‘Observers attributed the lacklustre tone to the absence of any market-affecting news’.
Share prices had been slipping slightly, activity was very low, and the reason – we are told – was that there was no reason on this particular day for things to be otherwise.
The quotation comes from a report on the French stockmarket, but might have been written about other markets, too. News – good or bad – is what brings out the buyers and sellers. Without the buyers and sellers, there is no activity. Markets thrive on activity and for the professionals, the brokers and marketmakers who derive their living from market activity, no news is very definitely bad news.
But in London, where shares of over 2,000 UK and many overseas companies are traded, there is no such thing as a day without news, and even if there is not much going on in London there will be plenty happening in other markets that affect London. The daily stockmarket reports that feature in the financial pages of the press and the Internet record both the ups and downs of the markets and the movements of individual shares. At their best, when they give background information on reasons for price movements, they are essential reading. At their most turgid, they are simply a list of price movements in narrative form, stretching the writer’s imagination to find synonyms for ‘rose’ and ‘fell’. Most of what they contain is self-explanatory, but a few technical terms crop up. More serious, the general tenor may be difficult to grasp without some knowledge of the influences that move share prices.
Looking at the stockmarket from a turn-of-millennium perspective, there has as yet been no movement in share prices to compare in terms of drama with the events of 19 and 20 October 1987. The later 1997 crisis in the Far-Eastern markets failed to spark a comparable panic in the West and Russia’s problems in 1998, together with the near-collapse of a large American hedge fund, caused only a temporary blip. But on those two days back in 1987 the London equity market fell 20 per cent. Since stockmarket crashes contain useful lessons for the future, we will look in the second part of this chapter at the facts behind world stockmarkets’ fastest ever bust. But the events of Autumn 1987 will be easier to understand if we look first at the influences that operate on share prices in more normal times.
When the new millennium dawned, investors in Britain could look back on many years of sustained share-price growth. This was very different from much of the post-war period, when share prices had followed a regular cyclical pattern of bull markets (prices in a rising trend for a year or so) followed by bear markets (where prices were falling). The highs and lows of each cycle generally mirrored the stop–go pattern of the British economy itself. The stockmarket peaks and troughs normally preceded those in real economic activity, because stockmarket prices always look forward a step. In the depths of a recession, share prices begin to rise to reflect the coming upturn. At the height of a boom they tend to become weak in anticipation of the next downturn. But over the post-war period as a whole, the movement in prices was upwards until the 1973–75 financial crisis brought a horrendous stockmarket collapse, with prices falling to scarcely a quarter of their previous peak.
It took some time to recover fully from the events of 1973–75. But the 1980s, with the Thatcher Government in power, were to see a sustained boom in share prices that was broken only by the crash of 1987. Even this event, dramatic as it was at the time, in practice wiped less than a year’s growth off share prices. It was remarkable more for the speed with which it happened than for the size of the fall. The recession of the early 1990s was the real price paid for the excesses of the 1980s, and its effects were felt far more widely across the economy. But the stockmarket suffered far less seriously than other areas such as the residential and commercial property markets. Though share prices underwent a couple of severe dips and several more minor ones, they were generally on an upward trend between 1988 and 1993, with the stockmarket looking forward to economic recovery long before it was discernible to the man in the street. And by 1995 shares were setting off on a five-year bull rampage which, with only the one serious blip in 1998, was to carry them up to the millennium. If you adjust for inflation, at the end of 1999 shares had been on a rising trend since 1982. If you take unadjusted prices they had been rising since 1975. It was tempting to believe that in the 1990s business cycles had become a thing of the past. Not everybody was quite so sure.
Whatever view you take on this point, it is clear even from this brief background that stockmarket movements need to be seen on at least three levels. First, there is the long-term trend of the equity market, second the short-term fluctuations up and down within this trend, and third, the movements of individual shares within the movement of the market as a whole.
Investors buy ordinary shares mainly because they expect share values to increase. Over a long period, what causes share prices to increase is the increasing earning power of companies, and their ability to pay higher dividends out of these increased earnings. But in the short run a lot of other factors can distort the picture.
An example helps. Suppose that companies on average pay out half of their earnings as dividends and the average yield on ordinary shares is 3 per cent and the average PE ratio is around 17 (in practice the PE ratio was considerably higher at the turn of the millennium – this is just for illustration). Suppose also that, on average, companies are increasing their earnings and dividends by 7 per cent a year. Share prices might be expected to rise by 7 per cent a year to reflect the underlying growth in profits and dividends.
