The website of The Wall Street Journal in the United States published an article titled "Is the 1987 Stock Market Crash Repeating? What Caused the Recent Market Plunge?" on August 5, written by James Mackintosh:
Financial markets are supposed to reflect collective wisdom. However, on Monday, people were running around and screaming. The Japanese stock market recorded its biggest single-day percentage drop in 37 years, and the volatility index VIX in the U.S. saw its second-largest increase since 1990. Panic ensued.
The trigger for this sell-off was last Friday's U.S. employment data, which suddenly shifted economic expectations from a soft landing to a hard landing. Additionally, the recent cooling off of hype around artificial intelligence, the Bank of Japan's rate hike to boost the yen, and news that Warren Buffett's Berkshire Hathaway had sold half of its Apple stock and increased its cash reserves, all contributed to the market's unease.
However, these factors do not fully explain the scale of investor actions. The reason for the massive sell-off (which at one point caused Nvidia's stock to drop by 15%) lies in investors having previously bet everything on a positive outcome. The question is how extensive the reverse operations of these bets (and the leverage behind them) will be. If this situation persists, will the sell-off drive up savings, weaken the economy, and even impact the financial system?
Extreme examples of past market crashes include the 1987 stock market crash, the 1998 collapse of Long-Term Capital Management, and the 2008 global financial crisis. So far, the current market downturn seems more like the (milder) version of 1987 rather than the other two.
In 1987, the U.S. stock market experienced its largest single-day drop in history, with the S&P 500 index falling over 20% on October 19, "Black Monday." Investors had accumulated excessive leverage after the market's stunning rise in August that year. The stock market plunge led to massive margin calls, and poorly designed automated trading exacerbated the sell-off. However, the Federal Reserve injected liquidity into banks, brokers did not default, and the market recovered all losses within two years. The U.S. economy remained in good shape.
The good news is that the turmoil in 1987 was limited to the stock market: it went up, it went down, with no other damage. The S&P 500 index rose 36% in the first eight months of 1987, similar to its 33% rise in eight months to this year's high. Just like in 1987, despite tightened monetary policy and rising bond yields, the stock market surged this year. Investors in 1987 were as anxious as those on Monday, ready to sell stocks to lock in unexpected gains. So far, investor losses have been small, but profitable trades have reversed, mirroring the overall market situation in 1987.
The situation in 1998 was much worse, although the stock market recovered more quickly. Back then, Russia's domestic debt default led to a flight of funds seeking safety, causing highly leveraged hedge fund Long-Term Capital Management's assets to plummet. The firm was so large that it threatened to collapse Wall Street. The Federal Reserve cut interest rates three times, rallied a group of banks to save the firm, and gradually unwound its trades. The stock market recovered in just four months, but low-interest loans fueled the internet bubble. Two years later, the bubble burst, causing a mild recession and heavy losses for tech stock investors.
We do not know if any hedge funds have been wiped out by the recent market moves, which have caused severe losses for "carry trade" players who borrowed yen at low rates to buy high-yield currencies like the Mexican peso or the dollar. However, traders have already bet that the Federal Reserve will significantly cut rates by 0.5 percentage points at its September meeting.
A repeat of the 2008 scenario would be the worst outcome but seems unlikely. It is true that some large U.S. banks failed last year due to unfavorable investments in government bonds. However, banks are much less leveraged than in the past, and the financial system is less affected by liquidity crises because private lending institutions have taken on many risks previously borne by banks. Large losses among lending institutions are entirely possible, and private funds may encounter trouble, but this will not happen immediately and will not cause a systemic crisis like in 2008.
Ideally, the market's excesses will end like in 1987 without causing more significant problems. Investor enthusiasm for artificial intelligence may wane further, lowering stock prices, but even a 30% drop from June's peak would still leave Nvidia's stock doubled for the year. The market has largely returned to normal levels, with the Nasdaq 100 index up only 6% and the S&P 500 up less than 9% for the year.
If panic subsides, the Federal Reserve cuts rates, and the financial system remains unscathed, we will be lucky. It would be fortunate if investors could remember the "plunge" feeling from Monday morning and be a little wiser and less speculative.