A repeat of the 1987 stock markets crash may not be imminent, but there are danger signs, warns Tony Dye
In 1988, I wrote about the 1987 stock market crash on Wall Street and in the City of London. Here is an extract, predicting that people would not learn from their mistakes in the financial sector and would repeat them. While hardly prescient, the point is illustrated by comparing markets now with those of 1987:
“Perhaps the most important feature of 1987 was how rational individuals’ behaviour became seriously impaired when involved with the stock market crowd. The self- feeding boom in equities was thought capable of perpetual upward motion, despite the fact that, from an historical perspective, equities were more highly valued than ever. Talk of economic miracles – always a dangerous sign – was rife.
“Everyone claimed to know that the market was expensive, and the [investment managers’] justification for not taking action focused on the short-term pressures created by the pension fund league tables [of performance].
“The excuse of ‘we couldn’t afford not to run with the herd’ was often used to justify the increase in equity investment ahead of a crash, with a footnote of ‘even though we knew the market was overvalued’. Some even went so far as to say that, because of the crash, they would not behave in this fashion again – in other words, that they had learned from the crash.
“There is almost no limit to the extrapolation of a market trend if all conditions appear favourable. Markets will continue to be driven to the depths of despair and the pinnacles of ecstasy, as will individual shares.”
In 1987, it appears that the closure of the American market was narrowly averted by the intervention of the Federal Reserve Board. The result that such a closure would have had is hard to imagine, but a domino effect in other financial markets would have been inevitable. The stewards’ inquiry, in the form of the Brady Presidential Task Force on Market Mechanisms, said that “regulatory structures designed for separate market places were incapable of dealing with a precipitate intermarket decline which brought the financial system to the brink”.
“Caps” and “collars” were introduced in an attempt, so far successful, to prevent the market being overwhelmed by any recurrence of the sudden desire to sell. It is quite likely that these mechanisms may lead to the precise problems they are designed to prevent by prohibiting certain types of trading during market downturns, thereby creating a backlog of urgent sellers and exacerbating a fall.
Oddly enough, the market least affected by the crash – Japan’s -suffered more in the long term. The great bull market in that country during the mid- to late-1980s led to a belief that Japan was different. Equities held up better because of the strong influence of the financial authorities on investors, and the Japanese miracle continued for another two years, finally peaking in 1989. Since then, the market has fallen by more than 55%, and the economy has had, and continues to have, a tough time.
The received wisdom regarding Japan has undergone a stark change: fted as the economy best able to deliver long-term growth, it now seems to suffer from incurable long-term problems.
Other markets in countries within the ambit of the Organisation for Economic Co- operation and Development (OECD) have recovered from the 1987 losses, and are now at record levels – having given very good returns, even from the pre-crash level. In fact, the United Kingdom market has doubled and America’s trebled.
Could an event like the 1987 crash happen again? The answer must be yes, but it is unlikely. There have only been two crashes this century -OECD markets in 1929, and almost everywhere in 1987. Normal downturns are lengthy, with periods of recovery followed by larger falls. The “bear'” markets in Japan, starting in 1989, and Europe and the United States in 1972, followed this pattern. Falls of 40% or more happened over a period of 18 months.
A prolonged drop in equity prices is likely because today’s markets are much more highly valued than they were in 1987.
Yields on equities are at a record low. There are a number of factors involved in this optimistic pricing of equity assets, but these are the most notable:
* Profits growing faster than gross domestic product (GDP);
* Falling inflation;
* The public being drawn into the stock market;
* Effective firefighting of problems by central banks.
Just as in Japan in the late 1980s, in the US the belief has grown that equities are risk-free investments. The flood of money into mutual funds [unit trusts] has been extraordinary – over $900-billion in the last five years. By comparison, during 1987, $30-billion was invested in mutual funds, equal to merely a good month’s inflow during this year.
Public exposure to financial assets is at unprecedented levels in the US, and cash is at an all-time low in personal balance sheets. European markets have been heavily influenced by American factors via relative valuations of similar companies and the growing offshore investment the Americans have made.
Last but not least has been the continuing growth in derivatives at an exponential rate, providing leverage without using money borrowed from a bank.
Keynes, the great economist, said: “Speculators may do no harm as bubbles on a steady stream of enterprise, but the situation is serious when enterprise becomes the bubble on a whirlpool of speculation.”
In 1987, equity markets were highly priced, although profits as a share of GDP were not. In 1997, equities are highly priced at a time of high profits – always the most dangerous situation for financial markets.
What is obvious today is that equity markets are larger, relative to GDP, than in 1987 – and derivatives exposure is vastly greater, relative to the size of the market, than in 1987. In Keynes’s terms, we appear to have speculation in equity markets and further speculation in derivatives.
Equity markets are much more highly valued relative to GDP, asset, cash flow, dividend yields and company earnings than they were in 1987. Yields are at historic lows -1,75% on the world index.
Markets are, therefore, much more risky, and prospective returns are well below average. Although a crash is statistically unlikely, a bear market seems highly probable. Harbingers in the Asian tigers and Japanese markets are being ignored by many investors elsewhere, at least for the time being.
Alan Greenspan, chair of the US Federal Reserve Board, suggested recently that the laws of supply and demand in the labour market have not been repealed.
It is unlikely that the laws of economics have been repealed, either. Unfortunately, current valuations in European and US stock markets are suggesting that they have.
— Tony Dye is head of investments at PDFM, one of the UK’s largest pension fund managers