Key points:
- For the US stock market, the October 1987 crash featured its largest ever one-day fall, but it turned out to be a relatively minor hiccup. The US market started rebounding the very next day and recovered its pre-crash high in less than two years.
- But in Australia the crash was much deeper (-50%) and took more than eight years to recover, and 17 years in real terms after inflation. Why?
- Although most of the underlying problems and trigger events were in the US, I provide ten reasons why the Australian crash was much worse than the US crash.
- The current US tech boom has several similar underlying conditions as in 1987– including over-pricing, speculative fever, inflation, mounting government deficits & debts, trade & current account deficits, weakening US dollar, a trade/currency war (then it was with Germany & Japan).
- These are underlying conditions conducive to a correction, not the trigger for the correction. The trigger is different in each case and may be years away. Meanwhile it pays to be vigilant.
This is Part 2 of my thee-part series on the 1987 crash.
The October 1987 crash 38 years ago was not the deepest sell-off for the Australian share market, but it was the steepest. The broad market index fell by 50% in just 19 trading days from 2,306 on 21 September to 1,151 on 11 November, including our worst ever single day fall of -25% on Tuesday 20th October (our ‘Black Tuesday’) after Wall Street fell -20% overnight (‘Black Monday’ for them).
Today’s chart shows the All Ordinaries index (green line) and the Dow Jones Industrial Average (red), with the key events highlighted. The lower section shows cash rates (green dots for Australia, red dots for the US).
Several things stand out immediately, including:
-
- The Australian market follows the US market almost in lock-step, not just in the crash itself, but also throughout the daily ups and downs along the way.
- The crash was deeper in Australia than the US market.
- The US market recovered and went on to new highs much more quickly than the Australian market (even though both economies suffered economic recessions in 1990-1).
What caused the crash? As with all crashes, there was no single factor or event that was responsible. I will separate the main contributing factors into two main groups – the underlying problems, and the triggers.
(I am not trying to summarise or paraphrase the countless reports, books, and PhD theses that have been written about the crash. These are just my views, having been in the market at the time, and having studied financial markets and tried to use the lessons professionally for much of the past 45 years. My main focus here is on why it was worse in Australia than the US, and how the underlying conditions may be similar to today's boom.)
Underlying problems or causes
There were probably three main underlying problems.
a ) Over-pricing
The first problem was stock market over-pricing. The US-led global share market boom was driven by declining inflation and declining interest rates after the 1970s inflation beast had been defeated by sharp inflation-busting recessions in 1980-2, brought on by savage rate hikes by US Fed Chair Paul Volcker in the US (and echoed in the UK, but not in Australia as I discuss below).
There was certainly a general rise in consumer and business confidence in the 1980s under Ronald Reagan, in stark contrast to the 1970s, with its high inflation, high unemployment, high taxes, stagnant growth, Vietnam war loss, civil/racial unrest, and sense of ‘malaise’ under Nixon, Ford, and Carter.
The 1980s boom was also fuelled by deregulation and financial innovation, including arbitrage trading, automated ‘portfolio insurance’ (algo) trading, and huge leveraged buy-outs financed by ‘junk bonds’. The era of 1980s corporate greed was highlighted in books and movies like ‘Barbarians at the Gate’, ‘The Bonfire of the Vanities’ and ‘Wall Street’.
The speculative boom had sent share prices rising well ahead of underlying earnings and dividends. By September 1987, the price/earnings ratio for S&P500 index had risen above 20 because share prices had soared +39% in the preceding 12 months, but aggregate earnings per share had actually shrunk by -3%, and aggregate dividends per share had risen by a paltry +3.7% (less than inflation).
A p/e ratio above 20 for the US market does not sound overly expensive these days, but at the time it was the highest it had been since early 1962 right before the 1962 sell-off (triggered by Kennedy’s attack on the steel industry). Numerous surveys at the time (including one by future Nobel Prize winner Bob Shiller) concluded that there was a general feeling that the US stock market was over-priced and susceptible to a major correction.
b ) Triple deficits
A second set of problems were the persistent and growing US budget deficits, trade deficits, and current account deficits during the Reagan years. Reagan won the 1980 Presidential election promising balanced budgets and small government – but he did the exact opposite. During Reagan’s rein, deficits and debt grew, and the US went from being the world’s largest creditor nation, to being the world’s largest debtor.
US Federal debt rose in a straight line from $900b (31% of GDP) in 1980 to $2.6 trillion (48% of GDP) in 1987. Reagan’s deficit spending spree was being bankrolled by Japan and Germany, and this was causing problems, as we shall see.
Alongside the build-up of government deficits and debt, the US also ran up huge trade and current account deficits. When Reagan came to power the US had a balanced trade account, but by 1987 it was running a trade deficit of more than -3% of GDP (similar to today).
