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U.S. Stock Market Crashes

The Crash of 2000

From 1992-2000, the markets and the economy experienced a period of record expansion. On September 1, 2000, the NASDAQ traded at 4234.33. From September 2000 to January 2, 2001, the NASDAQ dropped 45.9%. In October 2002, the NASDAQ dropped to as low as 1,108.49 - a 78.4% decline from its all-time high of 5,132.52, the level it had established in March 2000.

Causes of the Crash:

1. Corporate Corruption. Many companies fraudulently inflated their profits and used accounting loopholes to hide debt. Corporate officers enjoyed outrageous stock options that diluted company stock;
    
2. Overvalued Stocks. There were numerous examples of companies making significant operating losses with no hope of turning a profit for years to come, yet sporting a market capitalization of over a billion dollars;
    
3. Daytraders and Momentum Investors. The advent of the Internet enabled online trading –a new, quick, and inexpensive way to trade the markets. This revolution led to millions of new investors and traders entering the markets with little or no experience;
    
4. Conflict of Interest between Research Firm Analysts and Investment Bankers. It was common practice for the research arms of investment banks to issue favorable ratings on stocks for which their client companies sought to raise capital. In some cases, companies received highly favorable ratings, even though they were actually in serious financial trouble.

A total of 8 trillion dollars of wealth was lost in the crash of 2000.

Following the Crash:

1. New Rules for Daytraders. Under the new rules that were introduced, investors need at least $25,000 in their account to actively trade the markets. In addition, new restrictions were also placed on the marketing methods daytrading firms are allowed to use;
    
2. CEO and CFO Accountability. Under the new regulations, CEOs and CFOs are required to sign-off on their statements (balance sheets). In addition, fraud prosecution was stepped up, resulting in significantly higher penalties;
    
3. Accounting Reforms. Reforms include better disclosure of corporate balance sheet information. Items such as stock options and offshore investments are to be disclosed so that investors may better judge if a company is actually profitable;4. Separation between Investment Banking and Brokerage Research. A major reform was introduced to avoid conflicts of interest in the financial services industry. A clear split between the research and investment banking arms of brokerage houses was mandated.

The Crash of 1987

The markets hit a new high on August 25, 1987 when the Dow hit a record 2722.44 points. Then, the Dow started to head down. On October 19, 1987, the stock market crashed. The Dow dropped 508 points or 22.6% in a single trading day. This was a drop of 36.7% from its high on August 25, 1987.

Causes of the Crash:

1. No Liquidity. During the crash, the markets were not able to handle the imbalance of sell orders;
    
2. Overvalued Stocks;
    
3. Program Trading and the Use of Derivative Securities Software. Large institutional investment companies used computers to execute large stock trades automatically when certain market conditions prevailed. Some analysts claim that the program trading of index futures and derivatives securities was also to blame.

During this crash, 1/2 trillion dollars of wealth were erased.

Following the Crash:

1. Uniform Margin Requirements. New margin requirements were introduced to reduce the volatility for stocks, index futures, and stock options;
    
2. New Computer Systems. Stock exchanges changed to new computer systems that increase data management effectiveness, accuracy, efficiency, and productivity;
    
3. Circuit Breakers. The New York Stock Exchange and the Chicago Mercantile Exchange instituted a circuit breaker mechanism, which halts trading on both exchanges for one hour should the Dow fall more than 250 points in a day, and for two hours, should it fall more than 400 points.

The Crash of 1929

On September 4, 1929, the stock market hit an all-time high. Banks were heavily invested in stocks, and individual investors borrowed on margin to invest in stocks. On October 29, 1929, the stock market dropped 11.5%, bringing the Dow 39.6% off its high.

After the crash, the stock market mounted a slow comeback. By the summer of 1930, the market was up 30% from the crash low. But by July 1932, the stock market hit a low that made the 1929 crash. By the summer of 1932, the Dow had lost almost 89% of its value and traded more than 50% below the low it had reached on October 29, 1929.

Causes of the Crash:

1. Overvalued Stocks. Some analysts also maintain stocks were heavily overbought;
    
2. Low Margin Requirements. At the time of the crash, you needed to put down only 10% cash in order to buy stocks. If you wanted to invest $10,000 in stocks, only $1,000 in cash was required;
    
3. Interest Rate Hikes. The Fed aggressively raised interest rates on broker loans;
    
4. Poor Banking Structures. There were few federal restrictions on start-up capital requirements for new banks. As a result, many banks were highly insolvent. When these banks started to invest heavily in the stock market, the results proved to be devastating, once the market started to crash. By 1932, 40% of all banks in the U.S. had gone out of business.

In total, 14 billion dollars of wealth were lost during the market crash.

Following the Crash:

1. The Securities and Exchange Commission (SEC) was established;.
    
2. The Glass-Stegall Act was passed. It separated commercial and investment banking activities. Over the past decade though, the Fed and banking regulators have softened some of the provisions of the Glass-Stegall Act;
    
3. 3. In 1933, the Federal Deposit Insurance Corporation (FDIC) was established to insure individual bank accounts for up to $100,000.

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