Overvaluation
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Many people believed the crash should be attributed to the overvalued nature of markets that week. The S&P 500 price earnings ratio, a standard measure of market valuation, had reached 19 by the week of the crash, up from 10 only two years before. A high PE ratio meant that the average price of a U.S. listed stock had expanded much faster than its corresponding earnings. Without fundamental justification to back them up, stock prices had no choice but to tumble. In a survey conducted by Robert Shiller just after the crash, 71.7% of individual investors and 84.3% of institutional investors reported that they thought the market was overpriced prior to the decline.

There are many problems with this argument. First, determining the value of the market is more art than science. As of yet, I haven't heard of a scientifically accepted standard definition of overvaluation. If we say that the market considered the 19 PE ratio on the S&P the month of the crash as overvalued, and that overvalued conditions caused the crash, than instances of a PE over 19 in the past should have also caused a crash. Looking back into the market's history shows that the PE was over 19 in the early 60's and the early 70's, yet a crash was not provoked. Slow and steady selloffs were the result, not 23% crashes. If we loosen our rule and say that each instance of PE ratio over 19 resulted in decreasing markets, (a sensible statement) than the question is begged - what caused 1987 to decrease so much further and faster than any other occasions? There can only have been something specific to 1987 that differentiated it from other periods of overvaluation, something additional in the market mentality that caused investors to be more sensitive than before to a high PE ratio.

There is also the timing issue. If the market was overvalued on October 19, 1987 and a crash was the result, why did the market not crash on October 16, when it was also considered overvalued, or the 15th, the 14th, or any day in August when it traded with an even higher PE ratio? Overvaluation fails to explain the question of timing.

I don't doubt that markets were overvalued on October 19th. But we must look beyond overvaluation, for it explains little. Of the five problems a solution must explain, the overvaluation argument only answers the fourth, why the crash was international in scope. It is unable to account for the timing of the crash, its size, and speed of its fall. Valuation was a feature of the 1987 market, not a cause. It is necessary to dig deeper into what convinced investors to suddenly become hyper-sensitive to this feature where before they hadn't, and why they chose to act on that precise Monday.


  JPK and Lope
2002