October 20, 2017

Lessons from 'Black Monday': It's Not Easy to Spot Bubbles

Scott Sumner

Ralph G. Hawtrey Chair of Monetary Policy

Between Aug. 25 and Oct. 16, 1987, the U.S. stock market declined by more than 16 percent. Then, on Oct. 19 it plunged by another 20 percent, by far the largest one-day decline in U.S. history.

Interestingly, a graph of stock prices in September and October 1987 looks uncannily like the market of September and October 1929, except that the sudden October plunge occurred over two days in 1929. 

Immediately after the 1987 crash, pundits drew two conclusions, both of which now appear to be wrong. First, there was an expectation that falling stock prices might trigger a recession. That did not occur.

Second, there was a widespread assumption that the massive stock price advance during the first eight months of 1987 was a “bubble” and that the crash represented a “correction” back to more reasonable levels. Today, that view also seems incorrect.

It’s not unusual for the stock market to decline sharply just as the economy is entering a severe recession. Stock market crashes in 1929 and 2008 heralded the Great Depression and the Great Recession, respectively. But what exactly is the connection?

One theory is that stock market declines reduce wealth and that this depressed aggregate demand pushes the economy into recession. However, the 1987 stock crash is hard to reconcile with that theory. Even accounting for other factors, surely you’d have expected at least a tiny slowdown in the economy.

Instead, economic growth picked up steam, and the economy boomed in 1988 and 1989. In retrospect, it now seems that the 1929 and 2008 stock crashes were predictions of recession, not causes of recession. Indeed, both stock market crashes occurred after the recession had already begun. 

It’s natural for people to view a sharp runup in stock prices, followed by a sudden decline, as an example of an asset price bubble. In this view, “irrational exuberance” leads investors to pay too much for stocks, relative to fundamentals such as earnings.

In retrospect, however, stock prices do not appear to have been particularly high in 1987. Even at the market peak in August 1987, price-to-earnings (P/E) ratios were close to the historical average.

Alternatively, an investor who bought stocks right before the 1987 crash and held them until today did very well. According to popular metrics such as the P/E ratio, stocks today seem far more overvalued than at the 1987 peak.

Indeed, you can make a good argument that rather than being overvalued right before the 1987 crash, stocks became severely undervalued right after the crash.

One lesson for today is to be very careful in jumping to conclusions about asset prices. I would argue that two more recent asset price crashes are still rather poorly understood. The tech-heavy NASDAQ crashed from 5,048 in March 2000 to a low of 1,114 in October 2002.

At the time, it was almost universally assumed that the March 2000 price was wildly excessive, and the 2002 NASDAQ levels were more reasonable. The March 2000 tech stock prices probably were excessive, but with the NASDAQ now exceeding 6600, it’s the depressed 2002 level of tech stocks that seems the furthest out of line with fundamentals.

Similarly, after house prices plunged between 2006 and 2010, it looked like homes in several pricey markets had been wildly inflated. But house prices in some of these coastal markets have now soared well above the peak of the 2006 “bubble,” casting doubt on the view that those prices were clearly excessive. 

Many economists believe that low interest rates are the new normal, due to slower economic growth. If so, then asset prices should be higher than what you’d expect using traditional metrics such as P/E ratios and price-to-rent ratios.

The real lesson of 1987 is that all lessons are provisional, subject to revision as more time goes by and we gain a better understanding of the forces determining asset prices.

What looked in 1987 like a bursting bubble after a period of irrational exuberance, which was likely to trigger a recession, now looks like a period of irrational pessimism, which didn’t slow the economy at all.