Stephen King: Latest declines already the worst since 1973 crash

The September tragedy has accelerated what had already become an unpleasant bear market trend
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The Independent Online

From human tragedy to financial panic. The collapse in equity prices over the last few days has been extraordinary by any standards. Even worse, the collapse has accelerated a process that was already under way many months ago. From its peak in March of last year, America's S&P 500 has fallen by about 35 per cent. Most of this decline – approaching 30 per cent – occurred before the horrific events of 11 September. On this basis, the September tragedy has accelerated what had already become an unpleasant bear market trend. And it's a negative trend that is no longer restricted to technology stocks: over the last few days, all sectors have been suffering to a greater or lesser extent.

The decline in equity prices seen so far already looks hideous from an historic perspective. In a "league table" of bear markets since the 1950s, the latest decline is already in the "runner-up" position, beaten only by the collapse that began at the beginning of 1973 and which ultimately amounted to a drop of more than 43 per cent. Adjusting for inflation, the situation is – relatively – better: the latest decline is little affected (after all, inflation is very low) but the 1973/74 period looks a lot worse, with an inflation-adjusted decline of 53 per cent. Nevertheless, the "runner-up" position for the latest decline is still retained.

In other words, equity performance has recently been worse than during the early-1990s recession and Gulf war (down about 15 per cent), worse than at the time of the 1987 stock market crash (down about 27 per cent) and worse than during the early 1980s recession and Latin American debt crisis (down about 19 per cent). Indeed, to find declines which come close to matching the latest drop, you really have to go back to the end of the 19th century, and the first 40 years of the 20th century. The falls seen during those years were typically in the 30 to 40 per cent range. The obvious exception, of course, was the 1929 crash when equities ultimately lost about 85 per cent of their peak value.

What do the latest declines mean? For starters, there is a danger of extrapolating too much from just a few days' closing prices. After all, the wild gyrations in share prices on Friday afternoon – when the Dow Jones went from big losses to gains and, then, losses once more – suggest that there is little clarity either in terms of valuation or expectations for future profits growth. More importantly, it is becoming increasingly obvious that the equity market is in danger of becoming the financial tail that is wagging the economic dog. Put another way, we often tend to think that equity markets fall in anticipation of recession and rise in anticipation of recovery. Although partially true, the problem lies in explaining why the latest declines – and those in 1973/74 – have been so much worse than in other periods. After all, there have been plenty of recessions over the years yet equity declines are rarely this bad.

The recession risk is almost certainly playing a role in the market's persistent decline. Regular readers of this column will know that I was particularly pessimistic about America's economic prospects well ahead of the 11 September tragedy. Earlier in the year, this was not a universally held view. According to Consensus Economics, the forecasting community was pointing to real GDP growth in the US of 1.6 per cent this year followed by a further 2.7 per cent next year. Although not an impressive outlook by recent standards, these numbers nevertheless implied a "soft landing" for the US economy.

Most economists, therefore, saw recession as a risk rather than as a central scenario. The US tragedy has changed all that: forecasters in general now appear to be intent on downgrading their numbers aggressively. To the extent that this reflects a shift in recessionary fears for the market more broadly, it is not surprising that the equity markets should have fallen further.

Other factors, however, are also at work. Over the last few days, the equity strategists at HSBC have been re-assessing the outlook for the equity risk premium. The risk premium fell rapidly through the 1990s, helped along by falling inflation, a perception of greater macroeconomic stability and the peace dividend which stemmed from the collapse of the Berlin Wall. The attacks on New York and Washington have the potential to reverse this trend. Suddenly, the world seems a more dangerous place, both in terms of any military response from the US and its allies and from the risk of further terrorist attacks. Other things being equal, a rising risk premium must imply a fall in the value of equities against other, more liquid, financial assets.

Perhaps the dominant long-term issue, however, is the extent to which the equity price falls over the past year or so are simply a reversal of an earlier bubble. On this basis, the latest declines could be more a sign of earlier excess rather than current failure. Throughout this year, economic developments have supported this thesis. For example, the Fed has slashed interest rates by a total of 3.5 per cent since January, a pace of monetary easing virtually unprecedented in recent history. In normal circumstances, this degree of interest rate cuts would have led to a rapid equity rebound. Yet, as the chart shows, this manifestly has not been the case. Moreover, the failure of equities to rise may also have had negative consequences for economic growth: falling equity values should be associated with negative wealth effects for households and a decrease in capital availability for companies.

It may simply be that monetary policy is taking its time to feed through, that the lags in the transmission mechanism are a bit longer this time around. Maybe. However, a weak response to lower interest rates may indicate ingrained problems within the balance sheet of the US private sector. In the late 1990s, the gains in equity prices – driven by hopes of a productivity miracle – were associated with rapid rises in private sector liabilities. A good example of this is the massive increase in consumer indebtedness over the past few years. Expanding the balance sheet is fine so long as asset prices continue to rise. When the process goes into reverse, the risk becomes one of extended economic pain. Previous perceptions of a strong economy change very quickly, with asset prices collapsing like a house of cards.

If there is some good news, it comes from the policy actions seen over the last few days and the likelihood that we will see more to come in the months ahead. Indeed, it now looks likely that US interest rates could fall a further 1 per cent by the first quarter of next year, which will prompt interest rate cuts in both Euroland and the UK. It's also likely that the US will be loosening fiscal policy a lot more quickly than might otherwise have been the case. On that basis, a more aggressive economic contraction over the next couple of quarters should be followed by a rebound later next year.

Even then, however, there are grounds for caution. To the extent that the recovery will be increasingly prompted by fiscal loosening, the government will have a bigger and bigger role to play. That may be entirely appropriate. Note, however, that active fiscal policy leads to sometimes unforeseen and unwelcome changes to economic structure. In the late 1960s, the combination of loose monetary and fiscal policy – partly a response to the Vietnam war – contributed to the emergence of inflation. Loose fiscal policy during the early 1980s, accompanied this time by tight monetary policy, gave rise to penal real interest rates for the private sector. Of course, neither argument may apply today. However, as Fed chairman Alan Greenspan warned last week, rubbing the fiscal policy lamp too aggressively now could release all sorts of unpleasant genies.

Stephen King is managing director of economics at HSBC.

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