Market Crash of 1987 - Research Paper Example

Market crashes of 1987 and 2000 1987 Market Crash The 1987 market crash was a major systematic shock as not only did the prices of many financial assets tumble but it impaired the market functioning severely. The 1978 market crash began in Hong Kong and extended westward to Europe hitting the United States after many other markets that already declined. This was the largest one day percentage drop in history. In august 25th 1987 the markets hit a new high as at this time the Dow Jones had hit a record of 2722.44 points and then it slanted. On Monday October 19th 1987(black Monday), saw a great stock market crash as the Dow Jones Industrial (DJIA) dropped by 508 points to 1738.74 (22 .61%) of its single day trading percentage decline in history; this was a drop 36.7% from its high on august 25th 1987. The S & P 500 index fell by 57.86 points which was a decline of 20.46% overall. The NASDAQ fell by 46points which was 11.35% of its value (Shiller, 1992). This market crash is a significant event because it showed the weaknesses of the swiftness and sternness of the market decline and the weakness of the trading systems and how they could be strained and bring close the breaking in extreme conditions. Crisis was made worst when the major problems in the trading systems interacted with the prices decline. At the end of October stock markets in Hong Kong 45.5%, the united kingdom it was a fell 26.45%, Australia had a 41.8%, Spain 31%, Canada 22.5% and the new Zealand market was the most hit as it had a fall of 60%from its peak (Shiller, 1992). Causes of the market crash The cause of 1987 market crash is deep-rooted from the futile attempts by the United States and the G7 countries (Japan, United Kingdom, Germany, Italy, Canada and France) in preventing the dollar from falling in the international exchange markets (Siegel, 2008). The some various causes that were believed to have contributed to the 1987 market crash include the illiquidity, market psychology, program trading and overvaluation. This causes all contributed to the 1987 crash but not entirely. Computer trading (program trading) Many analysts blamed the computer trading as the computers were programmed in an automatic state hence they could order large stock trades automatically while certain markets conditions prevailed. The portfolio insurance is believed to have contributed to the crash; the purpose of the portfolio insurance was to protect individual investors from any losses and when used by many investors at the same time it may assist in the fall of prices a systemic event with a feedback loop. The portfolio insurance cannot be blamed entirely to this crash as there were many other non portfolio insurers’ institutions selling stocks and futures. Illiquidity Specialist could not be able to get enough buyers to purchase the large orders of stocks that sellers wanted to get rid of at certain prices. This led to the termination of trading in many listed stocks; this insufficient liquidity had a significant effect on the crash as investors had overestimated its amount. The markets were not able to handle the inequity of sales orders during the crash. On the crash day it was difficult to sell stocks as bids didn’t appear and brokers and refused to answer phones the stocks failed to open till 10:00 morning. During the crash mechanisms and financial markets could not be able to deal with the large flow of orders. This inadequate liquidity is believed to have had an effect on the price drop (Haramis, 1995). Derivative securities This was a major factor that led the crash as stock markets and derivatives markets failed to operate in sync. Some analysts also claimed that the trading program of index futures and derivates securities was also to blame. Overvaluation Individual investors and institutional investors thought and reported that the market was overpriced prior to the decline. A standard market valuation had reached 19 by the time crash up from 10 only two years before, hence a high PE ratio meant that the average price of a U.S. stock had expanded faster than its earnings. Federal Reserve The Federal Reserve took preventive measures by carrying out open market operations however this operation also pushed the federal funds rate down and this was done to provide significant liquidity to relieve the turbulence and tension in the financial market upheaval. Federal Reserve continued injecting reserves in maintain liquidity in financial markets. Federal Reserve also worked with banks and security firms so as to support availability of credit in order to support the liquidity and funding needs off brokers and dealers (Hetzel, 2008). Market crashes of 2000 The 2000 market crash is remembered as the year of the crash in dotcom stocks. This crash started in January 15th 2000 and ended in October 9th 2002. During this crash a total of 