MUST IT COME DOWN SOON?
And if so, how soon? Mark Archer tries
to answer the one big question about the stock market
INVESTORS are expecting it, William Rees-Mogg is predicting it, even Old Moore's Almanac is forecasting it, but is the great stock market crash going to happen? As a rule, when confidence in share prices hits an all-time high, when no one dares leave a penny uninvested, crashes tend to follow. But when as now almost everyone has raised cash in anticipation of the crash, so as to be able to buy shares at lower prices, stock markets rarely oblige. Just before the Polish market halved in 1994, having risen an extraordinary 894 per cent the previous year, War- saw taxi drivers would tell one how they were And yet stock markets keep rising. Both the British and American markets, for instance, have rallied strongly after their New 50- and 100-point falls early in the 'New Year. Indeed, 1996 was generally a good year for stock markets, with Wall Street up over 22 per cent, London up 16 per cent, most European bourses up over 20 per cent and Hong Kong up 33 per cent. By choosing to leave the party early, how- ever, British investment managers provided decent but far less spectacular returns for pension fund trustees in 1996. Have they been prudent — or recklessly conservative? It is certainly hard to find cause for gloom in the economic outlook. The OECD expects all its 29 member countries to enjoy growth this year, the first time they have done so together since 1985. Better still, the developing countries of Latin America and Asia will join in the fun, along with the transition economies of Eastern Europe and Russia. Not since before the first world war have virtually all rich and poor countries simultaneously enjoyed strong sustained growth. The OECD also expects the average world inflation rate to fall to its lowest level for 30 years. Even Brazil, famous for its hyperinflation, had an annual inflation rate below 10 per cent in December for the first time since the 1950s.
Of course, history teaches that stock market crashes are rarely influenced by good news. This is why bear markets that is, prolonged falls in share prices start so mysteriously; they almost always originate in a climate of unparalleled eco- nomic optimism. Since the second world war, bear markets have begun in the fol- lowing years in which American companies announced record profits: 1946, 1966, 1968, 1973 and 1976. Earlier in the century, peak profits were recorded in 1902, 1906 and 1916; bear episodes started in each. In 1929 in America, company profits set a peace- time record. President Herbert Hoover told the nation on Fri- day, 25 October, 'The fundamental business of the country . . . is sound.' By 13 Novem- ber, in little under three weeks, the market had fallen 39 per cent. The Wall Street crash remains the swiftest and largest decline ever recorded in stock mar- ket history.
Why do crashes hap- pen? At this point one should distinguish between bear markets and market panics. Bear markets are a nat- ural consequence of the economic cycle. For while panics offer no clue about the econom- ic future, bear markets have often correctly anticipated an eco- nomic downturn. Share prices are hardly a reliable guide in this respect, however. It is often said that the American stock market has correctly predicted 14 out of the last nine recessions. But even when the market was right, share prices usually began to decline about six months ahead of the recession. In each of the boom years for American company profits mentioned above, for instance, declining share prices correctly anticipated the drop-off in profits which occurred the following year. In most cases prices softened towards the end of the year as investors began to scale back their profit forecasts for the following year.
The most terrifying British bear market in most people's memory occurred in 1974. It began in 1973 with a traditional and, by most yardsticks, an understandable bear phase in which share prices fell roughly 15 per cent in response to higher interest rates and the prospect of slower economic growth following the 1972 'Barber boom'. By October the market had begun to recov- er, only for it to be hit by the Gulf States' decision to raise the oil price and impose restrictions on supplies to the West. All world markets fell in late 1973, with heavy energy users such as the motor industry being among the hardest hit. London fell 25 per cent in the six weeks to mid-October as the recessionary consequences of Opec's move became apparent.
Between mid-December 1973 and the general election at the end of February, share prices actually rose by 10 per cent, reflecting the belief that election would give the Conservatives a mandate to impose statutory controls on the trade unions and so solve the industrial relations problem. What followed in 1974 was entirely political. In the month following the Labour victory on 28 February 1974, shares fell 22 per cent before recovering and moving sideways until May. The next seven months then saw the worst period in London stock market history, during which the stock market, already 44 per cent down from its peak, halved again.
The causes were clear. The Conserva- tives had failed to solve the problems of the `British disease'; Labour was in the hands of the trades unions and incapable of con- trolling inflation. With 20 per cent infla- tion, most companies forced by company tax law to declare profits on goods held as stock or working capital would be bankrupted. In August, Tony Benn, the Secretary for Industry, published a White Paper, The Regeneration of British Industry, setting out plans for extending state owner- ship and control (unspecified) of key sec- tors of industry. It was only too easy to believe that the government would use the low share prices and the financial predica- ment of industry as a means of cheap widespread partial nationalisation.