Over a long period this may well happen. But the example assumes that investors always expect – again on average – that ordinary shares will yield 3 per cent and that investors will be prepared to buy shares at a price equal to 17 times current earnings. In practice there will be some times when investors expect higher yields and others when they will accept lower yields – times when a PE ratio of 17 looks too high and others when it may seem on the low side.
Why is this the case? It is easier if we now come down to a single company. Call it ABC Holdings and assume it is totally typical of the market averages: the ABC shares at 100p are backed by earnings of 6p per share, offer a yield of 3 per cent on the 3p dividend and stand on a PE ratio of 16.7. If ABC’s earnings and dividends grow at 7 per cent a year, a buyer of the shares can expect a 10 per cent a year overall return: 3 per cent of income and 7 per cent of capital gain from the rise in the share price. But suppose something happens to alter the outlook for ABC’s future profits: it comes up with a new product that should help raise the future growth rate from 7 to 9 per cent. Earnings will now rise faster in the future than had been expected. And, all else being equal, investors will be prepared to pay a higher price for the shares today because they are buying the right to share in a more rapidly rising flow of future earnings. The share price might rise from 100p to 120p, where the yield drops to 2.5 per cent and the PE ratio rises to 20.8. The share has been re-rated.
Remember, however, that share prices can be re-rated down-wards as well as upwards. One of the quickest ways for investors to lose money is to buy a highly rated growth stock that suddenly goes ‘ex-growth’. The late 1990s threw up several examples of this phenomenon, with once highly-rated household-name companies such as Sainsbury and Marks & Spencer seeming to lose their growth formula. But it is easier to demonstrate the process with our mythical ABC Holdings. Suppose its profits fall heavily and its earnings per share drop from 6p to 3p. At the same time, investors take the view that a rapid profits recovery is unlikely and future growth prospects are much worse than had earlier been thought. The share, they now decide, is not worth a PE ratio of 16.7 but something more like 10. To provide a PE ratio of 10 with earnings per share of only 3p, the shares would have to stand at 30p. Anyone who had bought at 100p would have lost more than two-thirds of his money as the shares were re-rated downwards.
The aim of investment analysts and managers, and of commentators in the financial press, is to find companies that are undervalued relative to their growth prospects. The writer who spots that a company is due for an upward re-rating before other people realize that its earnings prospects are better than expected is (if he is right) offering his reader the chance of a capital profit. And, as we have seen, it is equally important to spot companies whose growth prospects are diminishing and whose shares are likely to be re-rated downwards – astute investors will want to sell before the share price adjusts downwards. But warnings of this nature are a lot less common in print than the buy recommendations. And press commentators along with most other investment advisers are much less adept in forecasting major turning points in the market as a whole than they are at predicting price movements in individual shares. Don’t necessarily expect a press warning ahead of a major fall in the stockmarket!
Now take a totally different aspect, which we touched on in Chapter 1. ABC Holdings at 100p (we will assume it has not gone ex-growth!) yields 3 per cent and stands on a PE ratio of 16.7. With expectations of 7 per cent a year growth in earnings, the overall return is 10 per cent if the share price rises in line. An expected overall return of 10 per cent might look about right if, at this time, investors could get a redemption yield of 6.5 per cent on long-dated gilt-edged securities. It would not look nearly so good if interest rates rose so that gilt-edged stock prices fell till they offered a risk-free 10 per cent. Investors would want a higher return on the ordinary share, so its price would have to fall. Nothing has necessarily happened to alter the outlook for ABC’s profits. But the price falls because the returns available on other forms of investment have increased. So the price of any individual company’s shares – relative to others – will reflect the growth prospects of that company and therefore the overall return investors can expect. And the prices of ordinary shares as a whole will be affected by returns available on alternative forms of investment.
While these forces are always at work, they are not always so easy to spot in the reports of short-term price movements. Investors do not necessarily sit down and work out their assumptions on relative growth rates or returns available elsewhere before buying a share. But prices in the stockmarket reflect a balance of the (often instinctive) views of many thousands of investors. And it is notice-able that the ratings of individual companies do reflect their perceived growth prospects and that, over a long period, there is a remarkable correlation between movements in the yields on equities and those on fixed-interest investments (see Figure 7a. 1).
Thus in a period of buoyant economic activity and rising company profits, the equity market as a whole might be expected to show a rising trend (though it will anticipate what is happening in the economy). And when we come down to the particular, any news about a company which adds to expectations of future growth will cause the share price to rise, and events which might depress earnings will cause it to fall, relative to the market as a whole.