While the deficit/debt funded government and consumer spending sprees no doubt contributed to the booming stock market, there were mounting fears that major fiscal and/or monetary policy responses to address the triple deficit problems might derail the already over-priced and vulnerable stock market. They did.
c ) Weakening US dollar - US/German/Japanese currency war
Worsening deficits on the US budget, trade, and current accounts were weakening confidence in the US dollar. The US dollar had actually been very strong in the early 1980s. The rising dollar had been hurting US exporters, so US Treasury Secretary James Baker engineered an agreement called the ‘Plaza Accord’ in September 1985 where Japan and Germany (plus UK and France) agreed to sell dollars to bring down the USD. This worked better than expected, and the US dollar fell by 31% from September 1985 to the start of 1987.
It was part of a co-ordinated plan so there were no major concerns. But by early 1987 the rapidly declining dollar was starting to fuel US inflation, so a new ‘Louvre Accord’ in February 1987 was designed to halt the slide in the dollar.
It didn’t work. US interest rates were already more than 3% above rates in Germany and Japan, which ordinarily would cause a flow of funds back into the US causing the dollar to rise, but the US dollar was still falling, and the Bundesbank and Bank of Japan were hinting at rate hikes to counter their own domestic inflation, and this triggered more nervousness about the dollar.
The fear was that further US rate hikes to counter German and/or Japanese hikes and to prevent the dollar from falling further would kill the US stock market boom. They did. The dollar kept falling until the end of 1987 despite the US rate hikes. As it turned out, the dollar only started to recover in early 1988 after even more Fed rate hikes.
The trigger(s) – US inflation, rate hikes, bond yields & dollar
The main trigger for the crash was probably the Fed rate hikes, or more specifically, the rate hikes accompanied by fears of further rate hikes ahead because the rate hikes (including three in September) were not working. Inflation was still rising, bond yields were still rising (signalling further rises in inflation and/or rates), and the dollar was still falling.
First – US inflation had started the year at a rather low 1.2% but rose to above 4% by August 1987, despite the Fed’s rate hikes during the year. The market feared even more hikes would be required to tame the inflation surge. (There are always lags between rate hikes and inflation, but the fear of further hikes is always a negative.)
Second - Not only were cash rates rising, but US treasury yields were rising even more strongly, and these usually have a more powerful impact on asset prices that short-term rates. Yields on US 10-year T-Notes started the year at 7.2% but soared to over 9% by September on fears of further rises in inflation and rate hikes. That surge in long-term yields was always going to a problem for asset prices already in expensive territory.
Third – the rate hikes were not halting the slide in the dollar, so the market was fearing even more Fed hikes to follow.
Fourth – on 14th October the US Ways and Means Committee introduced a bill to cut tax benefits for financing mergers and leveraged buyouts. This would kill the golden goose driving all of those crazy leveraged buyout deals. On the same day, the US trade deficit numbers came out, and they were worse than expected, sending the US dollar lower.
The final trigger was US Treasury Secretary James Baker’s comments from the middle week of October, including on Sunday 18th, that he was unlikely to support the US dollar. He even threatened to devalue the dollar further to hurt German exporters, in the wake of the Bundesbank lifting the repo rate on the 6th and talk of further rate hikes in Germany to tackle inflation.
That was it. When the market opened the next day, ‘Black Monday’ 19th, the S&P500 fell -20.5% and the Dow Jones fell -22.6%. It was the worst single-day fall in US history (The -23.6% fall at the start of the 1929-32 crash was worse, but that was spread over two days: -13.5% on Monday 28th and -11.7% on Tuesday 19th October 1929).
Crash made worse by new technology
Several factors made the US crash a particularly bad that day (Monday). One was a huge build-up of sell orders, fund redemptions, and margin selling orders over the weekend that delayed the opening of the main cash market. The resulting mis-match between the cash market and the futures market triggered large volumes of futures arbitrage trading.
A couple of new tech-based ‘financial innovations’ also played a role accelerating the price falls, including computerised ‘portfolio insurance’ trading, and ‘program trading’ (mainly automated momentum trades that sold falling stocks, sending them lower) – called ‘algo’ (algorithm) trading today.
(After every incident of rogue technology causing market mayhem, regulators race in to improve systems and regulations. But they only work for a while until the next time, and there is always a next time. For example, we had the GFC, the May 2010 'flash crash', the Covid bond market melt-down, etc. Today we have new threats like hacking and rogue ai bots that could, and probably will, do enormous damage to markets next time.)
Why was the Australian crash worse?
The US market had a big one-day -20% fall on Monday 19th October, but then started to recover the very next day, and the S&P500 index recovered its pre-crash high less than two years later.
However, the Australian market fell -25% on Tuesday 20th October, but it kept falling until 11th November, for a total decline of -50% from the top, and it took more than eight years to recover.
