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Chicago Fed Letter

Bubble, bubble,toil and trouble'The October 19th stock market crashspilled more printer's ink than anyother economic event of the 1980s, yetby all accounts the economy hardlynoticed. The real economy just keptgrowing. Real GNP growth actuallyexceeded 6% on an annual basis in thequarter the Crash occurred and has re-mained above 3% since. Unemploy-ment as of September stands at 5.4%,more than half a point lower than itdid on October 19, 1987. In fact, ig-noring the carnage on Wall Street, theCrash's major impact may have beento dempen slightly a somewhat overex-

uberant economy.

How can that be? Memories of theCrash of 1929 and the decade that fol-lowed are some of the most traumaticin U.S. history. Yet today, lastNovember's rush of recession forecastsseems at best overblown. In retrospect,the reasons for this difference are actu-ally quite simple:

• Policymakers have learned a greatdeal about the management of finan-cial panics—they steadfastly refused to addto the panic by overresponding.

• Markets are far better able to shiftfunds around to accommodate investorsrunning for cover than they were in1929—money exiting the stock market wasquickly recirculated into the debt markets,preventing a credit crunch.

• And lastly, a large part of the lossin equity value between the Augustpeak and October 20th (see Figure 1)may simply have burst what economistscall a speculative bubble—the market fellbecause it was too high.

The real questions that confront us ayear later are, What damage to theU.S. financial markets is concealed un-

derneath the current calm? And, Howshould we proceed from here?

The purpose of financial markets

The primary role of the financial mar-kets in terms of the day-to-day businessof producing goods and services is toprovide new funds so that firms canbuild plants and buy equipment. Theday-to-day shifting of existing stock andbond certificates has little direct eco-nomic effect on U.S production. Thisobservation has led many critics ofWall Street and the Chicago futuresmarkets to suggest that these marketsare little more than very complicatedgambling casinos. Not so. The ongo-ing trading of existing assets is neces-sary to provide an efficient backdrop tothe real business of raising new capital.

The careful assessments of risk and re-turn done by market participants pro-vide a valuable and necessary startingpoint for evaluating new investment.It is precisely the lack of these assess-ments that makes venture capital fornew businesses in new industries so

much more expensive than other formsof new capital funding.

Further, the liquidity that active sec-ondary markets provide is essential. Iffirms must pay a higher return becauseinvestors may have trouble finding amarket for their stocks or bonds, lessinvestment will take place.

Similar reductions in investment willresult from any increase in perceivedmarket risks arising from the tradingprocess. For instance, after the Crashmany analysts suggested that programtrading might generate crashes withsome regularity. If such a belief werewidely held, investors would be lesswilling to hold stocks, thus impedingfirms' ability to raise new capital.

In assessing the fundamental, long-runimpact of the Crash, it is therefore na-tural to ask three questions. Has theCrash directly reduced firms' ability toraise funds? Has the Crash reduced theliquidity fundamental to a healthymarket? Has some other less tangiblefactor, such as a belief that a Crashcould happen again, created a new risk

thousands of new issues

equity dropof total new issues remain high

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premium that is raising the cost of newcapital?

Overall, our analysis indicates that theCrash has not had much impact onfirms' ability to raise new capital, butit has substantially changed the waythose funds are raised. Firms now findit more economical to raise fundsthrough the debt markets rather thanthe equity markets. Put another way,the Crash does seem to have damagedthe equity markets a little, but not thefinancial markets as a whole.

Raising capital after the Crash

Securities markets play a crucial role inpermitting firms to raise additionalcapital. While new issue activity hasdeclined since October 1987, it remainswell above levels that prevailed priorto 1986. The flow of new funds tobusinesses has not dried up.

Figure 2 shows the value of newly is-sued corporate debt and equity from1978 to present. From 1978 to 1986,total new issue volume grew fairlysteadily. During 1986, new issue ac-tivity boomed, and reached record lev-els in mid 1987. Immediately after theCrash, new issue activity dropped dra-matically, from $22 billion a month toabout $8 billion a month. While newissue activity has not returned to itspast peak, it has rebounded, and todayit remains well above historical levels.

their registrations but have yet to issuethe security.

While it is clear that new equity issueshave declined in importance since theCrash, it is less clear that this declinewill have an appreciable effect on theeconomy. Total new issue activity re-mains well above historical levels.Moreover, the declining relative im-portance of equity issues after the Crashmerely marks the continuation of atrend underway since 1983, a trendwhich so far has had no discernibleimpact on economic growth.

Financial market liquidity

A second issue is whether the Crash hasaffected financial market liquidity—theability to sell shares into the marketwithout affecting the market price.Trading volume can provide a roughindicator of market liquidity. TheCrash's medium-term impact on trad-ing volume in the stock market hasbeen minimal (see Figure 3). Duringthe first six months of 1987, over 22billion shares were traded on the NewYork Stock Exchange. The volume oftrading for the first six months of 1988was virtually the same.

While the volume of trading in the eq-uity market has been unaffected by theCrash, the same cannot be said for thetrading of stock index futures andoptions. Trading in the ChicagoMercantile Exchange's S&P 500 fu-

The Crash's impact on equity issuancealone has been more dramatic. In thefirst six months of 1987, equity issuesaccounted for 22% of total funds raisedthrough new issues. In the first sixmonths of 1988, equity issues accountedfor only 12% of new issues. This de-cline in the importance of equity islinked in large part to the cancellationof initial public offerings. According toa recent study, 229 businesses had beenscheduled to make initial public offer-ings in October of 1987. Of those 229firms, 55 actually went through withthe planned offering while 104 with-drew their public offerings. The re-maining 70 issuers have not withdrawn

points

Crash

Average expected pricemovement, S&P500

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1 /6/ 87 2/3 3/3 3/31 4/28 5/26 6/23 7/21 8/18 9/15 10/13 11/10 12/8 1/5/ 88 2/2 3/1 3/29 4/26 5/24 6/21 7/19'Implied volatilities derived from the S&P500 futures contract, and the S&P500 options contract, using the Black-Scholes options pricing model.

tures contract declined 40% betweenthe first six months of 1987 and the firstsix months of 1988.