If share prices in the long run depend on a combination of company profits and alternative investment returns, in the short term they can be moved by a variety of other factors. Many of these are purely technical. Investment comment draws a distinction between fundamental influences (those relating to company profits or assets) and technical influences (mainly those affecting the share price without reflecting on the trading position of the company itself). Here are some of the more important influences, mainly of a technical nature, that we have not yet covered.
Surprisingly, you will see from market reports that a share price often falls when a company reports good profits. A market report probably talks of profit-taking. The reason is as follows. In the weeks ahead of the profit announcement the share price rises as investors buy in expectation of the good figures. By the time these figures arrive, there is no reason for the speculators to hang on any longer, so they sell to take their profits. It is another example of the stockmarket discounting news well in advance.
Another type of announcement that very definitely affects the market price is the profit warning. If a company realizes that its profits for the year are going to be significantly lower than it had forecast or than the market was expecting, it will normally have to give advance warning to the stock exchange and therefore to investors. Sometimes investors already suspect that bad news is coming, but when these profit warnings emerge from the blue, the share price can fall very heavily.
If the press or a firm of brokers tips (strongly recommends) a share, the price will usually rise. It will rise furthest if the shares are a narrow market – in other words, the recommendation relates to a company which does not have a great number of shares in issue or available on the market. In this case a small amount of buying would push the price up, whereas a recommendation for a large and widely traded company such as British Telecom might have relatively little impact on the price.
Don’t assume, however, that all the price rise that follows a press recommendation is the result of share buying. Marketmakers read the press too, and when they see a share recommended they will tend to move up the price they quote in anticipation of likely buying. Thus investors often find they can buy a share only at a price considerably above the one quoted when the recommendation was made.
Figure 7a. 1 Share prices since 1964… and adjusted for inflation The top chart shows a long run of the FT 30 Share index, and pretty impressive it looks in recent years as a sustained bull market appears to have replaced the stop-go bull and bear markets of the 1960s and 1970s. The second chart, which shows the same thing adjusted for inflation, does not look quite so impressive, though it is still clear that anyone who bought shares in the early 1980s is likely to have done well. Source: Datastream.
You’ll sometimes see reports such as ‘marketmakers were short of stock, and prices rose as they balanced their books’. This simply means that marketmakers had sold shares they did not own – they went short – and later they had to buy the shares they needed to deliver to clients. This buying moved prices up.
Marketmakers and other dealers thrive on activity and when there is little activity they may attempt to stimulate it artificially. For example, at a time when there was little news to encourage investors either to buy or sell, they might move their quoted prices down to attract buyers and generate some action.
It is not only marketmakers that sell shares they do not own. Speculators in the market may also go short in expectation of a price fall. They sell shares in the hope they can buy them at a lower price before they have to deliver. The profit on a successful short sale is the difference between the two prices – though, as we saw, the manoeuvre is more difficult for private investors now that the fortnightly account system has gone and operations in the traded options market may be used instead.
Selling short is a dangerous manoeuvre. If the speculators get it wrong and the price rises rather than falling, there is no limit to their potential loss. They might sell shares at 100p in the expectation of a fall in the price to 80p. Suppose instead that there is a takeover bid for the company which forces its price up to 200p. They now have to buy shares at 200p to deliver the shares sold at 100p.
Short sellers have to buy to fulfill their contractual obligations to deliver the shares. If marketmakers sense there has been widescale short selling of a particular share they may deliberately move their quoted prices up, forcing the bears (those who had been trading on expectation of a price fall) to buy at an inflated price. This is known as a bear squeeze. Quite commonly you will see reports that prices rose on bear covering, even when the general trend of prices had been downwards. This simply reflects the forced buying by speculators who had earlier sold short and does not necessarily indicate a reversal of the market’s downward trend.
A bear raid occurs when speculators descend on a company and deliberately try to force the price down, partly by short selling but possibly also by circulating unfavourable rumours about the company. They hope to buy the shares cheaply once the price has dropped. Bear raiders are, of course, vulnerable to being caught in a bear squeeze.
Markets seldom continue up or down in an unbroken line. After a period of rising or falling prices you often see references to a technical correction or to the market consolidating. If prices have been rising for a long period, there will often be a break as some investors sell to take their profits and prices temporarily fall. They may well continue on up after the shakeout has taken place. A similar process takes place in reverse on the way down. The market tends to move in fits and starts, with investors pausing for breath at various points on the way up or down.
