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
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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