Abstract To put it briefly, in 1987, market participants felt that conditions were starting to resemble 1929, the year of the well known crash that ushered in the Great Depression. This feeling emerged from comparison of prices - if one overlays price graphs of the two markets, they appear eerily similar. Market participants started to compare the long seven year bull markets that characterized each era, and to many observers, the peaks and valleys near the end of their long bull moves seemed to overlap each other (see chart). My thesis is that a number of 1987 participants perceived a resemblance between their era and 1929, and sold stocks based on the analogy they had drawn. After all, why would anyone want to risk being caught by another '29 style crash and 30's Depression? The resemblance was only superficial, in reality 1929 and 1987 were two very different fish. Nevertheless, market prices were forced down by this selling, and in the eyes of market participants, appeared to be following 1929 even closer. Like a self-fulfilling prophecy, participant's belief that 1987 resembled 1929 resulted in trading that forced 1987 to conform to the old 1929 pattern. On Monday, October 19, 1987, enough people chose to sell based on the 1929-1987 analogy that the 1929 crash fully reappeared in 1987.
Unlike the typical panel of causes put forth such as program trading and overvaluation, my theory is able to explain precisely... 1) why the 1987 crash occurred on Monday, October 19. in the historical model investors had adopted, the crash had occurred on a Monday in October, 1929. The overlap in Mondays resulted in a self-fulfilling prophecy to emerge in 1987.
2) why the move was so extreme in price. 1987 fell 23% because participants noted that 1929 had fallen 24%. Their willingness to sell using 1929 as an example resulted in replication.
3) why it fell so quickly. 1929's 24% decline had only taken 2 days to occur. By analogy, market participants felt equities could fall as fast in 1987
4) why 1987 was an international phenomenon. the 1929 crash set a precedent by affecting markets from Paris to London to New York. Thus investors the world over were influenced by the memory of the crash and Great Depression, not just those in the U.S., and were willing to sell in 1987 using the 1929 memory as justification
5) how a lack of major news or important events prior to the decline could justify a 22% change. the cause was psychological, caused by an old memory. Thus it needed no events or important news to emerge.
The theory also explains an observation that has been noted by many - why 1929 and 1987 are so remarkably similar in terms of shape, timing, and extent (see another chart). Another strange observation commented on in the press was the continued strength in the U.S. economy both before and after the market crash. If the decline was purely psychological, this explains how the stock market could decline even though the economy was still kicking on all cylinders.
This is a simplified explanation, please read my essay Explaining the 1987 Market Crash (PDF) for a complete treatment.
Future Crashes? If all it takes to start a crash is a belief that current markets resemble past crash years like 1929 and 1987, then we may have crashes again in the future. Going into the second half of 2003, market participants are inevitably starting to make the perceptual connection between the present and 1987. Indeed, come October it has become a tradition to do so in the press. Commentators have warned about the potential for a repeat of 1987 every fall through the late 1980s and 90s, possibly causing small mini crashes in October 1989 and 1997 (see my paper for these explanations). It is entirely possible they will do so again.
(20min delay)