There is a theory that you can predict from past price movements what a share price (or the market as a whole, as measured by one of the indices) is likely to do in the future. Whether you believe in this theory or not, you cannot ignore the fact that at times it has a strong impact on share prices. Commentators who base their forecasts on these theories are known as technical analysts or chartists (because they use charts to plot the price movements).
The theory is not as silly as it might sound. Suppose the share price of ABC Holdings had, over the past few months, fluctuated between 100p and 120p. This would suggest that each time the price dropped as low as 100p there were investors who considered it cheap at this price and were prepared to buy. Each time it rose as high as 120p a fair body of investors considered it was becoming expensive and therefore sold. So 100p and 120p became recognized as resistance levels.
If subsequently the price dropped significantly below 100p or rose significantly above 120p, this would suggest that something had happened to change investors’ perception of the shares. The chartist would not need to know what had happened but simply that the price – reflecting the balance of opinion among buyers and sellers in the market – had broken out from a resistance level and might be expected to continue in the direction it had taken until a new resistance level was reached.
This merely illustrates the principle – in practice, the chartist projections may be based on considerably more complex analysis. And nowadays share prices are probably plotted with the help of computers rather than on graph paper, and the computer can be programmed to give buy and sell prompts at appropriate points.
Since most chartists work on broadly similar theories, their predictions can be self-fulfilling. If all chartists reckoned the ABC Holdings share price had breached a significant resistance level when it rose through 120p to 125p, all who followed the theory would duly jump in and buy and the price might be carried up to, say, 140p. Chartist techniques are also widely used in other markets such as gold and foreign exchange.
We have seen that a rise in interest rates will depress the price of gilt-edged stocks and may also depress equity prices by raising the returns available on other investments. But it will have different impact on different kinds of company. It might depress, say, housebuilders more than the average because higher interest rates mean higher mortgage costs and could deter housebuyers. It would depress highly-geared companies which use a lot of variable-rate borrowed money, because higher interest costs will depress their profits. It might actually help companies which are sitting on large amounts of cash and will therefore earn a higher interest income. But, all else being equal, higher interest rates raise the cost of borrowing for consumers and for industry and may be expected to damp down economic activity, which is bad for company profit prospects. This is quite separate from the purely technical factor that higher interest charges may depress share prices because of the higher returns available elsewhere.
The effect of currency movements is also complex. If sterling is strong (perhaps too strong, as it was in the later 1990s – see Chapter 16) the government will not necessarily try to counter any fall in the currency by raising interest rates. The fall might be welcome. But if sterling is weak and then falls further there will be the prospect of higher interest rates to defend the pound. This will usually hit gilt-edged prices and might be expected to have a knock-on effect on share values. On the other side of the coin, a lower level of sterling improves British industry’s competitive position in home and export markets and thus improves profit prospects. So sometimes a weakening in sterling will depress bond prices but boost ordinary shares.
Share prices tend to rise when there are more buyers than sellers. If there is a lot of money available for investment in stockmarkets, prices would normally tend to rise – hence the weight of money factor. But, now that the British can invest freely abroad as well as at home (foreign exchange controls were suspended in 1979 and later abolished) and foreigners invest heavily in Britain, this factor is difficult to pin down. In the past you might have started with the amount of new money that the financial institutions would have available for investment. From this you would knock off the amounts that would be soaked up by new issues of government debt, by new share issues on the domestic stockmarket and likely sales by existing investors, by investment in property and overseas securities, and so on. What was left would be available for buying existing shares in the UK stockmarket, whose prices it would tend to push up.
If the sums are now more difficult to pin down, the weight of money factor should not be ignored. The Japanese stockmarket in the 1980s was carried up to unrealistic heights by the very high savings of Japanese families which were channelled into the market, leaving it very vulnerable when economic and financial problems erupted.
At a domestic level, the weight of money factor may be seen at work in some of the stockmarket’s more excessive enthusiasms. Prices of Internet-related companies were roaring through the roof late in 1999, partly because private investors were prepared to pay virtually any price to get in on the latest hot stock. In other words, a vast weight of money was being thrown at the stockmarket’s current fashion. In many cases the companies in question consisted largely of hope value and were impossible to value on normal investment criteria.
When a company raises capital by issuing new shares or issues shares in a takeover, the price will often fall. This is simply because initially there are not enough buyers around to absorb all the new shares. And if it is known that there are owners of large blocks of shares who want to dispose of them (possibly underwriters left with shares they do not want – see Chapter 8) the price may be weak until these have been disposed of. You will see references to large blocks of shares overhanging the market.
