Could the 1987 Crash Happen Again?

As the 20th anniversary of the October 19, 1987, stock-market crash nears, fear dogs the stock market as closely as ever. You got a whiff of this in July and August. Twitchy traders, reacting to mortgage defaults and losses in several hedge funds, ignored what some commentators had called the strongest global economy ever.

Instead, the pessimists obsessed over the effects of the U.S. housing downturn and the tightening of mortgage credit, as if home construction was the primary catalyst for the world's economic growth. It took a stiff shot of pain-killer from the Federal Reserve Board to arrest the sellers' panic after eight weeks.

But no investment professionals I've spoken with lately think a 1987-style implosion is possible in 2007, with or without a merciful easing of monetary conditions by the Fed.

Subscribe to Kiplinger’s Personal Finance

Be a smarter, better informed investor.

Save up to 74%

Sign up for Kiplinger’s Free E-Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

Banks are still liquid, if not as accommodating to lend as they had been before the past summer's mini-crisis. "The money didn't disappear," says Steve Wood, a strategist for the Russell Investment Group. "The credit crunch was a case of lenders not wanting to lend, not of lenders running out of money." That would really slaughter the economy. Instead, it's still growing, albeit slowly.

The mood over the summer was dark, nonetheless. The Dow Jones industrial average, Standard & Poor's 500-stock index and the Nasdaq Composite index were three more bad sessions from matching the extent of the losses in the first few trading days after the 9/11 terrorist attacks.

And yet, scary as that seems, the gap between 1987's crash and the market's experiences in 2001 and 2007 is enormous. If you've forgotten the details, here they are.

From October 14 through October 19, 1987, the Dow industrials lost 31%. The 23% decline on October 19 was the biggest one-day drop ever. Let that sink in. That's virtually a one-third decline in the market value of 30 of the world's most prominent businesses -- in less than a week. From peak to trough, this summer's decline amounted to just 12% -- and that took 26 days.

The 1987 crash remains in a class by itself. In Why Stock Markets Crash, a 2003 book by UCLA professor Didier Sornette, the author terms the 1987 disaster an "outlier," meaning it was statistically disassociated from normally predictable events.

Of the 20th century's 12 worst other draw-downs (defined as stretches of losses lasting a few days to two weeks), only two happened after 1933, and those cost 12% and 13%. Moving to the 21st century, the S&P 500 lost 12% in the days after 9/11 and the Dow industrials 14%.

Tellingly, Sornette writes, the 1987 crash did not result directly from anything that would cause negative analysts, traders and speculators to look for blood today. The biggest concern back then was an overvalued market, one that was made more so by rising interest rates.

By August 25, the Dow had already climbed 42% that year. Meanwhile, yields on 30-year Treasury bonds, which started 1987 at about 7.5%, were approaching 9% at the Dow's peak on their way to 10%-plus by the time of the crash. With the S&P 500 trading at 22 time trailing earnings at the peak, it certainly seemed that the market was due for a setback, if not cruisin' for a bruisin'. But absolutely nobody had any reason to think that a crash was coming.

Accidents happen. The evidence instead points to a trading accident made on Wall Street. Numerous books and studies, from the government's official report on the 1987 plunge to the 2007 book A Demon of our Own Design, by former Wall Street derivatives designer Richard Bookstaber, agree. They cite technical factors, particularly faulty program-trading strategies that spiraled out of control and overwhelmed the primitive trading system with sell orders.

The market, still in the paper-and-pencil era, failed to match sellers with buyers at any price, so final prices on October 19 were guesswork. The New York Stock Exchange processed 600 million shares that day, a record at the time but a holiday compared with today's volumes. Because the exchange's capacity was limited, tens of thousands of investors who tried to sell, or bravely wanted to buy, couldn't act because they couldn't reach their brokers by phone or because, when they did, the brokers failed to get orders into the system.

It took a few weeks for any sense of normality to return. Eventually, however, a sense of normality did return and, by year's end, stocks were 12% higher than they were on the day of the crash.

The market's reaction to 9/11 might have been just as awful or worse. After 14 years, the public had a much larger stake in stocks -- almost $3 trillion in IRAs, for one thing, seven times the total of 1987. The 1990s were mostly a party for stock investors, so everyone had a lot more to lose. And in 2001, you could trade online without calling a live broker, never mind having to wait for a specialist's runner to carry order slips around the floor of the New York Stock Exchange. And the markets' shutdown for six days after 9/11 gave investors plenty of time to think about whether they wanted to sell their stocks or stock-owning mutual funds.

