stock bull & ALL: Why a Market Correction Won't Replay 1987
July 28, 1998 Wall Street Journal Interactive
By ROBERT E. LITAN and ANTHONY M. SANTOMERO
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.
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 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 Oct. 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 exchange 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 its 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 dangers 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
individual investors have been a destablizing 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 and 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.
Mr. Litan is director of economic studies at the Brookings Institution. Mr.
Santomero is a professor of finance and director of the Financial
Institutions Center at the University of Pennsylvania's Wharton School.
They are co-editors of "The Brookings-Wharton Papers on Financial
Services."
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