It used to be regarded as a general rule, particularly in the run-up to an election, that evidence that the Conservatives were doing well would boost gilt and equity prices and evidence to the contrary would depress them. This was never completely logical. Though, in the past, Labour governments might have been associated in the public mind with high inflation and high interest costs, shares had often performed well under a Labour regime. Sometimes share prices would rise in anticipation of a Conservative election win, but fall on heavy profit-taking when the expectation was fulfilled. Betting on elections was always dangerous. At millennium time, with a New Labour government in power but largely implementing Conservative economic policies, the odds looked more than usually difficult to call.
This is the indefinable factor. On some days investors feel cheerful and decide to buy. It may be good political or economic news, it may simply be that the day is sunny or England has won a game of cricket. But one strong and consistent influence on the London stockmarket is the performance of share prices in overseas markets. The behaviour of Wall Street has always influenced London. But with increasing globalization, the overseas influence today is often more than sentimental. The same world economic events may affect London as markets overseas. Shares that are quoted in New York or Tokyo may also be traded in London and a fall in the home market can trigger a fall in the UK. Though, for London, the Wall Street link is probably still the strongest, the crash of October 1987 (with its knock-on effect on all world markets) demonstrated how quickly market movements now travel across most frontiers.
We have left takeovers to last because at times they dominate stockmarket thinking. The assumption is that if Company A bids for Company B it will need to pay above the current market price of Company B shares, though in practice the Company B share price often rises as a result of leaks or inspired guesses in the weeks before a bid is announced.
Actual takeovers, and rumours of takeovers, raise the prices of individual shares. Investors’ thinking becomes obsessed with takeovers and they look for other possible bid candidates and force up the prices by buying the shares. The equity market as a whole is carried upwards by the takeover fever.
Price rises on takeover talk seem to fly in the face of the idea that a company’s earnings prospects determine the value of its shares. This is not so. The bidder is simply paying a price that takes account of the expected earnings growth of the victim company over the next two or three years, the earnings he expects to be able to squeeze out of his victim (possibly with the help of creative accounting), or the possible cost savings from eliminating overlapping activities and jobs. Thus for any share there are at least two possible values. What it is worth in the market on its own earnings prospects – and the price a bidder might have to pay, which pre-empts a few years of earnings growth or which is based on the potential for asset-stripping (see glossary) or selling off the constituent businesses. Shareholders in the victim company get jam today rather than jam tomorrow.
For an indication of what is moving share prices on any particular day, go to any of the sites that carry market reports and financial news. These include, of course, the Financial Times site at www.ft.com/ and the news agency sites (see Chapter 23). Many other sites include a feed of market reports and main financial news, including some of the personal finance sites and the portal sites such as Yahoo! on (for British readers) http://uk.finance.yahoo.com/.
Investors have short memories. After every major crash in financial markets we read that lessons have been learned and taken to heart. The same mistakes could not be made in the future. Do not believe a word of it! Within ten years or so the crash is no more than a faint folk-memory The same mistakes are resurfacing, perhaps in slightly different form. Once financial markets get a head of steam behind them, nobody wants to hear the words of caution. After the 1974–76 collapse in the commercial property market, for which the groundwork was laid by excessive bank lending, we were told that the same thing could never happen again. Between 1984 and 1990 the banks increased their property loans sevenfold. The early 1990s saw these same banks making provisions for their multi-billion pound property-loan losses as the bloated commercial property market once again collapsed.
Crashes in the stockmarket can be even more dramatic. For investors nurtured on the bull market of the 1980s the roof fell in on Monday 19 October 1987. And it was not only investors who suffered falling roofs. The Friday morning of the previous week (16 October), a once-in-a-century freak storm had devastated much of southern England, causing widescale property damage but also disrupting transport and all forms of communication. On that Friday the stock exchange in London had barely functioned. Many securities dealers had not arrived for work. The stock exchange’s SEAQ price information system was out of commission much of the day and such dealing as took place reverted to old systems of direct contact. No stock exchange indices were calculated in London that Friday.
America was spared the storm, but nasty things had been happening on Wall Street. On Saturday 17 October the Financial Times had led with a story headed ‘Wall Street ends two worst weeks with record daily fall’. The Dow Jones Industrial Average – the most commonly used index of the American market – had fallen over 17 per cent from its August peak. On Friday 16 October alone it had dropped almost 5 per cent. The Financial Times’s market report commented ‘It was not simply that the stockmarket fell … It was more: last week the US stockmarket lost its optimism’.
