Ten years on, will the bull market end in another crash?

  • @TomStevenson_
On Monday 19 October 1987, stock markets around the world crashed. As the 10th anniversary approaches, Tom Stevenson, Financial Editor, asks whether history will repeat itself.

If you own shares or have a pension and you want a fright, look at the two charts on this page. They superimpose the current bull market on Wall Street on to its two most notorious predecessors, the speculative bubbles that ended so catastrophically in 1929 and 1987. The similarities are, to say the least, worrying.

If you believe that history repeats itself, it is time to run for cover from a crash that will destroy billions of pounds of savings and pensions and couldwreak havoc in the real economy beyond the financial markets. History does not repeat itself, of course, either in the magnitude of events or their timing. Ask half a dozen City professionals what will happen to stock markets over the next year and you will get six different answers. That interplay between fear and greed, pessimism and optimism is what makes for a vibrant market.

But those raw emotions can blind otherwise rational people, as one famous investor, Joe Granville, noted: "Bear markets never come by appointment, ringing your front door by daylight hours. They come like a thief in the night, sneaking in the back door while the public sleeps the slumber of confidence."

If that is true, the growing bullishness on Wall Street should set alarm bells ringing. The ratio of calls to puts for S&P index options, as good a measure of stock market confidence as any, is showing a more worrying proportion of optimists about the future direction of the market to pessimists than at any time this decade.

That chimes with a cynical view of bull markets which suggests that they always go through the same three phases. In the early stage of a stock market rise there is plenty of value around and professional investors pile into underpriced stocks, driving their value up.

Once shares become overpriced on fundamental valuation models, the professionals bail out in anticipation of a correction. It doesn't come, however, because private investors push shares higher. That makes fund managers nervous because they are missing out and they think of a way of getting back into the market without losing face.

They can't admit to their trustees that they got it wrong when they withdrew from the market so they kid themselves it is different this time. The "new paradigm" is invented, usually a tenuous theory about low inflation and technological change, and the professionals return for a final orgy of speculation before it all ends in tears.

We are almost certainly in the final stages of the current bull run. What is unclear is whether this one will end with a bang or a whimper. There are plenty of reasons why a crash might happen - the scale of the rise on Wall Street, rising interest rates, high valuations, a heavy trade deficit and tensions about the US/Japanese exchange rate. But there are equally plausible reasons why it won't.

Some shares are very highly rated, but strip out banks, oils and pharmaceuticals from the index and 1997 has actually been a rather disappointing year on the stock market. Exporters, affected by the strength of sterling, and pretty much any small company, have missed out on the FTSE 100's bonanza.

Although the market is as highly rated as it was in 1987, with shares trading on average at around 20 times earnings and dividend yields low, that is possibly justifiable when low inflation and so interest rates reduce the attractions of other financial assets. Another crucial difference is in the supply of new equity to the market. In 1987 companies were issuing new shares like confetti, while this year there have been hardly any new issues or cash calls.

At the bottom end of the market, directors of companies are buying shares in their own businesses at a faster rate than at any time since the dark days of 1992, just before the pound fell out of the exchange rate mechanism. The prospect of a weaker pound and strengthening European export markets signals good profits growth for smaller exporters.

The way London tracks Wall Street means a fall in the US market will be impossible to shrug off here. But will it turn into a bear market like the slump between April 1972 and December 1974 when shares lost 70 per cent of their value?

Probably not. The crash of 1998 is likely to be a correction of between 10 and 20 per cent followed by fairly rapid recovery. But be warned. It is fashionable to dismiss talk of bear markets but one only has to look at Japan, where shares are still more than 50 per cent below their 1989 peak, to know that the wily bear is still out there. Waiting patiently.