An important lesson from the October 1987 crash

A comparison of the DJIA from 1922 - 1929 and 1980 - 1987 showed an uncanny similarity between these two bull markets. On October 19, 1987, we witnesse d the greatest 1-day drop in the stock market history, exceeding the great crash of October 29, 1929. In fact, the market in 1987 continued to trade like 1929 for the remainder of the year. Many forecasters, citing the similarities between the two periods, were certain that disaster loomed and advised their clients to sell everything.

However, the similarity between 1929 and 1987 ended at year's end. The stock market recovered from its October 1987 crash and by August of 1989, hit new high ground. In contrast, 2 years after the October 1929 crash, the Dow, in the throes of the greatest bear market in U.S. history, had lost more than two-thirds of its value and was about to lose two-thirds more.

What was different? Why did the eerie similarities between these two events finally diverge so dramatically?

The simple answer is that in 1987 the central bank had the power to control the ultimate source of liquidity in the economy - the supply of money - and, in contrast to 1929, did not hesitate to use it. Heeding the painful lessons of the early 1930s, the Federal Reserve temporarily flooded the economy with money and pledged to stand by all bank deposits to ensure that all aspects of the financial system would function properly.

The public was reassured. There were no runs on banks, no contraction of the money supply, and no deflation in commodity and asset values. Indeed, the economy itself moved upwards despite the market collapse. The October 1987 stock market crash taught investors an important lesson - that a crisis can be an opportunity for profit, not a time to panic.