What caused the 1987 stock market crash and lessons for the 2008 crash

Abstract

Purpose À The purpose of this paper is to review an explanation for the causes of the stock market crash in 1987, update the empirical support for that argument, and compare to recent market developments. Design/methodology/approach À While the market crash on October 19, 1987 was the largest one-day S&P 500 drop in percentage terms in history (20.47 percent) there was also a large market drop (10.12 percent) in the three trading days before the 1987 crash. Previous research has shown show that the three-day decline was the largest in more than 40 years, large enough that the drop was news itself (the October 16, 1987 drop immediately before the crash was also an extremely large oneday decline). The theoretical model of Jacklin et al. show how a surprise significant drop in the market could have provided information to the market that could directly lead to an immediate crash. Findings À The paper follows the stock market for 20 years after 1987, and finds the magnitude of the market decline immediately preceding October 19, 1987 was still a significant outlier À only one three-day period in the 20 years after 1987 had as large a market decline. The paper documents the large market movements and volatility in the period beginning in fall 2008 and suggests that this ''crash'' is different than what occurred in 1987.Research limitations/implications À This paper's main limitations lie in the implications drawn about the causes of the 2008 crash. Practical implications À This paper provides evidence on the causes of the 1987 crash and implications for the 2008 decline. The 1987 crash was due in part to characteristics news but also to the market and trading strategy, the 2008 ''crash'' is more likely a response to fundamental economic news. Originality/value À This paper uses empirical evidence since 1987 to look back on the causes of the 1987 crash. Keywords Stock markets, Stock prices, Take-overs, Regulation, Financial modelling, United States of America Paper type Research paper The cover story from the Newsweek (1987) issue that was released the weekend directly before the October 19, 1987 crash was titled ''Is the party over?'' The second paragraph of the article starts, ''The cascading Dow and record trading volume marked a major shift in psychology and sent a powerful shiver across the country'' (Dentzer, et al., 1987).

The Tale of Two Financial Crises: An Entropic Perspective

“…In the 1987 crash, a sudden news shock occurred three days prior to 19 October and it resulted in a 10% decline in the S&P 500 index [19]. This behaviourally affected the traders to panic and revalue stocks down by more than 20% in one day, while generating an unprecedented trading volume and price volatility.…”