Global Knowledge Management and Economy - Nik Zafri

The Star Global Malaysians Forum - Posted: 19 February 2007 at 2:18pm


I was spending my whole day, watching economic/market oriented - VCDs/DVDs, reading some books and magazines, researching the internet to find good 'historical' articles for my reference. All these efforts have led me towards a bunch of interesting reminders about 'when things go wrong'. Among others :

a) 1929 - Stock market crash. - Briefly -

The stock market crash ushered in the Great Depression. Causes :

Abstract

Capital - tools to produce things of value out of raw materials e.g. Buildings and machines. A factory is a building with machines for making valued goods. Later capital was represented by stocks. A corporation owned capital. Ownership of the corporation in turn took the form of shares of stock. Each share of stock represented a proportionate share of the corporation. The stocks were bought and sold on stock exchanges i.e. NYSE located on Wall Street in Manhattan.

1920 - 1929 - a long boom took stock prices to peaks never before seen - stocks more than quadrupled in value. Many investors became convinced that stocks were a sure thing and borrowed heavily to invest more money in the market. 1929 - the bubble burst and stocks started down an even more precipitous cliff. In 1932 and 1933, they hit bottom, down about 80% from their highs in the late 1920s. This had sharp effects on the economy. Demand for goods declined because people felt poor because of their losses in the stock market. New investment could not be financed through the sale of stock, because no one would buy the new stock. Also, it has created chaos in the banking system as banks recovering loans made to investors whose holdings were now worth little or nothing at all. Worse, many banks had themselves invested depositors' money in the stockmarket. When word spread that banks' assets contained huge uncollectable loans and almost worthless stock certificates, depositors rushed to withdraw their savings. Unable to raise fresh funds from the Federal Reserve System, banks began failing by the hundreds in 1932 and 1933. Franklin D. Roosevelt became president in March 1933, the US banking system had largely ceased to function. Depositors had seen $140 billion disappeared when their banks failed. Businesses could not get credit for inventory. Checks could not be used for payments because no one knew which checks were worthless and which were sound. Roosevelt closed all the banks in the United States for three days - a "bank holiday." Some banks were then cautiously re-opened with strict limits on withdrawals. Eventually, confidence returned to the system and banks were able to perform their economic function again. To prevent similar disasters, the federal government set up the Federal Deposit Insurance Corporation, which eliminated the rationale for bank "runs" - to get one's money before the bank "runs out." Backed by the FDIC, the bank could fail and go out of business, but then the government would reimburse depositors. Another crucial mechanism insulated commercial banks from stock market panics by banning banks from investing depositors' money in stocks.

b) Black Monday 1987

Black Monday is the name given to Monday, October, 19, 1987., when the DJIA fell dramatically, and on which similar enormous drops occurred across the world. By the end of October, stock markets in Hong Kong had fallen 45.8%, Australia 41.8%, the UK 26.4%, the US 22.68%, and Canada 22.5%. (The terms Black Monday and Black Tuesday are also applied to October 28 and 29, 1929, which occurred after Black Thursday on October 24, which started the Stock Market Crash of 1929)

A certain degree of mystery is associated with the 1987 crash. Many have noted that no major news or events occurred prior to the Monday of the crash, the decline seeming to have come from nowhere. Important assumptions concerning human rationality, the efficient market hypothesis, and economic equilibrium were brought into question by the event. Debate as to the cause of the crash still continues many years after the event, with no firm conclusions reached.

In the wake of the crash, markets around the world were put on restricted trading primarily because sorting out the orders that had come in was beyond the computer technology of the time. This also gave the Feds and other central banks time to pump liquidity into the system to prevent a further downdraft. While pessimism reigned, the market bottomed on October 20, leading some to label Black Monday a "selling climax", where the excess value was squeezed out of the system.