Why was the crash much deeper and much longer to recover here than in the US, when the main causes and triggers for the crash were in the US?
a ) Our market more over-priced and more speculative
Share market over-pricing was worse in Australia than in the US or elsewhere. Most commentators cite the ‘price/earnings’ (PE) ratio of 21 at the time as high. But a ‘price/earnings ratio’ is meaningless because the ‘earnings’ side of the equation was grossly inflated by accounting trickery, dodgy valuations, circular transactions, and other financial shenanigans – all signed off by tame, conflicted auditors.
I cover this in more detail in Part 1 –
In Australia it was the age of the debt-fuelled corporate raiders with inexperienced, newly deregulated bankers throwing money at them as quickly as they could. The rogue’s gallery of scoundrels included - Alan Bond (Bond Corp/Media/Brewing), Robert Holmes à Court (Bell Group/Resources), Ron Brierley (IEL, Brierley Investments), John Spalvins (Adsteam), John Elliott (Elders IXL), Larry Adler (FAI), Russell Goward (Westmex), Chris Skase (Qintex), George Herscue (Hooker), Bruce Judge (Ariadne), Kevin Parry (Parry Corp), Allan Hawkins (Equiticorp), and many others.
Most collapsed into bankruptcy in the 1990-91 recession, some went to jail, and/or became fugitives on the run.
At the top of the market, the raiders were still ‘cheap’ with low ‘price/earnings’ ratios – many in single digits. All bargains! But these P/E ratios were meaningless because of what was in the alleged ‘earnings’.
b ) ‘Real’ companies also caught up in the take-over frenzy
Many of the largest listed companies on the ASX were caught up in the debt-fuelled takeover fever, as they became take-over targets for the raiders. These included even BHP, two of the big banks, the big retailers (Coles, Myer, Woolworths), the TV stations (Nine, Seven, Ten), Fairfax, the big brewers (Fosters, Tooth, SAB), and many others.
c ) Bigger lending binge
The local boom was fuelled by an orgy of ultra-loose lending from the big banks (with the notable exception of NAB), and from the State-owned banks as well (the 1980s lending binge resulted in the disappearance of the State bank of every State except Qld, which did not have one).
Up until WW2, banks in Australia were virtually unregulated (and well-behaved most of the time, with one notable exception – the 1890s banking collapse following an orgy of bad property lending in the 1880s - exactly one century earlier). But in WW2 the Labor government took control of the banks and did not let go after the War ended.
In those 40 years of government control and direction, in which the banks were told how much to lend, where to lend it, and at what rates, banks had completely lost their ability to assess credit risks and price loans. When they were suddenly de-regulated in the mid-1980s, and foreign banks were allowed in to the local market, the Aussie banks went mad and threw money at anything that moved in the race to ‘get big’ for fear of losing market share to new foreign banks. They also threw money at all sorts of crazy overseas adventures – especially Westpac.
The mountains of bad debts from the orgy of bad lending in the 1980s following bank deregulation resulted in the 1992-3 banking crisis after the 1990-1 recession, but that is another story for another day!
For my history of the big Aussie banks in recent decades – see
e ) Our market had a lot further to fall
In Australia, the All Ords had doubled in value in the 12 months from August 1986 to August 1987. And so when it fell by -50% (halved) in the crash, it really only took the index back to where it was a year earlier.
In the US, the S&P500 index gained ‘only’ +36% in the 12 months before its pre-crash peak, and when it fell by -34% in the US crash, it also just gave back the prior 12 months gains.
The bigger fall in Australia was just gravity.
d ) RBA rate cuts
In the US, the Fed was hiking interest rates to kill rising inflation and support the ailing US dollar. But in Australia, inflation was running much higher (above 8% here) but the RBA was actually cutting cash rates (!) – which no doubt threw more jet-fuel on the fire here.
e ) Higher inflation & interest rates
Inflation in Australia was around twice the level of US inflation (eg 8% here versus 4% in the US at the time of the crash). Interest rates were also higher here (11% here after the rate cuts, versus 7.2% in the US after the rate hikes.)
Higher inflation and interest rates here means more sensitivity and vulnerability to shocks of any kind.
f ) Signs of speculative bubble
I remember signs of a bubble everywhere. There were ‘hot stock’ shows on TV, talk-back radio, magazines, newspapers (there were no ‘blogs’ or social media or internet or streaming services back then, and not even mobile phones).
Probably my most vivid memory was listening to a talk-back radio show in the middle of 1987. An elderly woman phoned in and wondered if she had enough money get involved in the share market as she ‘only had $50,000 in savings’. It sounded like that was her retirement money. The radio host excitedly rattled off a list of hot stocks and she was talked into giving it a try! This sort of thing was everywhere.
g ) Tax incentive
There was even a tax-driven reason to lure investors into the market. ‘Dividend imputation’ was introduced in July 1987. Stockbrokers were running regular seminars in the suburbs talking people into gearing up to buy shares to get access to the hot new toy called franking credits’!