Figure 7b. 1 How history lends perspective The top chart shows the boom in share prices in the 1980s which paved the way for the dramatic bust in October 1987. The bottom chart shows exactly the same thing, but has been updated to 1995 and uses a logarithmic scale. The ’87 crash seems barely more than a blip. Be careful with charts: they can be designed to deceive. Source: Datastream International.
Had London been fully functioning on Friday 16 October, and had share price indices been calculated, some indication of what was to come this side of the Atlantic might have filtered through. As it was, London was worried; but there was little sense of market cataclysm that weekend. Monday’s Financial Times led with a story ‘Bull yields to bear as Wall Street accepts the party’s over’. But it was writing mainly of the United States. In Britain, the biggest-ever sale of government-owned shares was about to take place: the £7.2 billion offer of the government’s stake in British Petroleum. Monday’s paper contained a piece on the BP sale headed: ‘A test for the bull market’s resolve’. In Britain we were still talking of bull markets.
By Tuesday 20 October the worldwide bull market was history. At the close on Monday 19 October the London market was down almost 10 per cent from its close the previous Thursday, as measured by the FTA All-Share Index (as it then was).
But on that Monday the United States had again held centre stage. The Dow Jones Industrials crashed by over 500 points to 1738.42: a one-day fall of over 22 per cent, the worst of which happened after the London market had closed. By Tuesday’s close London was a further 11.4 per cent down for a two-day fall of 20 per cent. And, with only modest occasional rallies, it continued down well into November. At its nadir the FTA All-Share Index was down 36.6 per cent from its July 1987 peak. Other markets worldwide had suffered a similar fate. On Monday 19 October and the following day the Tokyo stockmarket lost 17 per cent and the Australian market was down almost 28 per cent. Hong Kong could not be measured at this point. The market had closed.
Once the full extent of the market rout was apparent, the economic gurus were out in force to rationalize the week’s events. The instability in the financial system as a result of world trade imbalances, and particularly the budget and trade deficits in the United States, was apparently to blame for the mayhem in the world’s financial markets. The economists singularly failed to explain why, since these imbalances had been present for some considerable time, the crash had not happened before. There was in fact a far simpler and, at least with the benefit of hindsight, more accurate explanation of the week’s events. Most speculative booms in stockmarkets end with a bust: what sparks the fall is almost irrelevant. Professor J K Galbraith summed up the phenomenon in his book on an earlier and ultimately far more serious stockmarket crash in the United States, The Great Crash 1929. ‘… it was simply that a roaring boom was in progress in the stock market and, like all booms, it had to end. …When prices stopped rising – when the supply of people who were buying for an increase was exhausted … everyone would want to sell. The market wouldn’t level out; it would fall precipitately’. On Monday 19 October 1987, this happened again on Wall Street – and in London and across the world.
Figure 7b.2 The average PE ratio on shares of industrial and commercial companies (thick line and left-hand scale) rose to 20 in 1987 as share prices (thinner line and right-hand scale) boomed and lost contact with the fundamentals of company earnings. PE ratios returned to more normal levels and with subsequent crash in share prices. Source: Datastream International.
The price falls in the 1987 crash were as nothing compared with the bear market of 1973–75, when share prices in the UK fell to around a quarter of their previous peak. It was the speed of the fall that created the drama. A decline in share prices that in previous decades might have taken place gradually, over a year or more, was telescoped into a day or a few days. Again, many explanations have been advanced for the suddenness of the fall, and computers (or the men and women who programme them) were singled out for a large share of the blame.
There was much talk of the perils of programme trading, though the phrase appeared to mean different things to different commentators. In the United States widescale arbitrage habitually took place between the cash market and the financial futures market, with computers signalling the minor discrepancies in pricing between the two that offered the chance of a profit (see Chapter 18). Portfolio insurance was also common in the States. This is a tactic by which major institutional investors may seek to lock into the profits on their portfolios. It can involve operations in the futures or options markets (the value of the futures or options positions rises if the value of shares in the portfolio falls). It can also involve a set programme for turning part of the share portfolio into cash if prices fall more than a certain amount. And on top we have the familiar chartist theories (see previous chapter) whereby a price fall can itself signal a larger price fall and stimulate selling which makes the prediction self-fulfilling.
All of these factors and more were probably at work on Wall Street during the crash. The interaction of the stockmarket and the futures market meant that a fall on one stimulated selling on the other, which in turn led to further selling on the first. And the use of semi-automatic programmes made the spiral twist even more rapidly down.
