Samuelson: Lessons From The 1987 Crash

The stock-market crash of 1987 was horrifying even to Americans who weren't shareholders. On Oct. 19, the Dow Jones industrial average dropped 508 points, which was 22.6 percent and nearly twice the largest one-day decline during the 1929 crash. A comparable free fall today would be almost 3,200 points. Twenty years later, the crash of 1987 has changed the way we think. It's stripped us of the illusion that financial panics are a thing of the past: they remain a clear and present danger for the economy.

Let's be clear. A financial panic is not just a big price decline. Since World War II, there have been plenty of those. From early 1973 to late 1974, the stock market dropped roughly 50 percent (almost identical to the fall from early 2000 to late 2002). Nor is a panic simply the "popping" of a "bubble," though it might start that way. In a panic, fear takes control. Herd behavior swiftly triumphs. There's a stampede. People want cash—"liquidity," in finance lingo.

Americans thought they had immunized themselves against financial hysteria. Bank runs—depositors wanting their money—were the major form of panic, and Congress had dealt with them. In 1913, it created the Federal Reserve to lend to solvent banks. When that didn't prevent bank runs in the 1930s, Congress added deposit insurance so that a run on one bank would not cause a chain reaction. As for the stock market, the Securities and Exchange Commission, created in 1934, policed for the financial fraud that had often triggered panics. Finally, full-time portfolio managers for "institutional investors" (pensions, mutual funds, insurance companies) and investment houses dominated markets. Better informed, these professionals seemed less susceptible to herd behavior.

On Oct. 19, these comforting beliefs vaporized. General Electric fell from 50 to 41, Procter & Gamble from 84 to 61, IBM from 134 to 103 (all prices rounded to the nearest point). To be sure, stocks had seemed overvalued. Since recent lows in mid-1982, they had roughly tripled. The market's price-to-earnings ratio (P/E) was 22, up from 13 four years earlier. (The P/E is an indicator of stock value. If a company has earnings—profits—of $1 per share and a stock price of $15, its P/E is 15.) Although stocks might go lower, few investors expected a collapse.

What's fascinating is that "20 years later, we don't know much more about the causes of the crash than we did when it happened," writes Matthew Rees in The American magazine. In his recent memoir, former Fed chairman Alan Greenspan takes a similar view. Still, as Rees's retrospective makes clear, three lessons stand out.

First, financial markets change constantly, and, because what's unfamiliar is risky, they create new opportunities for miscalculation and mayhem. The unpleasant surprise in 1987 involved futures markets. Futures contracts (in effect, bets on some future price) on the Standard & Poor's index of 500 stocks were fairly new. As stock prices dropped, some investors sold S&P futures contracts—and their declines drove stock prices down more. The two fed on each other.

Second, financial markets depend on computerized systems to provide prices and complete trades, and their breakdown can compound turmoil. Without accurate prices, many investors freeze or panic. In October 1987, the New York Stock Exchange's order system was overwhelmed. Delays often exceeded an hour.

Third, professional money managers fall prey to greed, fear and crowd behavior as much as amateurs. The SEC's post-crash study found that two thirds of trading came from institutional investors and investment houses.

The crash of 1987 did have a happy ending. Early on Oct. 20, the Fed issued a one-sentence statement reaffirming its "readiness to serve as a source of liquidity to support the economic and financial system." Translation: it eased credit. Gerald Corrigan, head of the New York Fed, privately urged banks to maintain loans to brokers and securities dealers; that helped avert a fire sale of securities supported by credit. Around noon, many big companies—General Motors, Ford, Citicorp—announced buybacks of their stocks. That propped up prices. The panic subsided; the market stabilized. On Oct. 20, the Dow rose 102 points.

Since the 1987 crash, there's been a steady stream of financial upsets—the 1997-98 Asian financial crisis; the failure of the hedge fund Long-Term Capital Management in 1998; the popping of the stock bubble in 2000, and now the "subprime" mortgage debacle. None has turned into a full-fledged panic, and it's tempting to conclude that we've learned how to manage these problems.

Perhaps. But this may be wishful thinking. Global markets are more complex than ever. Financial innovations (again: "subprime" mortgages) constantly surprise, unpleasantly. Dependence on technology has deepened. Herd behavior endures. The real legacy of 1987 is: expect the unexpected.