Could the crash of ’87 happen again?

John W. Schoen Senior Producer • Profile • E-mail

For most of today's investors, the stock market collapse of Oct. 19, 1987, was a defining moment — the biggest financial crisis in memory and a stern reminder about the nature of investment risk.

On that Black Monday 20 years ago, the Dow Jones industrial average dropped a stomach-churning 508 points or 23 percent — the equivalent of 3,200 points for today's high-flying Dow. It was the second-biggest drop ever for the market, eclipsed only by the war-related Panic of 1914.

While the causes are still debated, the biggest question remains: Could it happen again?

For a quick answer, it is instructive to compare the crash of '87 with the credit crunch that swept through financial markets in August, challenging an untested Federeral Reserve Chairman Ben Bernanke much as his predecessor Alan Greenspan was tested two decades ago.

The credit crunch roil financial markets and depressed stock prices briefly, although this year's event played out largely behind closed doors in the murkier waters of the credit market. The crunch of '07 underscored the fact that as long as investment decisions are made by human beings, financial markets will remain vulnerable to future selloffs fueled by runaway emotions. But the stock market today is very different than it was 25 years ago; the odds have been sharply reduced that we will see a a replay of the crash of '87.

Black Monday
While most recollections of the 1987 crash focus on Oct. 19 the slide was well under way when Black Monday rolled around. In fact, the seeds of the crash had been sown years before.

Tales from The Crash   Discuss the lessons of 1987 Could it happen again? Storm clouds gathered before 'Black Monday' Opinion: What we’ve learned

After a decade of economic stagnation in the 1970s sent stocks trading in a sawtooth pattern — and sent many investors fleeing the market — the bulls returned in full force in 1982 after the news sank in that war on inflation finally had been won. With the bulls once again in charge, the market began one of the longest and strongest advances in history, tripling the Dow over the next five years.

The 1980s saw individual investors pour money into the stock market through mutual funds and the rapid expansion of 401(k) retirement plans. By 1989 some 32 percent of U.S. households owned stocks, up from 19 percent just six years earlier, according to the Investment Company Institute.

Institutional investors were also piling into stocks. Private investment firms, relying on research that purported to show that “high yield” debt (aka junk bonds) weren’t as risky as market prices reflected, generated a multibillion-dollar wave of leveraged buyouts paid for with freshly printed paper. All that money had to go somewhere, and much of it ended up pushing stock prices to new highs.

The party began to unravel in the summer of 1987, when the Dow hit an interim high of 2,722 on Aug. 25 and then began to slump. At first, the decline looked like a routine pullback; the Dow began bouncing back a bit in September after an 8 percent decline. To many, it looked like stocks were just taking a breather after years of rapid advance.  But by early October, the downdraft was back — and gaining speed. In the four trading days preceding Black Monday, the Dow dropped 10.4 percent.

Economists and financial analysts have attributed the decline to a number of causes. Worries about inflation and a weakening dollar had pushed interest rates higher, making the safe haven of Treasury bonds more appealing. Congress was debating raising taxes on capital gains from stock investments. Fresh data in mid-October showed the U.S. trade deficit widening. Though most of the data pointed to continued strength in the U.S. economy, some analysts had been warning clients that stocks looked “overvalued.”

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