But perhaps this form of computerized trading (which in any case was not widespread in London at that time) was the least significant aspect of computers in the crash. More important was the instant dissemination of information across the world by electronic message and computer screen. The trader knew instantly what was happening in other financial centres and marked down share prices in his own in consequence. As panic spread through the world’s financial centres it became clear that instant information had negative as well as positive features.
So much for the technicalities. Why had share prices been poised for a fall? If we take the London market in isolation (and many of its features were mirrored overseas) the charts tell much of the story. Look first at Figure 7b. 1 on page 122, plotting the FTA All-Share Index since 1983. Share prices had been climbing steadily through to the end of 1986. In the first half of 1987 the rate of increase accelerated (a typical feature of the late days of a bull market) as more and more investors or speculators climbed on the bandwagon, attracted by the profits made from the market in recent years. By its peak in the middle of July, the index had climbed 48 per cent from its beginning of the year level. Then look at Figure 7b. 2 on page 123, showing the average price earnings (PE) ratio on the FTA 500 Share Index.
The immediately striking point is that though on balance PE ratios were rising up to the end of 1986 – again, this tends to happen in a bull market – they were not rising anything like as fast as share prices. In other words, company profits and earnings were rising rapidly, providing part-justification for the increase in share prices. But the rise in share values in the first half of 1987 finally lost contact with the fundamentals – earnings, yield and alternative investment returns – which are the ultimate support for share values. Company profits did not rise 48 per cent in half a year, as shares did. Outright speculative fever had taken hold. If we look at Figure 7b. 3 on page 126, showing average dividend yields against average redemption yields on gilt-edged stocks, we get another facet of the same picture. Up to the end of 1986, company dividends had been increasing fast enough to prevent a great drop in yields despite booming share prices. In 1987 share prices shot ahead of dividend growth and dividend yields fell sharply to below 3 per cent on average. In the process, as the chart shows clearly, the traditional relationship between gilt-edged returns and dividend yields was sharply distorted.
When prices began to fall, there was therefore nothing to stop the rout until a rational relationship with the fundamentals was re-established. In fact, for all the drama, the crash did no more than return share prices to their values of a year earlier, when the final speculative fever had taken hold. The crash was a vindication – not a negation – of the theory that company profits and dividends determine share values in the long run.
What of the aftermath? Company profits and dividends continued to grow after October 1987. The economic collapse, which many felt that the crash foretold or would cause, simply failed to happen over the following eighteen months. Shares again began to look quite attractive on the fundamental criteria. The crash was a pure stockmarket phenomenon: a bust following an excessive speculative boom. That is not to say that it did not have its economic effects. The authorities in Britain, it is argued, were terrified of any action that might provoke further mayhem on the markets. They therefore failed to act soon enough to damp down an over-heating economy, with the result that the 1980s boom ran totally out of control and the reaction – the recession of the early 1990s – was correspondingly more severe. But that is another story.
Even in the short term, however, the crash had left its scars. It largely destroyed the illusion, prevalent at the time of the Big Bang a year earlier, that the City could sustain its extravagant lifestyle with ever more frenetic dealing in shares. There was little more talk of expansion in the equity trading rooms; cutbacks became the norm. The liquidity of the market had been exposed as an illusion. The events of 1987 showed that shares were easy to buy and sell while prices were rising. But once the fall began, those who hoped to get out fast found they were lucky if they could get through to their broker or to the marketmakers. The trading system introduced in the Big Bang was already in need of revision.
Figure 7b. 3 The average dividend yield on shares (solid bottom line) normally maintains a relationship with the yield on gilt-edged stocks (light upper line). But in 1987 the final stages of the share price boom pushed dividend yields below 3 per cent and distorted the relationship. This relationship returned to a more normal pattern after share prices collapsed and dividend yields therefore rose again. Source: Datastream International.
Could a crash on a similar scale happen again? It will already be clear that our own answer is ‘yes’, though such a crash is most likely to come after a period of feverish speculative activity in the markets. Before the 1987 crash the British government had encouraged such speculative fever, by hyping privatization issues and by offering the taxpayer’s assets to the public at below their worth. The illusion of the stockmarket as a source of instant profits had been created. It fuelled the boom that preceded the bust.
If such speculative fevers could be prevented in the future, perhaps crashes could be prevented as well. But once the stockmarket gets a head of steam behind it, nobody wants to miss the fun. Everybody holds on for the last five per cent of profit as the market approaches its peak, and everybody succumbs to the delusion that he or she will be able to spot the warning signs of the downturn ahead of the herd. The 1987 crash showed what happened when investors put this delusion to the test of reality and, in the event, all rushed to sell at the same time.
