Black Monday (Term Paper Sample)

CRITICAL ANALYSIS: CAUSES, EFFECTS, AND LESSONS LEARNT, OF THE 1987 BLACK MONDAY
Abstract
In finance, Black Monday may refer to Oct. 19, 1987 when the markets suffered the largest single-day plummet in value globally or Oct. 28, 1929 when Wall Street Crashed on the back of increased speculation on economic boom, development and rural-to-urban migration in the United States (Browning, 2007, p. C1). The focus of this paper is Oct. 19, 1987 which came to be known as Black Monday in the USA and Black Tuesday in the New Zealand and Australia, due to time zone differences, went down in history books as the day in which the Dow Jones Industrial Average (DJIA) saw the largest single-day percentage drop, 22.61%, dropping by 508 points to 1738.74 (Katzenbach, 1987, pp. 1-5).
This crash commenced in Hong Kong from where it spread due west to Europe, and finally hit the United States stock market after other major stock markets had already recorded significant margin drops. By the end of October, major markets in Hong Kong, Australia, the United Kingdom, Spain, New Zealand and the United States had recorded drops of 45.4%, 41.8%, 26.45%, 31%, 60% and 22.68% respectively (Murray, 1987, p. 1). New Zealand was the hardest hit registering a 60% plummet from its 1987 peak (Federal Reserve Bank of New York, 1988, p. 45).
Introduction
This single-day largest market decline is a significant event in finance and market trading not only because of the severity and swiftness with which the markets declined, but also since it exposed the weaknesses in the trading systems. One major problem during this crisis was the collection of information in the rapidly changing environment since the system was unable to simultaneously process the numerous transactions (Presidential Task Force on Market Mechanisms, 1988, p. 2). Several explanations have been put forward explaining the cause of crash, albeit none may be said to have been the main cause. Among these are computer trading, legislation by the House Ways & means Committee, illiquidity, trade and budget deficits, and overvaluation.
Causes
1 Illiquidity of the Market
The ’87 crash ended a five year market Bull Run in which the Dow Jones had risen from 776 points in August 1982 to an all time high of 2,722.42 points in August 1987 (Shiller, 1989, p. 49). To begin with, the crash could not be attributed to any major news event since prior to the crash, there had be no major news events. In the New York Stock Exchange (NYSE), many sellers had listed their stocks for sale but there were few buyers. This led to a backlog of orders and increased speculation on the value of stocks as most sellers had listed higher prices than buyers were willing to offer (Browning, 2007, pp. C1-C2). Consequently, most listed stocks’ selling was terminated.
2 Legislation by the House Ways & Means Committee on October 15
According to a study published in 1989 by Mark Mitchell and Jeffry Netter, economists from the Securities and Exchange Commission, market structures could not have been the cause of the crash, but rather contributed to it. They continue to argue that the main cause of the sudden drop in valuation of stock by investors was legislation by the House Ways & Means Committee on October 15 that scrapped the deductibility of interest on debt used for corporate takeovers. In their report, they state that the markets began reacting to the news of this report almost immediately it began going through congress, with stock prices dropping by more than 10% from October 13, first introduction stage of the legislation, to October 16, when the market broke for the weekend (Mitchell & Jeffry, 1989).
3 Overvaluation
Many market analysts concur that most stocks were overvalued at the time when the market crashed in ’87. In September of that year, Price to Earnings ratio and Price to Dividends ratio were at historically all-time highs. Both of these ratios usually stand at 15 to 1, but in September of ’87 they stood at 20 to1 (Mitchell & Jeffry, 1989, p. 55). Consequently, analysts speculate that they might have been the cause of the crash (Federal Reserve Bank of New York, 1988, p. 5).
Effects of the Black Monday Market Crash
The crash of the markets for that single day led to billions of dollars in losses with Dow Jones Index registering a staggering loss of $500 billion in a single day (Murray, 1987, p. 3). When people got word of the crash, they tried hard to contact their brokers in order to put up their stock on the market for sale. Nonetheless, the telephone jam that was taking place led to increased losses of millions of dollars due to inability to sell the stock. The National Association of Securities Dealers Automated Quotations (NASDAQ) also recorded huge losses which stood at 11.35% by the close of business that day, while the S&P 500 recorded a drop of 58 points translating to 30% of its value (Refer to appendix) (Presidential Task Force on Market Mechanisms, 1988, p. 7).
Prior to recovery of the markets, which took two straight years for the Dow Jones, many people were laid off work. According to an article in the New York Times on October 20th of ’87, business leaders had not expected the crash which wiped out huge values of their companies (Shiller, 1989, p. 50). Though they were optimist of a quick recovery, which took two years for the Dow Jones, what followed was a rise in the unemployment rates with most companies resizing in order to accommodate their reduced value and value.
Lessons Learnt
Perhaps the most significant lesson from this crash on Black Monday is that legislation enacted has a direct bearing on the movement of the markets, and ultimately the direction of the economy. Numerous studies by market analysts have shown that the leading cause of the ’87 market crash was the legislation that passed the House Ways & Means committee on October 13 (Mitchell & Jeffry, 1989, p. 56). The next lesson that could be learnt from the crash was the effect of computer trading on the market. As aforementioned, computer trading triggered a massive number of trades being initiated simultaneously which the system was incapable of processing at once. The effect of untested technologies and techniques on the market could be detrimental (Matthews, 2012).
Finally, the intervention of the Federal Reserve to restore sanity in the markets serves as a critical lesson on combating such market situations. Once the crash occurred, a league of 33 eminent economists across the globe met in New York with the aim of deciding on the way forward (Saunders & Cornett, 2007, p. 25). This team also predicted that the following years would be difficult for the markets across the globe. However, the Federal Reserve moved in to calm and stabilise the markets. Consequently, it is a pointer to the importance of governments and other financial institutions in stabilising markets.
Conclusion
In conclusion, it is clear that Black Monday went down in financial history books as the worst day in the markets with the large...