward race of prices (as a note, this rate hike stopped inflation, but made the debt of all nations with large external obligations in dollars more expensive, which in turn contributed to the so-called "lost decade" in Latin America). Ronald Reagan had just been in power for a year, so his cabinet and the economic establishment of that country in general opted for a "shock therapy". After a long period of post-war growth, the exhaustion of the economic model now demanded a paradigm shift. Led morally and intellectually by Milton Friedman and his Monetarist theory at the University of Chicago, a major policy of financial deregulation was undertaken (some call this the "Washington Consensus" or the "neoliberal era"). The new wave of policies reached foreign trade, the free flow of capital, reductions in federal taxes (although at the same time the minimum rate increased, see the "Tax Reform Act" of 1986), liberalization of investment rules for 401-K retirement accounts (the ability to place resources from these savings accounts in higher-risk instruments, thus leveraging the markets with a lot of fresh money; see the Economic Recovery Tax Act ERTA of 1981), changes in stock market rules, etc
In addition to the liberating impulse, the market also adopted new models for valuing derivative options. First, in the 1960s, Case M Sprenkle with "Warrant prices as indicators of expectations and preferences" (1961), James Boness with "Elements of a theory of stock-option value" (1964), and the multifaceted and Nobel laureate in Economics, Paul Samuelson with "Rational theory of warrant pricing" (1965) promoted the concept of Geometric Brownian Motion in finance. As a professional in the field, I must say that this mathematical postulate is perhaps at the center of financial theory. In fact, the richest field of research in this discipline is financial derivatives, which feed on this conception. First they, and then the famous articles "The Pricing of Options and Corporate Liabilities" (1973) by Fischer Black and Myron Scholes and "Theory of Rational Option Pricing" (1973) by Robert C. Merton, posed a partial differential equation with a stochastic element, with a closed-form solution. Easily programmable on low-power calculators. Although the discussion of its flaws (especially the consideration of a constant volatility, something unrealistic), promoted an academic response that resulted in a proliferation of models and proposals that expanded the theory and offered its main client, the Market, tools to evaluate derivative instruments, especially options, one of the sparks of this event.
Now, the moment when the boom cycle would end was expected (as it always does under a consumer capitalism model). And so we arrived at October 1987. With all this in mind, I will now try to describe in a timely manner the chain of events that led to the disaster. Mark Carlson' document, referred to at the beginning, lists the avalanche of sell orders caused by panic, the weakness of trading systems that were unable to process so many payment orders. And, very sensitive, the chain of consequences in options: a sharp drop in stock prices, a very rapid increase in the margin level required to maintain short positions (better known as 'margin call'). Participants with short put and call positions had to increase these positions (due to systemic rules of the CME' clearinghouse). This, in turn, reduced liquidity in the derivatives markets and, by extension, for the rest of the participants
Variables
The weakening industry in previous years that suffered from inflation, as well as cheaper and higher-quality products from Japan and Germany (a twist of fate: the main losers of WWII dominated their former adversary through trade) eroded the trade balance considerably, which was consistently in deficit from the third quarter of 1982. Two international agreements were reached with the main industrial countries of the time, first the Plaza Accord (September 1985) and later the Louvre Accord (February 1987), which sought to weaken the US dollar against the Deutsche Mark and the Japanese Yen, and thus correct the commercial deficit. Even with these agreements, according to Carlson (2007), on Wednesday, October 14, 1987, the Department of Commerce announced a trade deficit higher than expected; in fact, it was a historical maximum in a series that has been recorded since 1960 to date:
Graph 1: US Trade Balance, 1980s. Quarterly. Millions
