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Review of Accounting and Finance The 1987 market crash: 20 years later Guest Editors: G. Glenn Baigent and Vincent G. Massaro Volume 8 Number 2 2009 ISSN 1475-7702 www.emeraldinsight.com raf cover (i).qxd 12/05/2009 08:47 Page 1 Access this journal online _______________________________ 119 Editorial advisory board _________________________________ 120 Introduction: the 1987 market crash: 20 years later _____________________________________ 121 What caused the 1987 stock market crash and lessons for the 2008 crash Ryan McKeon and Jeffry Netter____________________________________ 123 Has the 1987 crash changed the psyche of the stock market? The evidence from initial public offerings James Ang and Carol Boyer_______________________________________ 138 Capital market developments in the post-October 1987 period: a Canadian perspective Laurence Booth and Sean Cleary___________________________________ 155 Review of Accounting and Finance The 1987 market crash: 20 years later Guest Editors G. Glenn Baigent and Vincent G. Massaro ISSN 1475-7702 Volume 8 Number 2 2009 CONTENTS The current and past volumes of this journal are available at: www.emeraldinsight.com/1475-7702.htm Find more articles from this journal and search through Emerald’s 200+ journals at: www.emeraldinsight.com See page following contents for full details of what your access includes Access this journal electronically This journal is a member of and subscribes to the principles of the Committee on Publication Ethics Revisiting derivative securities and the 1987 market crash: lessons for 2009 G. Glenn Baigent and Vincent G. Massaro ___________________________ 176 Fraudulent financial reporting, corporate governance and ethics: 1987-2007 Lawrence P. Kalbers _____________________________________________ 187 CONTENTS continued As a subscriber to this journal, you can benefit from instant, electronic access to this title via Emerald Management Xtra. Your access includes a variety of features that increase the value of your journal subscription. How to access this journal electronically To benefit from electronic access to this journal, please contact support@emeraldinsight.com A set of login details will then be provided to you. Should you wish to access via IP, please provide these details in your e-mail. 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To that goal, academics argue that capital markets should provide for price discovery and liquidity, where the best way to find out what an asset is worth is to attempt to sell it. As long as there are a large number of market participants, bidding among them leads to price discovery, and an asset is sold quickly resulting in liquidity. Moreover, in a well functioning market the price should be close to its intrinsic va lue. Bu t academic assumptions aside, is it not the case t hat i nstitutional and private investors have the same expectations of our secondary markets? For both institutional and private investors, capital markets are the domicile of our wealth. Capital markets reflect the performance of individual firms and the investment choices they make on behalf of shareholders. Markets reflect the value of retirement accounts such as 401 ks, 403 bs, or RRSPs in Canada. On a macro scale, capital markets are an indicator of the ex pectations of future earnings. The well-being of capital markets is of critical importance to all, even the US Treasury Department and Social Security. Having turned the generational clock in 2007, it seemed appropriate to revisit the events of 1987. The literature seemed to be mixed as to the cause of the 1987 crash, new streams of literature such as behavi oral finance have evolved, and many structural changes have occurred. Ironically, while all of the article reviews for this issue were in progress, the factors which cause market crashes or corrections became more important because we were witnessing a capital markets crisis in 2008. In most cases the authors had the difficulty of drawing their analyses to a close because each day there was more to add to the literature . But here we are, and we must conclude. There is a confl uence to the articles in this edition – each in some way speaks to the issue of efficient capital markets. McKeon and Netter have provided an extension to earlier work by Mitchell and Netter (1989). The current research reinforces the view (espoused in the 1989 paper) that relevant news caused the market crash in 1987, but they find that significant changes in market movements and volatility are associated with the market correction in 2008. The ‘‘something is different now’’ theme is continued by Booth and Cleary. They report that significant structural changes have occurred in the Canadian economy since 1987. Their analysis documents macroeconomic changes and speaks to the impact of fiscal policy and monetary policy on the resilience of the Canadian economy, which they describe as more resilient today than in 1987. Ang and Boyer examine an issue that was critical in 1987 – IPOs. They show that the 1987 market crash changed the psyche of the IPO market as evidenced by fewer IPOs from riskier firms. Following the crash, they find more rational pricin g in the context of smaller discounts and smaller mean reversion. Clearly, this speaks to a behavioral component in asset prices. Let’s hope that the current crisis leads to more rational pricing. The behavior of investors is continued by Baigent and Massaro who suggest that the existence of portfolio insurance can create more aggressive trading and a moral RAF 8,2 122 hazard problem. Lending relevance to the 2008 crisis, the notional value of derivative securities has increased from $1T in 1987 to $542T, about 37 times the GDP of the USA The findings suggest that researchers re-examine the role of derivative securities, especially since there seems to be a symbiotic relationship between derivative and asset prices instead of one being causal. Lastly, there have been significant regulatory changes in the capital markets since 1987 as documented by Kalbers. To the point, regulatio ns are intended to provide for more accurate accounting informati on, but Kalbers opines that regulation occurs after the damage has occurred. In the mid 1960s Eugene Fama formulated the efficient market hypothesis in which markets reflect all relevant information. The problem seems to be the information, not the markets. G. Glenn Baigent and Vincent G. Massaro Guest Editors What caused the 1987 stock market crash 123 Review of Accounting and Finance Vol. 8 No. 2, 2009 pp. 123-137 # Emerald Group Publishing Limited 1475-7702 DOI 10.1108/14757700910959475 What caused the 1987 stock market crash and lessons for the 2008 crash Ryan McKeon School of Business Administration, University of San Diego, San Diego, California, USA, and Jeffry Netter Terry College of Business, University of Georgia, Athens, Georgia, USA 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 one- day decline). The theoretical model of Jacklin et al. show how a surprise significant drop in the market could have provided infor mation 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 dec line. 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). 1. Introduction On Monday October 19, 1987, the US equity market suffered its largest single-day percentage decline in history. The S&P 500 index fell by 57.86 points, a decline of 20.46 The current issue and full text archive of this journal is available at www.emeraldinsight.com/1475-7702.htm The authors would like to thank Glenn Baigent, Annette Poulsen, Janis Zaima, and a referee for helpful comments and suggestions on the paper. RAF 8,2 124 percent. The Dow Jones Industrial average suffered a similar decline, falling by 508 points, 22.6 percen t of its value. The NASDAQ fell by 46 points, 11.35 percent of its value (although many of the dealers stopped trading early, limiting the reported decline). An important, but often forgotten, factor in this decline was the 10.12 percent decline in the S&P 500 in the three trading days prior to October 19[1]. Mitchell and Netter (1989) argue that this three-day decline was an important contributing factor to the crash À in fact, they describe the decline as a ‘‘trigger’’. In this paper, we review this argument, provide simple descriptive evidence supporting the argument and suggest how October 1987 is different from the market decline in late 2008. We report data that the drop in the stock market immediately preceding the October 19, 1987 crash that others have shown was very large in historical terms remains one of the largest declines over the next 20 years. Additionally, we document the unprecedented level of volatility since August 2008 and show how it is different from 1987. The October 19, 2007 market crash of mo re than 20 percent did not seem to be related to any fundamental news. However, Mitc hell and Netter (1989) argue that the three-day decline preceding the crash was a large enough dec line that it became the fundamental news and that shook the market. The theoretical model of Jacklin et al. (1992) (among others) shows how a surprise significant drop in the market could have provided information to the market that would directly lead to a crash. In this paper, we present evidence that even 20 years later, the magnitude of the market decline immediately preceding the 1987 is still a significant outlier À only one three-day period in the 20 years after 1987 had as large a market drop. Jacklin et al.’s model suggests that the sharp market decline preceding the 1987 crash revealed the effects of new investment strategies by investors that had not been fully anticipated by the market (they build on Grossman’s (1988) model of the effects of imperfect information about por tfolio insurance). This revelation to investors of the extent of dynamic hedging caused investors to dramatically revise downward their stock valuations. Other explanations of the 1987 crash include liquidity problems (the Presidential Task Force on Market Mechanisms (1988) À The Brady Report) in trading when volume increased tremendously (perhaps as the result of portfolio insurance trading), or changed investor psychology or some com bination of all the theories. However, each of the theories is consistent with the effects of a large downward market movement directly preceding the crash that was significant and unexpected, triggering the October 19 crash. The paper proceeds as follows. In section 2, we examine possible reasons for the 1987 crash, providing a general discussion on what causes large market movements, and reviewing the Mitchell and Netter work on the 1987 crash. In section 3, we examin e trading volume and market volatility since the 1987 crash, including the extraordinary market events of the fall of 2008. We conclude in section 4. 