Instead, the same reassuring pattern as in 1987 unfolded. Cooler heads concluded that terrorists can't determine the value of real businesses any more than hapless futures traders could in 1987.

The Dow, which had sunk from a close of 9,606 on September 10 to as low as 7,927 on September 21, re-crossed 10,000 by early December, before resuming the bear-market decline that had begun in March 2000. But except for 9/11's impact on travel-related companies, it's probably wrong to link the extension of the bear market to the attacks. The technology bust hit way harder.

Inevitable, or not? So if terrorists and quick-on-the-trigger traders can cause, at worst, a brief panic, doesn't that tell you that market crashes are random events? And if they are, doesn't that suggest that another crash, like any other force of nature, is inevitable?

Larry Swedroe, a St. Louis financial adviser and the author of several investing books, including Rational Investing in Irrational Times, is convinced the next crash could happen without warning. But he's not a perma-bear who natters on about gold or the state of the dollar.

Rather, he thinks the cause would be a financial accident caused by a greedy attempt to game the system, this time using heavy leverage. "The same stupidity we saw in 1987 was repeated this year with hedge funds," he says. "Unlimited liquidity is an illusion."

Swedroe, however, doesn't suggest that you should act as if your IRA will vaporize at any given moment. "You can be too conservative," he says. He adds that even if you are retired and believe you have enough savings to generate adequate interest income without exposure to stocks, you should have 30% in equities to offset the risk of high inflation and the chance that you might run out of money if you live to 90, 100 or longer.

Randy Frederick, Charles Schwab's director of derivatives, expects stock-market volatility to remain high for some time to come. Stocks were unusually calm in the five years before the past summer's unpleasantness.

One reason to expect more volatility, Frederick says, is that financial stocks now account for 25% of the S&P 500 -- they were 5% in 1987 and 15% in 2001 -- and financials feel the heat or turn it up when Wall Street gets edgy about bad debt or the availability of credit. So big banks and financial companies' shares become highly unstable, which affects the S&P 500 and other broad averages all the more.

Frederick cites Bear Stearns as an example. Bear gets some of the blame for this summer's troubles because it ran a couple of hedge funds that went bust because of bad mortgage investments. The daily trading volume in Bear Stearns is several times what it had been most of the past few years, and the stock (symbol BSC) has had some big daily movements. "One day they're taking a hit, the next day there's talk the Chinese will buy them and bail them out," Frederick says.

There's evidence that many traders and speculators react more dramatically when financial firms struggle than when a big airline or drug company or even General Motors gets sick. In the grand scheme of things, Pfizer is more important to the economy than Bear Stearns. But the recent bull market survived prolonged profit problems at Pfizer with ease. If a Bear Stearns or other prominent investment bank went down, a frightening bout of panic selling would likely occur.

Still, Fredericks says, the chance of another 23% fall in one day is nonexistent because of the improved infrastructure. Schwab, for example, "could handle three to four times the normal volume on any day with no hiccups at all," he promises.

This is true of the Nasdaq and NYSE, too. They've spent billions on capacity. So the settlement of trades and the pricing of stocks in a crash would be more accurate, and buyers would presumably be able to swoop in sooner to stabilize the market. The Internet lets you shoot first and aim later with instant trades, but it also provides better information than the hodgepodge of radio bulletins that provided updates on the 1987 crash.

Also, if stocks start dropping uncontrollably some morning, perhaps because something strange happened in China overnight, trading curbs and circuit breakers would slow things down by interrupting trading of certain stocks or even shutting down the market for an hour or two.

There were no such gates in 1987. While their deployment might not provide anything more than a time-out during a rout, they would provide a chance for investors to get their bearings and for the smart money to judge if the selling were overdone, as it often is on really bad days.

And that's the best way to handle the inevitable wreck, says Wood, the Russell strategist. "When times get rocky, like they did this summer, that's when discipline pays for itself." Fear will always be part of investing. There are no rewards without risks. But if you look for trouble all the time, you'll end up costing yourself in the long run.