8trillion dollars of wealth was lost. The NASDAQ traded at 4234.33 from September 2000 to January 2, 2001 then dropped at 45.9% (Hirsch and Lounsbury, 2010). This drop was slow as 1,108.49 which was a 78.4% decline from its all time of 5132.52 a level that was established in March 2000. NASDAQ consists of stocks related to new economy that is internet, computer hardware, software and telecoms. The main characteristic of these companies is that their price earnings ratios (P/E’s) and price dividend ratios often came in three digits prior to the market crash (Hirsch and Lounsbury, 2010). Causes of the market crash The causes of the market crash include; overvalued stocks, conflicts of interest between research firm analysts and investment bankers, corporate corruption and daytraders and momentum investors. Daytraders and momentum investors This was considered as a new, quick and inexpensive way to trade markets as it enabled online trading. This revolution led to millions of new investors and traders who had little or no experience at all entering the markets. Overvalued stocks Companies were making significant operating losses with no hopes of getting profits and still sporting a market capitalization of over a billion dollars. Corporate corruption Companies used loopholes to hide their debts despite fraudulently inflating their profits. The corporate benefited from the outrageous stock options that diluted company stock. Conflict of interest between research firm analysts and investment bankers Banks were issuing favorable ratings on stocks for clients whose companies sought the raise of capital. Some companies received highly favorable ratings despite being in a serious financial trouble. Federal Reserve During this crash, the Federal Reserve lowered interest rates to zero so as to make sure there was substantial credit in the economy and that the lending would continue (Hirsch and Lounsbury, 2010). Measurements taken for the 1987 and 2000 market crash In the year 1987 requirements for new margins were introduced to help in reducing the volatility for stocks, index futures and stock options. The stock exchanges adapted the new computer systems that increased data management effectiveness, efficiency, accuracy and productivity. The New York Stock exchange (NYSE) and the Chicago mercantile exchange established a circuit breaker mechanism which was to halt trading on both exchanges should the Dow Jones fall more than 250points in a day and 2 hours should it fall more than 400 points. In the year 2000 after the crash new rules were set and introduced. Investors were supposed to have more or at least $25,000 in their accounts so as to actively trade in the markets (Siegel, 2008). New restrictions were also placed on the daytradings marketing firm. Fraud prosecution was stepped up resulting to higher penalties. Major reforms were introduced to clear and avoid conflicts of interest in the financial services industry. The banking and brokerage research were separated and items like stock options and offshore investments were closed so as to enable investors to judge better if a company is actually profitable. Conclusion Before the 1987 crash there was a large market decline which participated on the crash. This market crash did not only affect the U.S. the world at large. The market crash of 1987 was so big that the market could not handle all of the transactions hence during this crash there were more sellers than buyers. Lack of accountability plagued the corporate culture prior to economic downturn that followed 2000. Both the 1987 and 2000 crashes had almost the same causes of market crash. The 1987 crash exposed the effects of new investment strategies by investors who had not fully anticipated by the market, this caused investors to dramatically revise downward their stock valuations. Traders should trade in orders that they can handle and both the investors and traders should have more information before entering the trading market. Companies found to be covering up loses should be suspended. Banks should not issue favorable ratings on stocks to individuals who are seeking capital rise for their companies and companies which have serious financial problems should not receive highly positive ratings. References Haramis, E. I. (1995). The Stock Market Guide to Profitable Investments. New York: The Stock Market Guide. Hetzel, L. R. (2008). The monetary policy of the Federal Reserve: a history. New York: Cambridge University Press. Hirsch, M. L., Lounsbury, M. (2010). Markets on Trial: The Economic Sociology of the U.S. Financial Crisis:, Part 1. Wagon Lane, Bingley BD16 IWA: Emerald Group Publishing. Shiller, J. R. (1992). Market Volatility. Los Angeles: MIT Press. Siegel, J. J. (2008). Stocks for the long run: the definitive guide to financial market returns and long-term investment strategies. New York: McGraw-Hill professional. Read More