2. Explanations for the October 1987 crash There are at least three general views of the causes of the stock market crash on October 19, 1987. The views are not mutually exclusive. One is the efficient market story À the market reacted to some fundamental news that led market participants to revalue stocks down by more than 20 percent in one day. A second is a liquidity story À for some reason, probably a large number of sell orders, liquidity declined significantly, de pressing prices. A third is some variant of a behavioral finance story À investor s acting irrationally either drive prices up too high, followed by a significant fall, or panic and sell for some reason, significantly depressing prices. What caused the 1987 stock market crash 125 2.1. Explanations of large market-wide stock-price movements Cutler et al. (1989) analyze the question of what fundamentally causes lar ge s tock price movements in a paper that followed s oon after the 1987 crash. Their general conclusion is that we are not very good at explaining large stock price movements, questioning the ‘‘ efficiency’’ of the mar ket. They first consider the impact of macroeconomic news on the stock market. The paper examines the relation of macroeconomic fundamentals as dividend payments, industrial pr oduction, r eal money supply, long and short-term interest rates, inflation and stock market volatility. They conclude that these macroeconomic varia bles are not statistically meaningful in explaining stock market returns. Cutler et al. also conduct a less formal analysis of the impact of ‘‘big news’’ on the stock market. Using the World Almanac as a source of significant news stories, the paper narrows its selection of ‘‘big news’’ to those stories which were featured on the front page of the New York Times or were the lead story in the business section of the paper. Few if any of the stock market returns on these days are comparable to the returns seen in October 1987. The paper then reverses the analysis, examining the largest single-day movements of the S&P 500 index and examining the New York Times for an explanation of the event. The explanation they find for the October 19, 1987 crash is ‘‘Worry over dollar decline and trade deficit; Fear of US not supporting the dollar’’. Cutler et al. conclude that it is difficult to explain large price movements even after the fact. An interpretation of their results is that if one cannot explain market movements after the fact, when news has been revealed, and markets do not move much in response to large news stories, it is difficult to argue that fundamentals drive markets, at least in the time of extreme movements. Haugen et al. (1991) perform a similar analysis, but focus on stock market volatility rather than returns. The authors document the largest single day shifts in stock market volatility and search for contributing explanations. When the authors are able to match large increases in volatility with a well-documented event, the event tends to be an act of warfare, a natural disaster or an assassination. The paper also notes that large decreases in volatility can generally be matched to political enactments or proclamations. This latter finding suggests a possible role for regulatory entities in ‘‘calming’’ markets during volatile times. 2.2. The cause of the market decline October 14-16, 1987 Mitchell and Netter (1989) provide a case study of one market movement in contrast to the more general but less detailed analysis of Cutler et al. Mitchell and Netter provide both cross-sectional and time series evidence supporting their hypothesis that the very large October 14-16, 1987 market decline was due to an unexpected proposal in the House Ways and Means Committee to end the tax deductibility of debt used in takeovers. Noting that the October 14-16, 1987 period represented the largest one-, two- and three-day declines (–5.16, À8.11 and À10.44 p ercent, respectively) since the French army’s defensive position was unexpectedly com promised in May 1941, in WW II, the paper examines the possible causes of this decline. The paper concludes that the market reacted negatively to news that a bill ending the interest deductibility of debt in takeovers was unexpectedly proposed by the US House Ways and Means Committee and was likely to pass. Therefore, it was the prospect of this bill being signed into law that may have caused the market decline of October 14-16, 1987, which then led to the subsequent more drastic decline on Monday October 19. On the night of October 13, 1987 the House Ways and Means Committee introduced a tax bill that had several provisions designed to restrict takeovers, especially ending [...]