Causes

In 1986, US economy began shifting from a rapidly growing recovery to a slower growing expansion, which resulted in a "soft landing" as the economy slowed and inflation dropped. As 1987 wore on, it seemed that recessionary fears were not warranted and that boom times would continue. The stock market advanced significantly, peaking in August 1987. There were a series of volatile days that caused widespread nervousness leading up to the crash, with the market ultimately sliding downward. In late August some observers warned that technical analysis indicated the market was now in a cyclical "bear" mode. However, this view was not widely subscribed to even as the market traded wildly. Potential causes for the decline include program trading, overvaluation illiquidity & market psychology.These theories might explain why the crash occurred on October 19 and not some other day, why it fell so far and fast, and why it was international in nature and not unique to American markets.

The most popular explanation for the 1987 crash was selling by program traders. Program trading is the use of computers to engage in arbitrage & portfolio insurance strategies. Through the 1970s and early 1980s, computers were becoming more important on Wall Street. They allowed instantaneous execution of orders to buy or sell large batches of stocks & futures. After the crash, many blamed program trading strategies for blindly selling stocks as markets fell, exacerbating the decline. Some economists theorized the speculative boom leading up to October was caused by program trading, while others argued that the crash was a return to normalcy. Either way, program trading ended up taking the majority of the blame in the public eye for the 1987 stock market crash. Economist Richard Roll believes that the international nature of the stock market decline contradicts the argument that program trading was to blame. Program trading strategies were used primarily in the United States, Roll writes. If program trading caused the decline, why would markets where program trading was not prevalent, such as Australia and Hong Kong, have declined as well? Although these markets might have been reacting to excessive program trading in the United States, Roll points to observations that would indicate otherwise. The crash began on October 19 in Hong Kong, spread west to Europe, and hit the United States only after Hong Kong and other markets had already declined by a significant margin.

Another common theory states that the crash was a result of a dispute in monetary policy between the G-7 industrialized nations, in which the United States, wanting to prop up the dollar and restrict inflation, tightened policy faster than the Europeans. The crash, in this view, was caused when the dollar-backed Hong Kong stock exchange collapsed, and this caused a crisis in confidence. Jude Wanniski stated that the crash happened because of the breakup of the Louvre Accord, a monetary pact between the US, Japan, and West Germany to keep currencies stable. Just prior to the crash, Alan Greespan had said that the dollar would be devalued.

Another theory is that the Great Storm of 1987, which happened on the Friday before the crash, helped contribute to it. In 1987 there was no Internet trading, and brokers had to physically get to work in the City of London in order to do their deals. On Friday, October 16, many routes into London were closed and consequently many traders were unable to reach their offices in order to close their positions at the end of the week. This made many people nervous on both sides of the Atlantic and there were certainly some traders who believed at the time that this acted as the trigger for the panic selling which took place on Black Monday. Panic selling in London and New York, the biggest stock markets in the world, then affected other markets around the world, creating a global stock market crash.

Yet another theory for the 1987 crash was the random placement of sell orders in a sufficiently small time interval as to cause a sudden decline in the indices, leading to a cascade effect of further sell orders. In the days preceding the actual Black Monday crash the markets began to sell off, beginning with a sudden 5% selloff on Wednesday, three days before the actual crash. Prior to that Wednesday, the trend for the Nasdaq/DJIA was stable, and undergoing what could be interpreted as a normal correction. If one were to zoom in on Wednesday one would notice normal trading activity and then an abrupt 1% intra-day drop. This drop could have been triggered by randomly placed sell orders that happened to all trigger at once. Although the odds of this happening are very slim, there is a probability that sufficient random sell orders placed by institutions, insiders, and the like will trigger a cascade effect should enough sell orders be placed in a small enough time interval.

The initial small 1% selloff caused by the 'clumped' random sell orders may have prompted trend traders to liquidate their positions, resulting in a larger decline that simply fed on itself like a domino effect, ultimately leading to the 26% crash of Black Monday.

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Others were 1998 Currency Devaluation, Post 9/11 Market Effects etc.

These 'dark' events serve as great reminders for us to be extra careful of rosy events.

The question now : "What lessons have we learned?"