Ironically, when world stockmarkets were again put to the test almost exactly ten years later, the system managed to withstand pressures that had their root in real economic events. But the problem this time did not start on Wall Street or on the London Stock Exchange. Instead, it had its origins in the former tiger economies of Asia – notably Thailand and South Korea – whence it spread to the longer-established Far-Eastern financial centres of Malaysia, Singapore and Hong Kong. Japan itself – with enough problems in its own financial system – was further shaken, and in November 1997 witnessed the collapse of its oldest securities house, the once-proud Yamaichi Securities.
Initially, the storm did not spare the United States or Britain. In late October, Wall Street saw its biggest daily fall since the crash of 1987 – a decline of over 8 per cent in the Dow Jones index which triggered an automatic temporary closure of the market under the safeguards built in after the crash of ten years earlier. The fall was blamed on a further severe decline in the Hong Kong market. The London market responded with a fall of almost 10 per cent at one point the following day, but closed the day with a comparatively modest decline as Wall Street staged a sharp recovery. Europe’s fledgling markets were hard hit, with Russian stocks falling almost 20 per cent in a day and further trouble to come.
The problems of the former tiger economies were ascribed largely to over-rapid expansion, financed extensively on borrowed money. They were exacerbated by some pretty ramshackle financial structures that had failed to develop to match the countries’ very rapid industrial growth. Adding to the problems were corporate structures which lacked the accountability and transparency found among more mature Western corporations. The term crony capitalism (see glossary) was much to the fore.
Once growth slackened in the tiger economies, servicing the debt became difficult or impossible. The expansionary years had been accompanied by a boom in securities prices and real-estate values. With securities and real estate forming the security for much bank lending, financial institutions were in trouble when values turned down. Much of the security for the lending had disappeared.
Though considerably more robust than the younger tiger economies, Japan itself had a long-standing problem stemming from earlier excessive lending by its financial institutions against the security of inflated share and real-estate prices. A very high level of bad loans among its banks and other lending institutions was the inevitable result when share prices and real-estate prices fell after the 1980s boom, and the problem plagued the Japanese financial system for most of the 1990s. Bad loans in Japan were reckoned to be equivalent to about 10 per cent of gross domestic product, though the true figure could have been considerably higher. In common with the more youthful tiger economies, Japan had always lacked a financial system that matched the strength and sophistication of its industrial base. Share prices in Japan at the end of 1997 were less than half of their all-time high.
Share prices in the stockmarkets of the former tiger economies collapsed when the growth bubble burst. By December 1997, South Korean shares were lower than ten years earlier, thus wiping out the market gains from a decade of growth. But not only shares were under attack. Each country in turn saw its currency fall steeply in the foreign exchange markets as the speculators moved in. When Malaysia’s currency came under attack, its prime minister accused the speculators of creating the crisis. His words found an echo amongst the population. Effigies of George Soros – king of the international currency speculators – were burned in Malaysia’s capital, Kuala Lumpur.
After providing help for Thailand, the International Monetary Fund (IMF) was called in to South Korea to mount its biggest-ever rescue package at that date, a total of $US57 billion, to help the country to avoid defaulting on its short-term overseas loans. The package had a price: as a condition of the assistance, South Korea was required to implement far-reaching financial and economic reforms.
The big question in Western financial centres was whether the storms in Asia would inflict severe permanent damage on the more mature economies of North America and Europe. There was the fear that a default on its debt by any one country could have a knock-on effect on other economies, perhaps triggering further defaults. This could seriously destabilize the global financial system. It was clear, too, that the problems of Asia’s former tiger economies would have a direct impact on Western companies that traded extensively with them. The problems would also restrict the Asian countries’ ability to invest directly in manufacturing plant abroad, which was bad news for the West. Britain saw delays or cutbacks in planned investment by Asian groups such as the South Korean Hyundai. A general slow-down in world trade was feared.
In the event, once the initial shock had subsided, the stockmarket repercussions were largely confined to Asia and to emerging markets in Eastern Europe and South America. Rightly or wrongly, the London market showed considerable strength and was riding high as the millennium approached. Jobs in Britain had been lost from the investment cutbacks. But for much of the population the most visible effect of the turmoil was a flood of bargain-priced personal computers and similar products resulting from the very low level of many of the Asian currencies and from manufacturers’ need to raise cash by offloading stocks.