... of the increase, 45 Year 1 982 1 983 1 984 1 985 1 986 1 987 Before crash 1 987 Post crash 1 988 1 989 1990 1991 1992 Average 1 982 to 10 October 1 987 Average 20 October 1 987 to 1992 t-test Gross spread as % price Reallowance fee as % of principal Underwriting Fee as % of principal Overallot amt sold as % of amount 8. 72 8. 16 8. 59 8. 29 7. 98 8.02 8. 47 7.91 8. 10 7.77 7.40 7.24 8. 29 7 .81 0 .84 2.30 1.74 1 .87 1. 68. .. psyche of the stock market 139 RAF 8, 2 140 Table I Aggregate IPOs in number of issues and the sum and average principal amount Year 1 982 1 983 1 984 1 985 1 986 1 987 1 988 1 989 1990 1991 1992 1 January 1 987 to 19 October 1 987 19 October 1 987 to 31 December 1 987 Number of IPOs 1 18 673 343 322 7 08 531 2 68 240 207 387 561 5 08 22 Principal amount Sum of all Average of markets ($ mil) all mkts ($ mil) 1,215 .8 12,071.7... October 1 987 to 1992 t-test Offer price $10. 68 $20.75 $8. 91 $10.77 $11.02 $10.75 $8. 33 $10. 28 $12.15 $11.04 $11.93 $12 .83 $12.15 $11.09 1.53 Issue priced relative to filing range Above (%) Within (%) Below (%) 13.27 11. 08 1.17 4.67 3.12 4.76 0.00 2.72 5. 58 8.00 8. 81 8. 39 6.35 4.03 2.17* 60. 18 66.77 69.01 79.13 82 .15 77. 58 95.45 82 .88 89 .27 82 .50 81 .61 78. 57 72.47 84 .97 1. 68* 26.55 22.15 29 .82 16.20... 1-October- 98 19-September-02 August, 120 08- November 30, 20 08 15-October- 08 29-September- 08 9-October- 08 20-November- 08 19-November- 08 22-October- 08 7-October- 08 5-November- 08 12-November- 08 6-November- 08 17-September- 08 15-September- 08 14-November- 08 2-October- 08 6-October- 08 22-September- 08 24-October- 08 Volume One-day return (%) 693,729, 984 917,500,032 197,300,000 251,170,000 1,279,699,9 68 2,330 ,83 0, 080 ... 27-October-97 À6 .87 8- January -88 À6.77 28- May-62 À6. 68 26-September-55 À6.62 13-October -89 À6.12 14-April-00 À5 .83 26-June-50 À5. 38 16-October -87 À5.16 17-September-01 À4.92 11-September -86 À4 .81 14-April -88 À4.36 12-March-01 À4.32 30-November -87 À4. 18 3-September-02 À4.15 August 1, 20 08- November 30, 20 08 15-October- 08 À9.04 29-September- 08 8. 79 9-October- 08 À7.62 31-August- 98 À6 .80 20-November- 08 À6.71 19-November- 08. .. 2,330 ,83 0, 080 211 ,81 0,000 1,2 28, 999,936 1, 289 ,799,936 9 38, 600,000 2,654,099,9 68 1,009,000,000 239,690,000 85 2,600,000 1,292,999,936 4,065,230,000 1, 386 ,099,9 68 1,425,500,032 1 ,81 6 ,89 9,9 68 2,2 48, 059,904 1,507,299,9 68 4,315,740,000 1,421,600,000 2,004 ,80 0,000 4,771,660,000 546,550,016 80 0,099,9 68 1,042,300,032 240,400,000 89 9,699,9 68 1,524,000,000 À6 .86 57 À6 .80 14 À6.7 683 À6.1172 À5 .82 78 À4.9216 À4.3560 À4.3 181 À4.1536... 197.2 4 38. 8 106.9 602.7 495.5 491.1 203.9 225.5 235.7 1613 140.9 734.4 141.1 753.7 1 986 22 30 40 33 63 90 78 73 52 81 67 79 460.9 440.2 1119 1447 2612 2 482 1 685 2215 1051 3054 3720 1722 Average 1 982 -1 986 1 987 Seasonally Adjusted 1 987 21 23 29 22 36 41 43 43 31 46 45 53 28 57 55 42 52 69 63 57 59 32 7 9 1.31 2.44 1 .88 1 .89 1.46 1.70 1.47 1.34 1 .88 0.70 0.16 0.17 2 68 309 670 527 86 3 89 5 733 906 5 58 1 289 1132... (1990-1992) t-test pre and post crash Pre1 987 Crash Post crash (1 987 -1 989 ) Post crash (1990-1992) Pre 1 987 crash Post crash (1 987 -1 989 ) Post crash (1990-1992) Pre 1 987 crash Post crash (1 987 -1 989 ) Post Crash (1990-1992) Pre 1 987 crash Post crash (1 987 -1 989 ) Post crash (1990-1992) 197.65 182 .82 122.53 0.0179 18. 60 34.70 26.95 276.61 327.61 469.01 11 .89 6.71 15.55 203.16 61.90 287 .80 3. 38 5.13 4. 38 0.01245 0.90... similarly 6 .88 percent and 5 .80 percent in 1 984 During the period 1 985 -1 987 , the percent of overallotment sold increased to 10.30 percent in 1 985 , 11. 68 percent in 1 986 and 9. 48 percent in 1 987 Within 1 987 prior to the crash, the overallotment sold was 9. 58 percent, but dropped to 6.97 percent after the crash In the years following, the number declines to 8. 66 percent in 1 988 , 7.01 percent in 1 989 and 6.22... fell to $8. 33 after the crash indicating that stock market prices as a whole fell and that the market was not willing to pay high prices for IPOs, however, the offer price is based on the number of shares offered In 1 988 , the average price was at a similar level to 1 987 at Year 1 982 1 983 1 984 1 985 1 986 1 987 Before crash 1 987 Post crash 1 988 1 989 1990 1991 1992 Average 1 982 to 10 October 1 987 Average . 14 and 15 of À1 .82 percent and À1.39 percent, respectively (volume of 3 ,81 4,630,000 and 4,290,930,000). . September 18, 20 08: volume reached 10, 082 , 689 ,600. 693,729, 984 À6 .86 57 31-August- 98 917,500,032 À6 .80 14 8- January -88 197,300,000 À6.7 683 13-October -89 251,170,000 À6.1172 14-April-00 1,279,699,9 68 À5 .82 78 17-September-01