Personal finance: Correction is some way off

What are the lessons of the great stock market crash of 10 years ago? Rather like the Kennedy assassination, anyone in the City who lived through the dramatic events of the Monday market meltdown in October 1987 is unlikely to forget it. It was a time when great reputations, as well as great amounts of money, were won and lost.

Even the seasons seemed to be out of joint, adding to the sense that what was happening was in some way unreal. The Friday before the market took its big tumble, much of Britain had been brought to a standstill by freakish hurricane winds - the famous storms which the weatherman Michael Fish famously failed to forecast. George Soros, to name but one of the crash's victims, proved to be just as fallible. The world's most famous market speculator had publicly predicted a market crash only days before, but thought that it would come in Tokyo, not in London and New York. He lost several hundred million dollars when the wrong markets fell.

By contrast, someone who did come out of the crash with his reputation enhanced was Alan Greenspan, appointed as chairman of the Federal Reserve only months before the market went into its record nosedive. His sure handling of the potential financial crisis established the reputation for calm prescience that has stuck to him ever since.

The immediate worry was that the stock market crash would turn a financial crisis into an economic slump, as it had done in the 1930s. Then governments and central bankers had compounded the problem by tightening monetary conditions. In 1987, forearmed by previous experience, and with Greenspan to the fore, the central bankers and finance ministers quickly made it clear that they were willing to take their grip off the monetary tiller if it proved necessary to keep the financial system afloat. With hindsight, maybe they were too willing to avert trouble.

Nigel Lawson, the then Chancellor, was certainly not helped by the crash. His "Yuppie boom" had helped to win the 1987 general election just four months earlier and sparked a lot of wild talk about Britain's new "economic miracle". But overconfidence of the kind that often precedes market setbacks proved his eventual undoing.

Looking back at the crash, it is easy to be sanguine. As we know now, the October 1987 market meltdown was a classic bursting of a speculative bubble, but the lasting fallout for investors was limited. On both sides of the Atlantic, share prices had simply moved too far ahead of themselves. The FT All-Share index had risen some 60 per cent in little more than seven months by the time it reached its peak (which was actually in July).

All the crash did, with hindsight, was bring the market back down to earth, albeit in dramatic fashion. The index fell by some 30 per cent during the October crisis, but for all the drama still managed to end the year slightly higher than it had begun it. As the charts show, how you interpret the crash depends on the perspective from which you look at it. On a short-term view, it was a dramatic collapse. What made it so frightening was that shares seemed for a while to have gone into virtual freefall.

The Dow Jones index in New York lost 508 points, or some 20 per cent, in a single day. Nobody has ever seen anything quite like it, before or since. But from a longer-term perspective, in the context of a 15-year bull market in equities, it merely looks like a blip in an otherwise relatively smooth upward path. (Anyone buying unit or investment trusts should look out for sudden improvements in their performance records, thanks to the management companies now being able to rebase the start of their 10-year record to the days after the crash.) Most shares were back to their pre- crash levels within a couple of years.

Why was it so dramatic a fall? Two key factors in the scale of the fall were the impact of portfolio insurance and the still imperfectly understood links between the stock markets and the rapidly growing futures markets. Portfolio insurance was a clever but untried invention: a theory- driven system for using computers to re-engineer institutional portfolios. Its fatal flaw was that it generated a flood of automatic sell orders at just the wrong time: the more share prices fell, the more sell orders it produced. It therefore exaggerated the market's decline.

Could the 1987 crash have been foreseen? No, in the sense that the scale of the fall was way beyond previous experience. But yes in the broader sense that the stock market had become overvalued and was bound to have to correct before too long. There was no shortage of signs that the market was becoming dangerously overheated in the early part of 1987. All the traditional valuation indicators that investors rely on - dividend yields, price/earnings ratios, asset value multiples - were flashing a warning as the market went into its giddying rise in the first half of the year.

The indicator that gave the most telling signal was the yield ratio, which measures the relationship between bond yields and the yield on the stock market. The ratio is a fundamental determinant of share values. In the UK, the yield on bonds at its peak in 1987 was 3.3 times the yield on the stock market, a higher multiple than it had been at any previous stock market peak. Medium and long-term interest rates started to rise some months before the market crashed.

That is one reason why it is possible to say that the market today is overvalued without having to say that it has to end in another crash like that of 1987. Although conventional valuation indicators suggest the market is again becoming overvalued, the yield ratio is still within its historical trading range. Long-term interest rates have not yet made any significant upwards move. When they do, it may be time to start worrying about violent market corrections, but that time is not yet here.