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October 19, 1988
"After the Crash - 'Noise' Traders Learned their Lesson"
San Jose Mercury News
By Timothy Taylor
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ONE year later, it's clear that the stock market crash of October did not foretell another Great Depression.

At the end of 1930, a year after the stock market collapse of 1929, the market had fallen by nearly three-fifths of its 1929 value. For a similar decline to occur by the end of 1988, the Dow average would have to fall by about half in the next two months. Even if the economy slows down or dips into recession, that sort of utter collapse seems extremely improbable.

But if the stock market crash wasn't caused by an imminent depression, then what was the cause? Strangely enough, most non-economists have focused on economic causes for the crash, while most economists have focused on non-economic causes.

Most non-economists simply designated their favorite economic problem as the cause of the stock market crash. Democrats blamed the crash on discouraging news on the trade deficit; Republicans blamed it on a protectionist Congress; many investors blamed it on the threat of higher taxes on takeovers. But none of these explanations are very sound, for two main reasons.

First, stock markets declined all over the world on Oct. 19, in countries with big budget deficits and small budget deficits, high inflation and low inflation, protectionism and free trade. This fact renders suspect any particular explanation based only on U.S. events.

Second, any explanation of the crash must explain why it was such a rapid and violent event. Bad economic news might be able to explain why stock prices were drifting lower the weeks before the market crash. They can't explain how a normal price decline became a panic, with a fall of 22 percent in a single day and whipsaw up and down movements, as shown in the accompanying figure.

The crash and its aftermath proved that the peak stock prices of mid-1987 were a high bridge built on trembling and shaky foundations. The Presidential Task Force that investigated the crash reported that only 3 percent of the shares of stock in the country were traded in October 1987, but the total decline in stock value was nearly $1 trillion. The key in explaining the crash is to understand why the foundation of stock prices became so rickety that a bit of bad news could cause such a huge collapse.

It is useful here to think of stock prices as determined by two different kinds of strategies. "Value trading" examines the companies that originally sold the stock. When a new product or a new manager or some economic event seems likely to change corporate profits, value traders will buy or sell stock so that stock prices change in the same direction.

A stock market full of value traders would be a fairly stable market, changing only as economic news reaches investors.

The second type of investing is called "noise trading." Investors using this strategy may buy and sell the same stock several times a week, or even several times a day, to try to profit from every twist and turn in the market.

If market prices seem to be increasing, noise traders will buy stock to profit from the upward trend, without worrying whether the higher price is justified by good economic news. A noise-trading strategy helps create a bandwagon and then rides on it.

A stock market with both value traders and noise traders is like one of those inflatable punching bags with a weight in the bottom. You know the type? You punch it and it rebounds back and forth, eventually stabilizing in an upright position. The question for economists has been whether the joint effect of value traders and noise traders is to make the stock prices stabilize more rapidly, or to overreact and not stabilize at all.

With the benefit of hindsight, evidence is accumulating that the stock market seems to overreact quite often, even if the overreactions are not usually as vivid as those of October 1987. Here are some facts about the stock market that seem to have no adequate value-based explanation:

On average, some individual stock has changed its value by more than 10 percent on every day in the last two decades. Stock prices of small companies rise faster in January than other months and fall on average over the weekend. On three or four or five days every year, the market as a whole changes value by more than 2 percent. Stocks which lose the most in a given period of time tend to rise the most in the next period of time. In general, stock market collapses are followed by recessions slightly less than half the time.

Perhaps most interesting of all, the Dow Jones industrial average increased about 50 percent from 1960-65, while the economy grew by less than 40 percent; the Dow then didn't increase from 1965 to 1982, even though the GNP quadrupled over that time; then the Dow tripled between 1982 and 1987, even though the economy had grown by only about 50 percent in those five years. The only viable explanation of trends like these is consistent overreaction by the market.

Franco Modigliani of MIT, the 1985 Nobel laureate in economics, has argued that the only plausible explanation of these major swings in the stock market since the 1960s is that investors do not understand how inflation affects the value of corporate assets.

When confronted by high inflation and unstable economic conditions in the 1970s, investors did not increase stock prices at all, not even to account for inflation. As a result, many stocks became dramatically undervalued, and when the economy started perking in the early 1980s, there were many companies with too-cheap stock waiting to be taken over. In addition, noise traders probably exaggerated the mistakes of investors by pushing stock prices even lower in the 1970s and even higher in the 1980s.

By August 1987, when the stock market peaked, "stocks were valued at levels which challenged historical precedent and fundamental justification," said the Presidential Task Force. The only real question at that point was not whether stock prices would fall, but how soon, how far and how fast they would fall.

Given the overvalued level of stocks, a stock market crash may have been better than long slow decline. A crash finished the whole decline in a couple of spectacular days; it forced politicians to stop talking about protectionism and start talking about the budget deficit. A long slow decline might have pushed stock prices still lower without causing the same political pressure.

In addition, as many commentators have pointed out, the crash led many consumers to spend less, which has helped the economy shift toward relying more on export sales and less on domestic demand. Over time, that shift will be necessary for the United States to reduce its trade deficit and pay off its foreign debts. A long, slow decline in stock prices might not have led to the same adjustment by consumers.

But although the stock market crash has turned out to be a surprisingly benign way of achieving the inevitable reduction in stock market prices, it would still be better for everyone's piece of mind if the correction hadn't been needed in the first place. What policies would help prevent the stock market from bouncing like an inflatable punching bag?

The most popular answer seems to be: If the market is falling, stop the trading and shut it down. But if the market needs to move for fundamental economic reasons, freezing it is clearly a mistake. Government regulators can't bottle up the momentum of a multi-trillion dollar stock market. If they try, stocks will be traded outside of the stock market, related investments like stock options and stock futures will be used in place of trading stocks, and when markets open again prices will move wildly, perhaps with the sort of whipsaw changes that occurred during the 1987 market crash.

It's difficult to recommend policies that will lead to stability in the markets, since confused or misguided investors can mess up any market if they try hard enough. But a partial answer is for government regulators to keep prices moving smoothly. Declines in stock prices are sometimes inevitable, but up-and-down whipsaws in prices are a sign that the system of stock trades is breaking down.

One step the government can take is to make sure that the stock exchanges themselves have enough cash on hand to execute their trades. During the crash of 1987, for example, the Federal Reserve extended loans to make sure that the exchanges had enough cash to allow trading to continue. If a pause in trading has to occur because the market is overloaded with orders, as happened repeatedly in the market crash, government regulators can make sure that trading only restarts when everyone who wants to buy or sell at the prevailing price has had a chance to place an order.

In the end, the best protection against inflated stock prices is, well, a stock market crash or two. It's safe to say that there are more value traders after the stock market crash than there were before.

But the best hope for market stability is that a significant group of noise traders will learn the underlying lesson of the market crash: The stock market tends to overreact.

An investment strategy based on overreaction would mean that noise traders would tend to sell stocks that have increased the most and buy those that have declined most. Noise traders acting in that way would tend to damp down the unavoidable wobbles in the stock market, rather than exaggerating them as they did during the great stock feeding frenzy that ended in October 1987.

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