Twelve steps to market meltdown
Stephen Vines says stock markets may seem wildly volatile at times of crisis, but they always follow a pattern At times of financial crisis there is often a feeling that all the old certainties have been blown away. But what is striking about the entire history of stock-market crises is that they fall into a pattern — and this pattern makes it possible to make broad predictions about the panic cycles that have been remarkably consistent for more than a century.
American experts have dominated the sub-genre of identifying panic cycles, notably the market historian Charles Kindleberger and the economist Hyman Minsky. Based on their work, it is possible to identify the stages of the cycle — but not, to pre-empt the obvious question, to know exactly when it will end. So, here’s a 12-point guide.
Stage 1: all cycles can be said to begin with buoyant equity markets fuelled by a major development which stimulates at least one sector of the economy. In recent memory, one such stimulus was the development of the internet that led to the dotcom boom. In the most recent cycle the stimulus was clearly provided by the provision of cheap and plentiful credit to businesses and individuals, largely as a consequence of US monetary policy.
Stage 2: what all these stimuli have in common is that they lead to the expansion of money supply and of bank credit — spectacularly so in the current period. Stage 3: the cash swilling around the system induces irrational euphoria, producing heavy speculation and excessive borrowing. Stage 4: the entry of large numbers of market novices into the stock market is the most visible characteristic of this next stage. Tales of fortunes made stimulate even greater risk-taking, combined with a reckless belief that this time it will be different. The classic example was the statement by Irving Fisher, the renowned Yale University professor, who said, just ahead of 1929 crash, ‘Stock prices have reached what looks like a permanently high plateau.’ It took two and a half decades for that plateau to be reached again.
Stage 5: once stock-market news, and news of property prices, moves from the business pages of newspapers to the front pages, the die is cast. Stage 6: as the market heats towards boiling point, there is increasing detachment between stock prices and the underlying value of the assets they rep resent. Shares trade on daunting price-earnings ratios and ‘old-fashioned’ ideas such as the relationship of share prices to their yields — that is, their dividend payments — are widely scoffed at. Stage 7: as investors scramble for shares, issuers obligingly produce all kinds of new issues to cater for this demand. As demand for conventional financial instruments rises, new and ingenious derivatives are brought to the market, allegedly for the benefit of more sophisticated investors. But the truth is that they become so complex that even so-called professionals have trouble understanding them. The key problem here is that these derivatives are, almost by definition, margin plays: as the bubble begins to burst there is a rapid and brutal demand for repayment by lenders who have funded the growth of the derivatives markets.
Stage8: things start unravelling as a number of outright scams and dubious practices come to light. Stage 9: the more savvy investors start making their way out of the market, while newer players fret and wonder what to do. As prices fall, lending institutions become more insistent on repayment of loans and make conditions more onerous, forcing sales of assets, which leads to greater downward pressure on prices. Stage 10: the downward plunge of prices is in full flight. There is a scramble for the exit and the price of good assets tumbles alongside the weak. Usually there is a specific incident that greatly exacerbates this flight. History may well record that in the current crisis it was the collapse of Lehman Brothers.
Stage 11: there is now widespread revulsion towards the very assets which once basked in the sunlight. Hence the word ‘dotcom’ became a term of investor abuse at the end of the internet boom, and nowadays the same odium attaches itself to the concept of subprime lending, once the joy of Alan Greenspan and his merry band of market deregulators and money-supply boosters.
Finally, Stage 12: we have now reached the most problematic stage of all, when markets appear to be in free-fall and minds turn to recovery as seemingly irresistible bargains start to emerge. This stage of the panic cycle contains a number of false dawns when, amid extreme market volatility, it may appear that the carnage is over. On 13 October this year, for example, the Dow Jones Industrial Average rose by 11 per cent, the second biggest percentage rise in the history of the index. In London on the same day, share prices rose by 8.3 per cent, the second biggest gain since 1987. Note that the most spectacular share price gains came during the depths of past crises: in America it was during the panic that started in 1929; in London it followed the Black Monday collapse of 1987. Incidentally, reporting of the present crisis is constantly marred by references to shares having suffered their sharpest price falls in history when in percentage terms today’s falls remain well below levels recorded during the 1987 crash.
So, it is extreme volatility that characterises the current stage of the financial crisis. But sadly, the past offers only limited guidance as to when recovery will set in. The severe crash of 1987 gave way to price increases of 10 per cent and above within a few days and rises of 20 per cent within eight months. The end of the dotcom boom in 2001 produced gains of 10 per cent within two months and a 20 per cent rise within six months. What can be said with tentative confidence is that recovery times from more recent crises have been shorter than in the past.
Looking for the bottom of the market is largely a futile task. Nathan Rothschild, one of the founders of the bank that bears his name, modestly used to say, ‘I never buy at the bottom and I always sell too soon.’ Even if he is taken at his word, this does not diminish his financial reputation, because practically no one has ever been clever enough to spot the peaks and troughs. Yet it is possible to identify trends.
The time to return to the market is generally marked by an end to extreme volatility; sure, the best bargains will have gone by then but so will the false dawns that lure in the witless, convinced that sharp price rises mean they need to rush back in the market. Investors with a really long-term perspective will simply wait until compelling valuations emerge on shares they think are trading at bargain basement levels, even if the basement keeps getting lower. That, basically, is the Warren Buffett view of share-buying. But interestingly, these days he’s less attracted by playing the stock market than by direct investment in undervalued companies.
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