Data from the Bureau of Economic Analysis (BEA). Series International Transactions. Available at: https://apps.bea.gov/iTable/?appid=62&step=1#eyJhcHBpZCI6NjIsInN0ZXBzIjpbMSwyXSwiZGF0YSI6W1siUHJvZHVjdCIsIjEiXV19
Graph 2: Japanese YEN X USD Dollar 1985-1988. Monthly
Data from FRED. Japanese Yen to U.S. Dollar Spot Exchange Rate (EXJPUS). Available at: https://fred.stlouisfed.org/series/EXJPUS/
Graph 3: Deutsche Mark (DEM) to US Dollar (USD) Exchange Rate, 1985-1988. Monthly
Data from FRED. Germany / U.S. Foreign Exchange Rate (DISCONTINUED) (EXGEUS). Series discontinued due to the replacement of the Deutsche Mark with the Euro. Available at: https://fred.stlouisfed.org/series/EXGEUS
As can be observed, by October 1987, the US dollar had significantly weakened, yet it failed to rectify the trade imbalance, which reached a historic deficit that same month. Meanwhile, the Federal Funds Effective Rate (FFR) attained its annual peak a few days prior, on September 30th. According to the subsequent graph, it peaked again on the 15th, remained relatively stable through the infamous Monday 19th, and then declined sharply on the 20th and 21st. The Fed's swift response to provide liquidity to market participants, particularly those facing urgent margin calls, averted the feared scenario of a systemic banking crisis. The rate cuts were implemented in response to the extremely stressful market conditions, as detailed in Alan Greenspan's autobiography, "Age of Turbulence," which dedicates an entire chapter to the events surrounding the crash.
Graph 4.1: Federal Funds Effective Rate. Daily data, 1987
Data from the Federal Reserve Economic Data (FRED). DFF series available at: https://fred.stlouisfed.org/series/DFF
Graph 4.2: Federal Funds Effective Rate. Daily data, september - november 1987
From a macroeconomic perspective, these were the key developments: inflation remained stable within a 4.5% to 5% year-over-year range since being tamed in the early part of the decade, and GDP, as previously mentioned, continued to grow. Additionally, although the fiscal balance remained in deficit, it appeared to be "under control", indeed, at his five-year lower level.
Graph 5: Sticky Price Consumer Price Index Excluding Food and Energy. Monthly Year-over-Year Change
Data from the Federal Reserve Economic Data (FRED). CORESTICKM159SFRBATL series available at: https://fred.stlouisfed.org/series/CORESTICKM159SFRBATL
Graph 6: Quarterly Nominal GDP. Trillions. 1985-89
Data from BEA. Available at: https://www.bea.gov/data/gdp/gross-domestic-product
Graph 7: Fiscal deficit, nominal. Billions. 1980-89
Data from Federal Reserve Economic Data FRED. Series Federal Government: Current Expenditures (FGEXPND), Available in: https://fred.stlouisfed.org/series/FGEXPND and Federal Government Current Receipts (FGRECPT), available in: https://fred.stlouisfed.org/series/FGRECPT
How did the major indices arrive at this event? Let’s examine the evolution of the S&P 500 (GSPC), the Dow Jones Industrial Average (DJI), and the winning segment: short-term US government bonds, specifically the 3-Month Treasury Bill Secondary Market Rate, Discount Basis (DTB3). At that time (beofore the distortions caused by modern heterodox monetary policies), there was an almost ironclad rule: when the price of equity instruments (especially stocks) declines, highly liquid participants seek safe-haven assets, a phenomenon known as “flight to quality.” As a result, the price of debt rises and its yield decreases (and vice versa), as illustrated in Graph 10.
Graph 8.1 S&P500 (GSPC) 1987. Daily
Data from Investing.com Available in: https://mx.investing.com/indices/us-spx-500
Graph 8.2 [Candlestick] S&P500 (GSPC) October 1987. Daily
Graph 9.1 DowJones Industrial Average (DJI) 1987. Daily
Data from Investing.com Available in: https://es.investing.com/indices/us-30
Graph 9.2 [Candlestick] DowJones Industrial Average (DJI) October 1987. Daily
Graph 10 3-Month Treasury Bill Secondary Market Rate, Discount Basis (DTB3).October-november 1987. Daily
Data from Federal Reserve Economic Data FRED. Serie: DTB3 Disponible en: https://fred.stlouisfed.org/series/DTB3
Chronicle
According to Mark Carlson, on Wednesday, October 14th, the Department of Commerce announced a larger-than-expected trade deficit (see Graph 1), which, coupled with the continued depreciation of the dollar due to recent international monetary policy agreements (see Graphs 2 and 3), increases the likelihood of the Fed tightening its monetary policy. This environment attracted bearish agents, who were very active for the rest of the week. Bearish sentiment took over the Market.
