Last week’s retreat in stock prices may have been the beginning of a long-awaited market correction. If there is a correction, will it turn into a rout like that of October 1987? Then, the Dow Jones Industrial Average dropped by more than 25% in two days.
Last fall-coincidentally two days after the industrial average dropped 7% in a single day- the Brookings Institution and the Wharton School convened their first annual conference on financial-sector issues to assess lessons learned since the 1987 crash. Many of the nation’s leading academic scholars and market practitioners were there, as well as some of the leading figures from the dark days of 1987. The message from the conference, papers from which were published recently, should be a comforting one to investors: A correction may come-and may even be in process-but a repeat of the hair-raising events of 1987 is highly unlikely.
Contagion Can Spread
The crash of 1987 demonstrated how flaws in the financial infrastructure can significantly aggravate a sudden downturn in prices triggered by any one of many possible causes. If trading volume overwhelms the physical ability of the exchanges to handle it, then trade and price information is delayed. The resulting uncertainty can induce many investors to sell before they wait to find out how far their stocks have fallen.
Prices can plunge even further if investors fear that the mechanisms for clearing and settling trades will grind to a halt, as they nearly did in the Chicago options clearinghouse in October 1987. And contagion can spread if stock prices are falling against a backdrop of weakness elsewhere in the financial system, as in 1987 when many of the nation’s leading banks were plagued with problem loans to real estate developers and less developed countries.
The good news is that each of these sources of structural fragility has been substantially, if not totally, corrected.
On October 19, 1987 the New York Stock Exchange could not handle the 600 million shares panicked investors wanted to trade that day. Today, a 600-million-share day is a routine event, and the exchnage can handle up to five times that volume if it has to. Similar improvements have been made at other exchanges, notably the Nasdaq.
The options clearinghouse has strengthened the liquidity reserve and taken other steps to avoid a collapse. Just as significant, so has the Clearinghouse for International Payments, known as Chips, the large-dollar clearing and settlement system for the largest U.S. banks and many of their foreign counterparts. Chips can now withstand the simultaneous failure of the two largest banks in the system, a level of safety far greater than that of a decade ago.
The banking system is as healthy as it has been in a generation or more. Virtually all banks-especially the largest ones-have larger capital cushions than are required by regulators. And while the biggest banks are also much more active in derivatives markets than they were in 1987, the danger from derivatives have been exaggerated in some quarters (notably in a recent article in Time). To be sure, derivatives exposures should be better reported, but it is critical to keep in mind that the lion’s share of over-the-counter derivative transactions are made between a relative handful of large institutions, whose obligations are largely (but not totally) offsetting.
Some observers nonetheless fear that the market is now more susceptible to a deep plunge because so many more investors participate through mutual funds. At the end of 1996, for example, equity funds accounted for 21% of the overall market, three times the 7% share they had in 1987. Since a good chunk of the new money comes from investors who have never experienced a bear market, there is widespread concern that these investors will flee from the markets when a true correction occurs, and that their flight will aggravate any initial selling pressure.
No one knows whether this will occur, but the worriers should be cognizant of two important factors. First, much of the growth in mutual fund ownership has come from both direct shareholding by individuals and declines in pension plan claims, so that the share of outstanding shares held by households has not increased as substantially as some have suggested. Second, there is little evidence suggesting that indivisual investors have been a destabilizing influence so far, whether as direct shareholders or investors in mutual funds.
Another source of concern is the apparent increase in price volatility since 1987. It is not uncommon now to see the Dow Jones Industrial Average swing by more than 50 points on a daily basis. In just the past month, the Dow one day dropped by more than 200 points, only to bounce back two days later by more than 160 points. To some, the wild gyrations may be the warning signals of something much worse.
In fact, research by William Schwert of the University of Rochester, presented at the Brookings-Wharton conference, demonstrates that stock price volatility has remained low by historical standards. This seemingly counterintuitive result comes from looking at the percentage movements of stock prices rather than their absolute changes. Investors and those in the media who believe stock prices have become more volatile are actually victims of “scale-illusion”: They don’t realize that a 100-point drop with the Dow at 8000 is the equivalent of a 25-point drop with the Dow at 2000, roughly where it was a decade ago.
Ironically, some investors may draw false comfort from the one major policy change made in the wake of the 1987 stock market crash: the introduction of circuit breakers, or temporary halts in trading. As Lawrence Harris of the University of Southern California demonstrated at our conference, the empirical and theoretical evidence developed since 1987 has yielded a decidedly mixed verdict on the effect of trading-halt rules and the limits on program trading. Given the many factors that may be influencing prices at any time, it is hard to make the case that circuit breakers have been helpful. In fact, following the one instance that the New York Stock Exchange’s circuit breaker was employed, the exchange and the Securities Exchange Commission chose to reduce the likelihood of its use by tying the breakers to percentage changes in the Dow Jones Industrial Average instead of movements in the absolute value of the index.
Why do policy makers find mechanisms like circuit breakers so attractive, given that the empirical support is so weak? Because such measures offer a relatively low-cost way for regulators to say to the public that they are “doing something” to prevent another crash. But this is false comfort.
In sum, the fundamentals may warrant a further correction of stock prices at some point. But the major improvements in the structure of the markets over the past several years have significantly reduced the chances of a sudden free fall of the magnitude witnessed during October 1987.