What Do the Black Monday Crash of 1987 and the Tech Crash of 2000 Tell Us About the Efficient Market Hypothesis?
On October 19, 1987, dubbed “Black Monday,” the Dow Jones Industrial Average declined more than 20%, the largest one day decline in U.S. history. The collapse of the high tech companies’ share prices from their peaks in March 2000 caused the heavily tech laden NASDAQ index to fall from around 5,000 in March 2000 to around 1,500 in 2001 and 2002, for a decline of well over 60%. These two crashes have caused many economists to question the validity of the efficient market hypothesis. They do not believe that an efficient market could have produced such massive swings in share prices. To what degree should these stock market crashes make us doubt the validity of the efficient market hypothesis? Nothing in the efficient market hypothesis rules out large changes in stock prices. A large change in stock prices can result from new information that produces a dramatic decline in optimal forecasts of the future valuation of firms. However, economists are hard pressed to come up with fundamental changes in the economy that can explain the Black Monday and tech crashes. One lesson from these crashes is that factors other than market fundamentals probably have an effect on stock prices. Hence these crashes have convinced many economists that the stronger version of the efficient market hypothesis, which states that asset prices reflect the true fundamental (intrinsic) value of securities, is incorrect. They attribute a large role in determination of stock prices to market psychology and to the institutional structure of the marketplace. However, nothing in this view contradicts the basic reasoning behind the weaker version of the efficient market hypothesis—that market participants eliminate unexploited profit opportunities. Even though stock market prices may not always solely reflect market fundamentals, this does not mean that the efficient market hypothesis does not hold. As long as stock market crashes are unpredictable, the basic lessons of the theory of rational expectations hold. Some economists have come up with theories of what they call rational bubbles to explain stock market crashes. A bubble is a situation in which the price of an asset differs from its fundamental market value. In a rational bubble, investors can have optimal forecasts that a bubble is occurring because the asset price is above its fundamental value but continue to hold the asset anyway. They might do this because they believe that someone else will buy the asset for a higher price in the future. In a rational bubble, asset prices can therefore deviate from their fundamental value for a long time because the bursting of the bubble cannot be predicted and so there are no unexploited profit opportunities. However, other economists believe that the Black Monday crash of 1987 and the tech crash of 2000 suggest that there may be unexploited profit opportunities and that the theory of rational expectations and the efficient market hypothesis might be fundamentally flawed. The controversy over whether capital markets are efficient continues.