How to guard against a market crash
Monday 19 October 1987 will live in the memory of advisers and clients as the day of the Black Monday stock market crash. But this is not the only anniversary of note that has already been marked in 2017.
The Asian currency devaluations and debt crisis happened 20 years ago and we have just passed the tenth anniversary of the failure of Northern Rock.
Each date resonates and prompts the question of what could go wrong this time around with American and British equity indices hovering near all-time highs, Japanese stocks trading at a two-decade peak, copper reaching a three-year high (and palladium a 16-year one), bond prices still elevated and Bitcoin going bananas.
Been there, done that
While all market bull runs look different from afar, they are in fact all remarkably similar in their origins, development, crescendo and ultimate collapse – as Charles P. Kindleberger pointed out in his seminal tome on the topic Manias, Panics and Crashes.
- The first step in the formation of a bubble is usually the appearance of a transformational opportunity, such as the chance to invest in trade flows with America, the railways, mines, real estate or a new technological development.
- The initial legitimate entrepreneurial profits then attract more capital, often made through the concurrent availability of cheap credit, which then facilitates further sound investment.
- It is now that matters start to get out of hand. Entrepreneurs and investors are joined by speculators who are lured in by the gains already made and the fear of missing out (FOMO) on further profits. Such is the enthusiasm of the speculator that they are even prepared to borrow to raise the capital to get involved as they decide no price is too high to pay for the assets or securities in question.
- The first sign of trouble is how copy-cat products and services appear, easily raising money. Fraudsters appear to target the unwary. And the original entrepreneurs and investors start to lock in their profits and sell, in the knowledge that there are lots of willing buyers to be found and they are only interested in the price they are paying rather than the value they are getting (at the peak of the 1636-37 tulip bubble, the 2,500 florins paid for one bulb would have bought 50 tonnes of rye, 27 tonnes of wheat, three tonnes of cheese, two tonnes of butter, 12 sheep, eight pigs, four fat oxen, four kegs of beer, two vats of wine and a silver beaker, according to Edward Chancellor, in another study of bubbles, Devil Take the Hindmost).
- The first cracks appear. The new issues, the frauds and the legitimate selling from company founders and insiders begin to overwhelm even the tidal wave of buying. Securities prices dip, rally as speculators keep the faith and then dip again.
- Doubts creep in. Frauds are uncovered. Prices fall. Speculators who bought on margin face calls for more capital (which they do not have as they have already borrowed). They become forced, price-insensitive sellers. Confidence sags. Fear begets more selling, which creates more margin calls, selling and finally panic. Prices collapse and the rout is on.
Beware bear traps
As an aside, this is a table we first prepared for our good friends at the Daily Telegraph. It shows the ten biggest one-day falls in the FTSE 100 since its inception in January 1984.
It is no shock to see 19 and 20 October 1987 come top (Black Monday and then the day after, which saw further selling after the overnight rout in the USA).
It may surprise some to see it took less than 18 months to recoup the losses, to show that the best gains are made at times of panic, when everything seems terrible, and the worst losses at times of exuberance, when everything seems wonderful.
The ten worst one-day falls in the FTSE 100’s history
Source: Thomson Reuters Datastream
When sentiment was washed out, patient advisers and clients had a chance to accumulate positions because it took a relatively long time for confidence to recover.
This contrasts markedly with the rapid rallies that followed sell-offs during the bear markets of 2001-03 and 2007-09. They proved to be bear traps, luring in unwary speculators and traders, just as we see in the fifth stage of the cycle outlined above by Kindleberger.
The lesson here is that buying on the dips works well as a strategy – until it doesn’t because two other powerful factors that support bull markets on the way up also feed bear markets on the way down.
To ‘L’ and back – leverage and liquidity
These two salient features that run through all of the Kindleberger model are leverage and liquidity.
During bull runs, both are plentiful. During bear markets, leverage drives forced selling as it is unwound and liquidity either proves inadequate in the face of this tidal wave of supply or simply dries up altogether.
