The Stock Market Crash of 1987: A Macro-Finance Perspective

Jeremy J. Siegel

Rodney L. White Center for Financial Research Working Papers from Wharton School Rodney L. White Center for Financial Research

Abstract: No economic event on or about October 19, 1987 can explain the record collapse of equity prices that occurred on that day. In the summer of 1987 equity valuations were at a historically high levels based on current and projected earnings and the real interest rates available in the bond market.

This paper constructs a theoretical index of stock prices based on the range of actual forecasts of future corporate profits made during 1987. The dispersion of these profit forecasts increased markedly prior to the crash and the actual level of stock prices reached in the summer of 1987 could be justified by only the 10% most optimistic forecasters. Some reasons for the divergence between the actual level of stock prices and the level based on the mean forecasts of corporate profits are analyzed. These include the effects of the unprecedented five-year bull market in stocks, changes in the equity risk premium, and investors’ misjudgment of the market impact of portfolio insurance.

The divergence between the theoretical and actual stock market levels may have made stocks extremely vulnerable to any negative shocks. The stock market decline appeared to be a related response of investors to rising real interest rates, which reached their peak on the morning of October 19th. Evidence is presented which suggests that the deteriorating US trade deficit was the most important source of the rising dollar interest rates prior to the crash. Increasing inflationary expectations played only a small role in the rate rise and the Federal Reserve assumed a neutral or only moderately tight stance during most of 1987. It is shown that, despite much public opinion to the contrary, there is little evidence to suggest that investors’ perceptions of the US budget deficit worsened prior to the crash and were a factor in the fall of equity prices.

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