For Friday, tranches of index options and other instruments contracts expired. Options that were at-the-money on Monday were no longer so by Friday. Short position holders were unable to easily reestablish their positions. Simultaneously, an arbitrage opportunity opened up in derivatives: participants sold CME futures contracts as protection, anticipating further downward pressure. While the difference was positive, others took advantage of this to buy these contracts and sell stocks. Thus, the price gap between the NYSE and CME began to widen. Traders with semi-automated models (e.g., portfolio insurers), those who were long in stocks, institutions with hard investment rules, and the general investing public sought to exit, increasing the volume of selling.
And so we arrived at Black Monday. The significant bearish pressure from the previous week caused some market makers to not open operations when the NYSE did. In fact, of the S&P 500 constituents, 95 stocks did not open, and 11 of the DowJones. This is where the confusion began. The index points were calculated with many outdated prices, so initially they did not reflect the overall market decline. On the other hand, the CME opened without interruption, widening the gap between the two exchanges. When the NYSE finally opened, the major indices suffered severe declines. By the end of the day, the S&P 500 had fallen 25% and the Dow Jones by the now-famous 22.6%, its largest single-day decline in his history
Subsequently, a misperception arose when David S. Ruder, Chairman of the SEC, hinted at the need for the NYSE to temporarily halt trading. This exacerbated the panic and selling pressure, causing confusion and distress over such an extreme event. According to the SEC, many market makers attempted to defend their positions, but even they were unable to escape.
On Tuesday, the 20th, the Fed announced its support for ensuring sufficient liquidity in the market (see Chart 4). Both the S&P 500 and the Dow Jones experienced better days, however, confusion persisted. The delay in some clearinghouse settlements at the CME fueled rumors of potential insolvency due to market participants unable to meet margin calls, which was cited as one of the reasons for the Fed's intervention to provide liquidity. By midday, the CME and CBOE suspended operations due to the prospect of the NYSE doing so and leaving them without information. The pause eased the downward pressure in the derivatives market, supporting the recovery. Moreover, large corporations began supporting their own stocks through buyback operations.
As we have seen, and according to Carlson, three key factors were at play: a lack of liquidity due to margin calls, the interruption of trading flow (on Monday morning), and the forced mass selling by semi-automated trading programs and algorithms. All of this, combined with the pessimistic news from the previous week, unleashed the animal spirits (Keynes dixit) in the market. Let's not forget the spooky moments in market history. While October might not have a quadruple witching day, the trouble began on it's third Friday. Happy Halloween everyone!
Main resourse
Mark, Carlson. (2007). A Brief History of the 1987 Stock Market Crash with a Discussion of the Federal Reserve Response. Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs. Federal Reserve Board, Washington, D.C. Available in: https://www.federalreserve.gov/Pubs/feds/2007/200713/200713pap.pdf
See also:
The anatomy of a crash: What the market upheavals of 1987 say about today. Available in:
No One Wants to Remember 1987. Then There’s 1916 (Bloomberg). Available in:
Brady, Nicholas F, et al. (1988) Report of The Presidential Task force on Market Mechanisms. US Department of Treasury. Available in:: https://www.sechistorical.org/collection/papers/1980/1988_0101_BradyReport.pdf
Video
Black Monday crash - 30 years on https://www.youtube.com/watch?v=O66rwnH9YZY&ab_channel=FinancialTimes
The 1987 stock market crash: Original news report https://www.youtube.com/watch?v=0_8YEglCFdU&ab_channel=PIX11News
