Can It Happen Again?
Twenty years and some 12,000 points later, the stock market is at a record high, volatility is relatively low and Wall Street is marking the crash of October 1987 with a dose of nostalgia and … perhaps some dread?
After all, just two months ago, with credit market problems in full bloom and the 2007 rally wilting, plenty of people were asking – “Was a market crash of the proportions of the October 1987 one possible?”
Pretty much regardless of whom you ask – economic historians, statistical theorists, Wall Street veterans, behavioral economists, politicians – the answer is: Yes, Black Monday can happen again.
That answer, however, is not as black and white as it may seem.
“I don’t see why not,” says William Silber of NYU’s Stern School of Business, taking a largely empirical view. “This is a low probability event. You need a lot of time for a low probability event to occur.”
Statistics bear that out. The most the market has fallen on any given day since the crash of ’87 is about 7 percent, and that includes the day the market opened following the Sept. 11 terror attacks.
Some market historians and academics now think that in retrospect the crash day itself was something of a non-event, a historical footnote or sorts, because it led to neither a recession nor a bear market. Indeed, people and firms lost lots of money but many of the same ones made much money thereafter.
“People laugh when I say this but it’s not a big deal,” quips Eugene Fama of the University of Chicago’s Graduate School of Business. “In the Great Depression, it was followed by further declines. This one didn’t last long.”
Then And Now
Much about the market has changed today from an explosion in trading volume and the number of investment products to the abundance and speed of information to the communication between exchanges and governments.
Take daily trading volume, for example. In 1987, volume rarely broke 200 million during the heady days of the record-breaking rally before the crash and it wasn’t that common after the crash. Daily trading volume topped the 600 million-level on only two days, Oct. 19-20 and surpassed 400,000 shares on one other day, Oct. 21. By contrast, trading volume passed the daily 5 billion-mark in June 2007
Robert Stovall, a managing director for Wood Asset Management who started at E.F. Hutton in 1953 and whose father worked on Wall Street during the 1929 crash, ticks off a list of differences in the markets and investing.
“We’re not as American-centric as we were then,“ says Stovall of the 1987 period. “There are more players, more markets, more liquidity, a lot more instruments, more diversification, more cushioning.”
For those reasons and others, Stovall says we’re “probably not” going to see another crash like the one 20 years ago.
Former IMF chief economist Michael Mussa agrees a crash “is less likely “ now then it was 20 years ago. “The authorities are more closely tuned in to what’s going on in the market,” he says.
Mussa, who was in his office at the President's Council of Economic Advisors at that time in 1987, adds that the world of information has changed dramatically. “An ordinary individual with a BlackBerry today has better sources of information than what the U.S. government had at that time,“ he jokes.
As for the so-called NYSE circuit breakers, the trading curbs and halts installed in the wake of the 1987 crash, there are few believers or fans. Various people called them detrimental, innocuous or self-serving.
It’s worth noting though that under the current New York Stock Exchange guidelines, for instance, that it would take a 4,050-point, or 30 percent, decline in the Dowat any point in time to shut down the market. And only after 2:30 p.m. woulda 2,700-point, or 20 percent, drop prompt a premature close. A 10 percent decline doesn’t even merit one, merely a 30-minute or one-hour halt.
Fama, who is known as the father of the efficient market theory – that prices fully reflect availabe information-- takes something of a Devil’s advocate position, implying that trading halts might not be welcome in all quarters of the investing community.
“Given the way hedge funds operate today, I would be interested if there a big market event and it was cut off in mid-stream. What would people do.”
Fed -- First And Foremost
The biggest factor in the equation is the Federal Reserve, from what may be an evolution in its proper role in the markets to changes in investors' perceptions even expectations of the central bank.
Goldman Sachs International Vice Chairman Robert Hormats is among those quick to cite the Fed card.
“The role of the central bank is to create a bottom when there is none,” explains Hormats, who appeared on network news shows at the time of the crash to comment on what happened. “It [the market] will adjust without the Fed but the pain would be so enormous no one would want it to happen.”
Hormats rejects the hotly debated notion of the Fed and moral hazard – do investors lack the incentive to guard against risk if they are essentially protected against by the likelihood of a central bank action such as a rate cut or bailout.
“The notion that the market is being bailed out is wrong,” he says. “Does it lead to moral hazard? I don’t think so. It’s the cost of having a sophisticated economy. “
The Fed played a critical, if not decisive role, in damage control in 1987. Then-Chairman Alan Greenspan earned widespread praise for his handling of the event and will be remembered for his “The Fed-stands-willing” statement on the morning after Oct. 19.
Silber off NYU says it was Oct. 20, the day after the crash -- when the payments system “almost broke down” because of the huge liquidity problem caused by the crash – that merits a place in history because the Federal Reserve saved the day by pumping billions of dollars into the banking system.
Nevertheless, Silber – whose latest book, When Washington Shut Down Wall Street: The Great Financial Crisis of 1914 and the Origins of America's Monetary Supremacy, deals with government intervention and financial crises – worries that the risk tolerance of today is worrisome.
“We've gotten dangerously close to a sense of real comfort that the Fed would bail us out,” he says.
Herd On The Street
One thing that probably hasn’t changed much in the past 20 years is the psychology of investing.
Professor Robert Shiller of Yale University, a leader in behavioral finance and author of the 2001 cautionary tale on investing, Irrational Exuberance, is among those who are worried.
“It is possible we’re coming up on a very bad period,” says Shiller, who surveyed hundred of people after the crash in an effort to determine whether the event was based on fundamentals or psychology. (LINK)
While not anticipating a full out crash, Wall Street veteran Stovall says he’s become “somewhat fearful”, citing the real estate crunch of the summer and the February market slump triggered by events in China. “I now have a lot in cash.”
Vanguard founder and mutual fund trailblazer John Bogle has been nervous about a significant market event for the past couple months. His asset allocation has been 60 percent stocks-40 percent bonds since the late 1990s.
“I look at the market being a little bit more friendly then,” says Bogle of the 1987 period. “We’ve moved from investment to speculation. The stock market is a giant distraction. Why get all exercised about it if you’re a long-term investor.”
That advice would have served just about anyone very well 20 years ago.