There are at least two possible causesfor the loss of trading volume in thefutures markets: reduced reliance onportfolio insurance and increased mar-gins on stock index futures.

Before the Crash, stock index futuresplayed an important role in the portfo-lio insurance strategies of a number oflarge institutional investors. However,futures-based portfolio insurance re-quires that price differences betweenthe stock index futures contract and theunderlying basket of stocks remainsmall. Unfortunately for portfolioinsurers, this spread widened dramat-ically on October 19th and 20th.

The large spread between cash and fu-tures prices that developed during theweek of October 19th led many to re-consider portfolio insurance. This inturn reduced futures trading volume.

Changing margin requirements onstock index futures also reduced tradingvolume. Initial speculative marginrequirments on the S&P 500 futurescontract were $10,000 on October 16,1987. One year later, the initial mar-gin requirements on a speculative posi-tion were $20,000.

Hidden risk premiums

The Crash's impact on the long-termstability of the financial markets is dif-

ficult to assess. There have been manychanges since October 19th. The ma-jor securities exchanges, as well as themajor futures and options exchangesdealing in equity-based contracts, haveadopted a system of coordinated trad-ing halts. Margins on stock index fu-tures have been raised. Severalexchanges are working to pool data onthe risk position, and are exploring thepossibility of unified clearing.

The impact of these changes will haveon financial market stability is difficultto judge. However, it is possible to in-fer investors' fears of further largemovements in stock prices by lookingat options and stock price data. Thisis possible because the value of a stockoption increases as investors' expecta-tions of a large change in price in-crease. Figure 5 shows estimates of theaverage expected one-day change inthe price of the S&P 500 futures con-tract. The average expected pricechange increased rapidly in the weekbefore the Crash and remained wellabove pre-Crash levels through the firstquarter of 1988. Since that time, theaverage expected price movement hasreturned to its pre-Crash level. Thesetrends suggest that most of the uncer-tainty generated by the Crash has dis-sipated, making it unlikely that theCrash has created any permanent in-crease in the cost of capital.

Conclusions

The Crash has served to reinforce muchof what we already knew about the fi-

nancial markets and their relationshipto the real economy. We have seen, forexample, that any single part of thesystem can take a serious hit and thesystem can survive and even prosper.

No one can deny that a healthy finan-cial system is a fundamental require-ment for economic prosperity. But thecollapse of one firm or the disruptionof one market in today's diverse finan-cial system can only damage the systemif it sets off a general crisis in confidence.

The policies implemented by the Fed-eral Reserve, the Securities and Ex-change Commission, the CommodityFutures Trading Commission, and therest of the financial regulators provedequal to the task of maintaining calmand preserving the system. There maybe many good and even necessary re-forms that should be applied to theinternal functioning of the markets.But it is hard in retrospect to argue thatthe overall system was not up to thechallenges of October 1987.

Herbert L. Baerand Steven Strongin

1 This is not what Shakespeare's witchessay (Macbeth, Act 4, Scene 1). The au-thors have adapted the words to the occa-sion. They also thank Don Wilson, forproviding data on implicit stock volatility.

Karl A. Scheid, Senior Vice President andDirector of Research; David R. Allardice, VicePresident and Assistant Director of Research;Edward G. Nash, Editor.

Chicago Fed Letter is published monthly by theResearch Department of the Federal ReserveBank of Chicago. The views expressed are theauthors' and are not necessarily those of theFederal Reserve Bank of Chicago or the FederalReserve System. Articles may be reprinted if thesource is credited and the Research Departmentis provided with copies of the reprints.

Chicago Fed Letter is available without chargefrom the Public Information Center, FederalReserve Bank of Chicago, P.O. Box 834, Chicago,Illinois 60690, or telephone (312) 322-5111.

ISSN 0895-0164

MMI— Midwest Manufacturing Index

index, January 1973=100160

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U .S.Current performance:

August 1988percentage change from:month ago year ago

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Manufacturing activity in the nation rose slightly in August, following its strongestgrowth of the year just one month earlier. The slowdown was widespread amongboth durable and nondurable goods industries and was supported by other datashowing a slowing in the pace of growth in the national economy in August.

The Midwest Manufacturing Index was virtually unchanged in August, withabout half of the seventeen industries gaining and half declining from their Julylevel. The biggest gains occurred in the electrical equipment and instruments in-dustries, which is consistent with the continuing strength in business equipmentnationwide. Other durable goods industries, however, recorded modest declines.Most nondurable goods industries continued to advance in August.

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NOTE: The MMI is a composite index of 17manufacturing industries and is constructed froma weighted combination of monthly hours workedand kilowatt hours data. See "Midwest Manu-facturing Index: The Chicago Fed's new regionaleconomic indicator," Economic Perspectives, FederalReserve Bank of Chicago, Vol. XI, No. 5,September/October, 1987. The United Statesrepresents the Federal Reserve Board's Index ofIndustrial Production, Manufacturing.

Chicago Fed LetterFEDERAL RESERVE BANK OF CHICAGOPublic Information CenterP.O. Box 834Chicago, Illinois 60690(312) 322-5111

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