By the end of September, the market had fallen 40 per cent in five months. At this stage it yielded 10 per cent (compared with a historical average of 4.4 per cent) and the Industrial Group of companies was valued at less than five times their expected earn- ings for the following year (compared with a historical average of 14 times). Investors believed they had seen the bottom. The market paused for six weeks; then in mid- November it began a free-fall of 18 per cent in four weeks, faster than at any earli- er time. The fall was caused by panic, induced by rumours that many financial companies would be insolvent at the end of their financial year because of the depreci- ation in the value of their investment port- folios. The bottom came just before Christmas 1974, when a group of financial institutions decided to enter the market and buy on a large scale. There were no willing sellers left at this depressed level and, as everyone else who had been accumulating cash fol- lowed them into the market, in January 1975 prices rose even more dramatically than they had fallen. By the end of Jan- uary, shares had risen 65 per cent. The market did not pause until early March, by which time it had more than doubled. It was now within 10 per cent of the level of a year earlier, when a Conservative election victory had been expected.
Although these violent fluctuations look irrational today, they were justified by the prospects at the time. British industry real- ly was heading for bankruptcy and was only saved by the introduction of stock relief in November 1974 which protected profitable companies against inflation.
Panics, then, can coincide and overlap with bear markets. This occurred most notably in 1990, when shares fell 10 per cent in the first half of the year in anticipa- tion of the imminent recession. Panic set in in August, when Iraq invaded Kuwait; the oil price rose to $40 a barrel and shares fell 20 per cent in two months. This was a clas- sic panic, however, for with the onset of hostilities and the likelihood of an allied victory shares had risen more than 20 per cent by the following April.
Unlike bear markets, panics are sudden and irrational. They are generally short, intense and dramatic, wreaking their dam- age in days, even in hours. The five-day share price meltdown of 1987 was the most frightening financial experience since 1974, but the decline of 33 per cent was not sub- stantially greater than the now-forgotten bear market of 1979, when the Conserva- tives first introduced the tough economic measures which were to prompt a protest letter by 364 economists to the Times. October 1987 was a classic panic: searing in its intensity but not destructive for any length of time, for within a year the market had regained its highs. Likewise the panic of 1987 lacked any predictive quality. World economies continued to grow and the British economy did not enter recession until a good three years later. Indeed, according to this definition, the famous Wall Street crash of 1929 was just a 1987- type panic. President Hoover was right about the American economy and by April 1930 most shares had recovered almost all of their losses while some had gone on to reach new highs. But in 1930 real economic problems took hold worldwide. Protection- ist trade policies were adopted, Britain came off the Gold Standard, precipitating a sterling crisis, and America experienced a banking collapse. Although everyone remembers 1929, the worst year for the American stock market was 1931, when shares fell 53 per cent.
Panics can do as much damage as bear markets but share prices recover much more quickly. And in the present climate, in which most world stock markets have doubled and in some cases tripled in value over the last ten years, investors' nerves, not unnaturally, are stretched, making more frequent market panics virtually cer- tain. But if investment firms really are anticipating a major bear market, they should be raising serious cash in prepara- tion — not the 8 per cent which pension funds hold currently but something much more like 25 per cent.
The Cassandras predicting the onset of a major bear market fall into two camps. The William Rees-Mogg school sees the world still so saddled with the debts of the 1980s that the economic locomotive can hardly get going. Profits evaporate and share prices suddenly seem to be supported on air. The other camp believes the opposite, namely that world growth is suddenly going to accelerate, with the result that first infla- tion and then interest rates soar — thus causing a recession. But what will really happen? The likely outcome, at least for this year, is a continu- ation of the combination of moderate growth with subdued inflation which has so far been the happy medium between these two extremes. With the American econo- my, in the words of the head of the Ameri- can Central Bank, 'enjoying the best prospects for a generation', a prolonged bear market in share prices is unlikely.
In the 1980s there were many more eco- nomic problems threatening the American economy than there are today. They included large budget deficits, property speculation and high levels of company borrowing. Now, however, timely touches by the Central Bank on the interest rate tiller seem able to keep the economy on a course of steady growth. Share prices may always show signs of panic from time to time, not least because many new investors in America, who have started to invest through mutual funds, the equivalent of our unit trusts, have never known their shares to fall. A panic, prompted perhaps by a rise in interest rates or a slowdown in profits, could knock as much as 20 per cent off American share prices. Such a fall would only return shares to where they were at the start of 1996, after which the benign economic outlook would reassert itself. Overall, then, the message stay invested. is simple:
Previous page
