What Caused the 1987 Crash?

So what caused the big crash 30 years ago? The official answer was program trading. But Gary Alexander at Navellier Market Mail says it was political mistakes.

On October 19, 1987, 30 years ago, the stock market fell 22.6% in one day – almost twice the decline of the previous worst day on Wall Street, which was Monday, October 28, 1929 – the now-forgotten Black Monday between Black Thursday (October 24) and Black Tuesday (October 29). What caused this crash?

The answer seems like “settled science.” Investopedia says, “The cause of the stock market crash of 1987 was primarily program trading.” Barron’s (“Computers in Control,” October 16, 2017) says the culprit was “portfolio insurance, a quantitative tool designed to use futures contracts to protect against market losses.” This, they said, creates “a poisonous feedback loop as automated selling begat more of the same.”

I beg to differ. Saying that a market crash is caused by computerized trading is like saying the California wildfire was caused by a localized fire that spread fast. But what sparked the fire and fueled its growth?

Let me offer a longer-term, three-stage explanation – using three “P” words. In chronological order, the core cause of the crash was Prosperity (rapid GDP growth and a huge 50% market surge in the previous year), exacerbated by Politics (a series of bone-headed mistakes, mostly by Congress, a Secretary of State, and a rookie Fed Chairman), and then Panic, when fear stalked the market floor, creating a selling frenzy.

Blaming computers focuses only on the final panic day, paying no attention to what caused the record declines in two of three previous trading days (October 14/16) and what made Monday much worse.

In short, the market crashed in mid-October 1987 because it had risen too far too fast, based on rising prosperity caused by two major tax cuts, the 1981-82 Kemp-Roth tax cuts and a major 1986 tax rate cut.

The first thing to remember about historic panics is that they generally follow parabolic increases during “manic” episodes of over-hyped greed. In the biggest crashes last century, namely 1907, 1929, 1987, and 2000, the market was already too high, but then it shot 50% higher in a year or so. Back in 1985 and 1986, the market was rising to all-time highs almost every month. Then it took off in a hockey-stick rise:

On October 22, 1986, a year before the crash, President Reagan signed the Tax Reform Act of 1986 into law. The top rate was cut dramatically from 50% to 28%, giving us the closest thing to flat taxes we’ve seen in the last century. The Dow Jones index was 1805 on October 21, 1986, but it rose 50.8% in 10 months, to 2722 on August 25, 1987, based in part on the euphoria over those drastic tax rate cuts.

Going back further, the Dow had risen 250% in five years after the first Reagan tax cuts. The GDP was soaring each year in the mid-80s, starting with a huge 7.8% real gain in 1983. After a deep recession in 1981-82, real GDP rose 25 years in a row (1983-2007) with the mid-80s (1983-88) averaging +4.8%.

Political Mistakes – not Economic Fundamentals – Panicked the Market

When the market crashed in 1987, there was no fundamental reason for the crash. There was no recession in sight; earnings were strong, and inflation was under control, but the rapid rise in stock prices had created fears of an exploding bubble. Specifically, there were widespread fears of a recession, slower earnings, and rising inflation, when there was virtually no evidence for any one of those three major fears.

Right before the market peak, on August 11, 1986, economist Alan Greenspan was sworn in as Chairman of the Federal Reserve Board. Within a month, on September 4, Mr. Greenspan made a rookie mistake, firing a pre-emptive strike against relatively tame inflation by raising the Discount Rate 50 basis points. The Dow fell 62 points on that news, while the Prime Rate rose from 8.25% to 9.25% by early October.

Then, another political blunder emerged on Wednesday, October 14, 1987, when a tax bill was introduced in the House Ways and Means Committee that would severely limit tax deductions for interest paid on debt used to finance mergers or hostile takeovers (which had been running rampant throughout 1987).

Bonds had already fallen 13% in the previous six months, but the bond market got hit particularly hard that week. On Friday, Treasury bond rates rose to over 10% and contributed to Friday’s record down day.

On Saturday, U.S. Secretary of the Treasury James Baker III told the Germans to “either inflate your mark, or we’ll devalue our dollar.” Then, Baker went on some of the Sunday morning talk shows to say the U.S. “would not accept” the recent German interest rate increase. An unnamed Treasury official added that we would “drive the dollar down” if necessary. This led European markets to fall on Monday.

In summary, blunders by two political appointees caused the 1987 crash. First, the rookie chairman of the Federal Reserve Board, Alan Greenspan, made it his first order of business to announce his presence by raising the Discount Rate. Then, Secretary of the Treasury James Baker talked tough to the Germans about the dollar, causing global markets to crash. Between Baker’s currency wars, Greenspan’s tight money, a new tax bill that punished businesses, and more threats of protectionist legislation, the problem was too much, not too little, federal government intervention in a fairly smoothly-running economy.

In the morning after the crash, Greenspan tried to undo all the damage he had helped to cause. He cut the Discount Rate to where it was before he took office. As a result, Tuesday, October 20, 1987 set a record for the largest single-day gain (102.27 Dow points) and a 55-year record for daily percentage gain (+6%). Both records were then decimated on Wednesday, October 21, with a 10.1% gain of 186.84 Dow points.

After the crash, Congress reversed itself on their corporate tax grab. They reduced the corporate income tax rate from 40% to 34%, giving business a firmer footing for their financial planning, resulting in stronger earnings growth and net GDP growth the following year. For all of 1987, the Dow actually rose 2.2% and we reached a new all-time high within two years – as if the crash had never happened.

In 1987, Wall Street feared a drying up of corporate profits, but corporate profits soared in 1988 after the corporate tax rate was sliced from 40% to 34%. This can happen again. Applying all these lessons from 1987, we can (1) create a new boom by lowering personal tax rates (while repealing most deductions). We can also (2) avoid a crash by not punishing businesses for their success, and we can (3) revive a slow economy by reducing corporate taxes and regulations, giving businesses more reasons to expand and hire.

Could 1987 happen again? It’s not likely now, but a stock “melt-up” following a major tax reform bill this year or next could push the market up too fast. If the Dow rose to 27,000 or higher in a year, that would be too-far, too-fast, but we’re highly unlikely to see a major crash without seeing manic gains at record highs amidst a new wave of panic-buying and greed. We’re nowhere near those manic levels now.

Posted by on October 17th, 2017 at 1:02 pm


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.