The market vulnerability now is quite different to 1987, and is derived from the most expensive US stock market ever. This is accompanied by widespread investor irrationality (evidenced by the scale of ETF buying with a focus on price, and a reckless disregard of value). Together these two elements are the foundation for a classic investment bubble.
The 30th anniversary of the 1987 Crash is just ahead, and parallels will be drawn in the media in the coming weeks. I was not just there, but selling client holdings in the week before - so I’m reasonably well-qualified to comment.
My conclusion is straightforward:
This time when the market goes down, it is much more likely to stay down.
SUMMARY
- While the market has not moved too far too fast in 2017, valuations are much more extreme.
- Markets now are dependent on central bank action, where in 1987 a strong economic recovery drove the market higher.
- Evidence of investor complacency is widespread in 2017, just subtler.
- The role of ETFs and high-frequency trading creates a crash potential just as great as 1987, if not greater.
- Favourable demographics and political cohesion created bounce-ability in 1987. These are now totally absent.
- And this is a classic investment bubble, unlike 1987.
This time when the market goes down, it is much more likely to stay down. History suggests falls of 40-60% - only the timing is yet to be determined.
THE DETAIL
The essential foundation for the crash-vulnerability was that the market had run too far too fast – it’s that simple. By August the FTSE 100 index was running 30% above the long-term trend (the 200-day moving average). Right now, it is almost exactly at the level of the long-term trend.
Yet in 1987 valuations were not extreme, measured by the various versions of the price earnings ratio. (For the latter reason ’87 was not an investment bubble).
This vulnerability had an important second leg. Government bond yields had risen to 10% by the summer – therefore bonds offered roughly the same return as the average long run stock market returns, but guaranteed by the government.
In the week before Black Monday the triggers for The Crash came into view: US tax reforms (which would hit the takeover mania); then rate increases (where the trend of falling rates through the 80’s had increasingly buoyed confidence).
Then the stock market closed in London on the prior Friday (following The Great Storm in SE England on Thursday night), which created considerable pent up selling pressure. On the day of The Crash computer-generated selling exacerbated the downward spiral.
Why no recession like 2008/9? Central banks acted, certainly. But more fundamentally this was a time of growing confidence following the horrible 1970s; demographics were extremely favourable, and there was considerable political cohesion. These positives are not just absent today, but are serious impediments.
There were good fundamental reasons for the depth of confidence in the 1980s, which provided “bounce-ability” after Black Monday. Now such confidence as there is in markets is driven by the hand of the central banks, and their extraordinary intervention since 2009.
The market vulnerability now is quite different to 1987, and is derived from the most expensive US stock market ever. This is accompanied by widespread investor irrationality (evidenced by the scale of ETF buying with a focus on price, and a reckless disregard of value). Together these two elements are the foundation for a classic investment bubble.
The most expensive stock market ever has had one single plank - the extraordinary intervention by central banks, through both QE and zero interest rates. It is the clear stated intention of central banks, led by the Federal Reserve, that this plank is removed - at some point the markets will blink.
Ordinarily, as the market has risen relatively slowly, we might expect the cyclical downturn (whenever it might arrive) to be a long drawn out bear market. Yet when ETF investors take fright this will play a similar role to program trading in 1987, accelerating and deepening falls.
SUMMARY
- While the market has not moved too far too fast in 2017, valuations are much more extreme.
- Markets now are dependent on central bank action, where in 1987 a strong economic recovery drove the market higher.
- Evidence of investor complacency is widespread in 2017, just subtler.
- The role of ETFs and high-frequency trading creates a crash potential just as great as 1987, if not greater.
- Favourable demographics and political cohesion created “bounce-ability” in 1987. These are now totally absent. With the added ingredient now of over-whelming debt levels.
- Plus, this is a classic investment bubble, unlike 1987.
This time when the market goes down, it is much more likely to stay down. History suggests falls of 40-60% - only the timing is yet to be determined.
Do keep in touch with unfolding events, and we will continue to feedback to you week after week.