Mar 30, 2009|
Lessons from the past: The crash of 1987
In the previous article of this series we had discussed about the Asian Financial Crisis. The economies of Thailand, Malaysia, Singapore, Indonesia, Hong Kong, and South Korea, had witnessed impressive economic growth rates in the world during 1980 to 1990 but these Asian countries began to crumble in early 1997 and lost a decade of economic progress due to this crisis.
In this article, we will discuss the '1987 Crash'. A five-year 'bull' market which started in 1982 came to an end in 1987, between October 14 and October 19, 1987 and major indices of the United States dropped 30% or more.
The 1987 crash
After 1982 companies listed on the US bourses started posting strong gains but soon the price of stocks outpaced earnings growth, thereby inflating price to earnings ratios. This led to markets becoming overvalued. This prompted an influx of new investors, such as pension funds, into the stock market during the mid 1980s. The increased demand supported the inflated prices. Furthermore, favorable tax treatments given to the financing of corporate buyouts, such as allowing firms to deduct interest expenses associated with debt issued during a buyout, which increased the number of companies that were potential takeover targets helped in pushing up their stock prices.
By mid 1987 the macroeconomic scenario turned less certain. The trade deficit of the US grew significantly. In order to manage this deficit, the treasury Secretary James Baker suggested the need for a fall in the dollar on foreign exchange markets. This move led foreigners to pull out of dollar denominated assets which caused a sharp rise in interest rates. The legislation regarding elimination of tax benefits associated with financing mergers also added to the fear and stock market started sliding.
The trading mechanisms in financial markets were not able to deal with a large flow of sell orders. This added to the woes of the stock market. Furthermore, insufficient liquidity also played a significant role in the size of the price drop. Stock markets and derivatives markets also failed to operate in sync and played their part during the crash.
The global markets have become more complex than ever. While financial innovations and new technology are creating new opportunities, they are also increasing the scope of miscalculation and mayhem. In times such as these panic is inevitable and anything rash that investors do might make the situation worse. So the best advice one can give to investors is to stick with their long-term investment strategy, and take advantage of the markets' volatile movements. Especially, in the current scenario, given that there is all pervading pessimism due to the global financial crisis, now would be the time to buy good quality stocks at bargain prices.
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