- There is no shortage of leverage in the system. Global indebtedness has passed the $200 trillion mark and is one-third higher than it was in 2007. Encouraged by record-low interest rates corporations are borrowing with gay abandon while cash-strapped Governments are doing so out of necessity. Consumers lie somewhere between the two, although margin debt on the New York Stock Exchange stands at a record $550 billion and growth in these figures does seem to move in lockstep with the S&P 500. Note that these observations apply much more to developed, western economies than emerging ones.
American retail investors are extensively using margin to get involved in the US stock market
Source: New York Stock Exchange, Thomson Reuters Datastream
- Markets are basking in a deluge of liquidity from record high corporate dividend payments in the US and UK (for example) and lofty levels of share buyback activity. By contrast, new flotation activity is muted and even secondary placings are relatively rare, so cash is not being drained away by market newbies as it was in 1999-2000 and 2006-2007.
Above all, central bank policy remains ultra-loose. By our calculations the US Federal Reserve, Bank of Japan (BoJ) , Bank of England, European Central Bank (ECB) and Swiss National Bank have pumped $11.5 trillion into the global system since January 2007 (about 15% of global GDP).
Central banks continue to inject liquidity into the system
Source: Bank of England, Bank of Japan, European Central Bank, Swiss National Bank, US Federal Reserve. FRED, St. Louis Federal Reserve database. Thomson Reuters Datastream.
There is lots of leverage but it matters not when borrowing is cheap and there is lots of liquidity. But the Fed is raising rates and swapping Quantitative Tightening for Quantitative Easing. The ECB may start to dial down QE. The Bank of England may tighten policy. Buyback activity is fading and dividend cover is thin (again in developed rather than emerging markets)
- If liquidity gets a little scarcer then we could see the first real test of the post-2009 bull run.
- If any cracks do appear, watch the periphery first – for Florida property and obscure French real estate funds in 2007, perhaps read Bitcoin, vintage cars, fine wine, junk bonds or internet/social media stocks this time around. They are where there is already a feel-good factor after stunning price rises and you can feel the optimism that can ultimately breed overconfidence
- If we suddenly get a deluge of new issues that would be a potentially bad sign (even if it would not necessarily immediately call the top.) The chart below shows the number of new flotations and secondary placings on the London Stock Exchange for each year back to 1995
Note how a torrent of issuance accompanied the stock markets surges of 1998-2000 and 2005-07 – just before the smash – while BP’s monster £7 billion flotation took place barely a week before the 1987 Crash.
Surge in new issues warned of market tops in 2000 and 2007 as liquidity was drained away
Source: London Stock Exchange
In these circumstances, advisers and clients would do well to remember the words of Bernard J. Lasker, chairman of the New York Stock Exchange:
‘I can feel it coming ... a whole new round of disastrous speculation, with all the familiar stages in order – a blue-chip boom, then a fad for secondary issues, then an OTC play, then another garbage market in new issues and finally the inevitable crash. I don't know when it will come but I can feel it coming and, damn it, I don't know what to do about it.’
Lasker said this in 1970, just before a very nasty wobble in the Dow Jones Industrials – although the market then rallied again all the way through to the frightening bear market of 1973-74.
A rush of new market entrants warned of the 1970 stumble and 1973-74 bear market in the USA
Source: Thomson Reuters Datastream
It’s never different this time
Fund management legend Sir John Templeton once stated that: “Bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria.”
With the possible exception of Bitcoin, the fourth stage of Sir John’s cycle is hard to find but there seems to be a lot of the third emotion around. The paucity of new issues relative to 1998-2000 and 2005-07 suggests no-one is getting too badly carried away just yet, although the rise of Exchange-Traded Funds and tracker funds perhaps needs to be followed as they are generating a lot of interest among investors and soaking up vast amounts of cash (and thus liquidity).
Nor does optimism rule out further welcome gains (far from it, as the stock market surges of 1998-2000 and 2005-2007 would attest) but advisers and clients need to think about:
- Kindleberger’s model for manias and subsequent panics and take a view on where we are in the six-step cycle
- what value they think they are getting right now when they asses securities’ valuations
- trends in both global leverage and liquidity
Then, and only then, are they well placed to begin to prepare their asset allocations for 2018 and beyond and ensure that portfolios are correctly calibrated to meet not just target returns but also risk appetite and ensure there is some margin of safety and downside protection, just in case they are needed.