There were some warning signs of excesses that were similar to excesses at previous inflection points. Economic growth had slowed while inflation was rearing its head. The strong dollar was putting pressure on U.S. exports. The stock market and economy were diverging for the first time in the bull market, and, as a result, valuations climbed to excessive levels, with the overall market’s price-earnings ratio climbing above 20. Future estimates for earnings were trending lower, but stocks were unaffected.
Under the Plaza Accord of 1985, the Federal Reserve agreed with the central banks of the G-5 nations–France, Germany, the United Kingdom, and Japan–to depreciate the U.S. dollar in international currency markets in order to control mounting U.S. trade deficits. By early 1987, that goal had been achieved: the gap between U.S. exports and imports had flattened out, which helped U.S. exporters and contributed to the U.S. stock market boom of the mid-1980s.
In the five years preceding October 1987, the DJIA more than tripled in value, creating excessive valuation levels and an overvalued stock market. The Plaza Accord was replaced by the Louvre Accord in February 1987. Under the Louvre Accord, the G-5 nations agreed to stabilize exchange rates around this new balance of trade.
In the U.S., the Federal Reserve tightened monetary policy under the new Louvre Accord to halt the downward pressure on the dollar in the second and third quarters of 1987 leading up to the crash. As a result of this contractionary monetary policy, growth in the U.S. money supply plummeted by more than half from January to September, interest rates rose, and stock prices began to fall by the end of the third quarter of 1987.
Market participants were aware of these issues, but another innovation led many to shrug off the warning signs. Portfolio insurance gave a false sense of confidence to institutions and brokerages. The general belief on Wall Street was that it would prevent a significant loss of capital if the market were to crash. This ended up fueling excessive risk-taking, which only became apparent when stocks began to weaken in the days leading up to that fateful Monday. Even portfolio managers who were skeptical of the market’s advance didn’t dare to be left out of the continuing rally.
Program traders took much of the blame for the crash, which halted the next day, thanks to exchange lockouts and some slick, possibly shadowy, moves by the Fed. Just as mysteriously, the market climbed back up towards the highs from which it had just plunged. Many investors who had taken comfort in the ascendancy of the market and had moved towards mechanical trading were shaken up badly by the crash.