Market Volatility

As we’ve seen in the past, the market doesn’t always respond in the manner investors would like.  The stock market crashes of 1929 and 1987 are good examples of this.  But what causes these sharp dips in the market?  Is it simply investors’ response in creating an efficient market?  Or is it more complex than this?  I will illustrate a complicated answer with an example.

The crash of 1987 heralded some distinct warning signs of imminent disaster.  For one, the US dollar was overvalued in the mid-1980s.  When the dollar’s value began falling, the Federal Reserve interfered in order to stabilize the dollar.  Instead of solving the problem, however, it only worsened.  Rising interest rates were introduced to help keep foreign investors interested in the US market.  Despite the fact that there was no inflation (yet), rates rose up above 10%.  It took several months for the market to respond to this.  By the end of August of 1987, the Dow Jones was at an all-time high.  When the market finally did respond, it did so harshly.  The market experienced a larger one-day drop than it did in 1929.

Why did this happen?  Did market investors respond too sharply to the concerns of rising interest rates?  Studies show that the market is too variable to be explained solely by dividend and interest rate behavior.  The logical answer points to something known as a cycle.  A cycle is characterized by fluctuating prices that resemble a sine wave.  Basically, this is the case because when prices reach a specific low point, more investors jump into the market, pushing prices upwards.  Once prices reach a certain level, investors exit the position fearing that their position is overvalued.  This leads to the ups and downs that define the cycle.  Of course, as you will notice by looking at any stock chart, the cycle is not as clear-cut as this.  There are many unpredictable mini-ups and downs within the overarching trends.  These are discussed in detail in other articles.

Unlike the 1929 crash, the crash of 1987 did not have many long-lasting effects.  The market rebounded relatively quickly, by August, 1989, the market was at a new high.  This is because the Federal Reserve flooded the market with an increase in the money supply.  Unlike the crash that led to the Great Depression, the 1987 crisis spelled opportunity for many investors by allowing them to invest in the market at ultra-low prices.

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