The same thing happened in the 2007 boom when hundreds of seminars in the suburbs encouraged people to gear up into superannuation to take advantage of the ‘$1 million contribution window’. Thousands of people borrowed money at the top of the market in both of the booms, threw it into the market, and promptly lost most it in the crashes that followed immediately after.
Crazy stuff, but tax incentives always drive bad decisions – especially at the tops of speculative booms. They drive the booms even higher, and create bigger losses in the busts that always follow. Sad to see, but that's just human nature.
ASX much longer to recover than Wall Street
In the US, the crash was a relatively minor hiccup. The S&P500 index recovered its pre-crash high in less than two years. But in Australia the All Ords took eight and a half years to recover, and 17 years to recover in real terms after inflation.
It was not just because our boom was higher, and therefore had further to fall. It took five times as long as the US market to recover. There were several reasons for this.
Inflation not cured here
Australia still had not conquered inflation. The US killed the 1970s inflation with the harsh 1980-2 Volcker recessions, and then enjoyed declining inflation and interest rates through the 1980s. But Australia did not. The Fraser/Lynch government was too weak in the early 1980s, and did not have the stomach to fight the unions when unemployment was already running above 6% in 1980-2 (and then soared above 10% in the 1982-3 recession).
The new Labor Hawke/Keating government rejected the ‘monetarist’ medicine of money supply contraction and high interest rates used in the US/UK to kill inflation, and they adopted their ‘Accord’ process instead. As a result, inflation remained high (1983-7 average = 7.7%), and so did unemployment (1983-7 average = 8.6%).
Deeper inflation-busting recession
Australia had its big inflation-busting recession in the early 1990s, which was worse in Australia but relatively mild in the US, just as the US had its big inflation-busting recession in the early 1980s, which was worse in the US but relatively mild in Australia.
Another difference was that the Fed in the US had relative autonomy since 1951, but the RBA in Australia was only granted autonomy/independence to tackle inflation in 1992-3.
Our lending binge turned 'systemic'
Our 1990-1 recession was deeper than the US, and our wilder lending binge turned out to be ‘systemic’ in the sense that it infected the banking system here, resulting in the 1992-3 banking crisis. In contrast, most of the bad lending in the US boom was financed by ‘junk bonds’, not the mainstream banking system, so there was no general banking crisis.
(A question for today’s boom – Will the orgy of bad lending in ‘Private Credit’ funds end up being ‘systemic’ when the boom ends – ie infect the real banking system, like credit derivatives funds infected the real banks in the GFC? The Bank of England thinks private credit lending has a good chance of turning into a systemic risk that will infect the banks. To date I believe the BofE is being overly cautious, but we'll see!)
With Australia’s higher inflation, higher interest rates, deeper recession, and crippling banking crisis as a result of our wilder lending boom, it took the All Ords more than 8 years to recover its pre-crash highs in nominal terms and 17 years in real terms after inflation.
Bottom line – it was just our turn to have a bigger boom and a bigger bust. The US and Australian share markets have been taking turns to have the bigger boom and bigger bust for a more than a century see –
How does the current boom compare?
While the current US-led tech boom has more similarities to the 1990s ‘dot-com’ boom, there are also several features of the 1987 boom/crash that are of concern. These underlying causes and conditions can kill off any speculative boom, regardless of what it is that investors are actually speculating on at the time.
Checking off the underlying causes and conditions (especially for the US market):
-
-
- Over-priced share markets? – yes. Worse today.
- Speculative fever? – yes. Probably worse today, but similar to 1990s dot-com boom.
- Government deficits? – yes. Worse today.
- Government debts? – yes. Worse today.
- Trade/Current a/c deficits? – yes, especially US CAD with rising interest costs
- Weakening US dollar? – yes, but not yet as critical.
- Fears of further Fed rate hikes to support the dollar or attack inflation? – Probably not under Trump.
- Rising bond yields? – yes, but not as high
- Debt-fuelled speculative acquisitions? – No. Mostly using equity, not bank debt. But Private Credit is a worry.
This time we have some additional factors and risks – including tariff wars, geopolitical flare-ups, political unrest, hacking risks, ai errors.
The underlying conditions today certainly have some troubling elements and material similarities to the 1987 crash and other prior boom/bust cycles. But these provide no indication of timing. Over-priced booms can run on for a decade (like the 1920s and the 1990s) before the eventual collapse.
What we don’t have yet is the final triggers for a correction that will end the current boom.
‘till next time. . . .Save investing!
See also -
For my recent six-part series on share market pricing - here is a link to Part 1, which contains links to the other five parts in the series –
For my most recent monthly report on global markets for Aussie investors –