Though our hearts missed a beat, we shouldn't be shocked

A BEGINNER'S GUIDE TO: INVESTING IN SHARES The sharp fall in share prices alarmed many. But it was on the cards, writes Magnus Grimond

Stock market crashes can be disconcerting enough for experienced investors, but for those new to the joys of shares they can be downright offputting. The events of the past week, which saw around 10 per cent of the value of London shares wiped out on Tuesday, are hardly evidence of the sort of glittering returns from shares that this column has been trumpeting.

To be fair, we did highlight the warning signs. Shares are risky; that is why investors demand a return above safer investments like bank accounts. History shows that equities outperform other investments, but it also proves time and again that sometimes they lose touch with reality.

Given the huge rises in stock markets this year, there have been many suggestions that the 10th anniversary of the great crash of 1987 could prove the trigger for a downturn.

The uncanny timing of the latest wobbles in world stock markets, virtually 10 years to the day after the 1987 fall, is probably more than coincidence. Despite the mystique invested in it by some commentators, insiders and politicians, the stock market is just a collection of individuals who make mistakes like anyone else. Indeed, people in a crowd often make bigger mistakes than the separate individuals would on their own. The bull market has shown many of the symptoms of mass psychology.

Sentiment, a sort of indefinable gut feeling that animates all markets, has been unrelentingly positive until recently; so much so that it ignored a raft of bad news in the UK.

It has managed to shrug off the soaring value of the pound, up by a quarter against the deutschmark since last year. This has made the exports of British companies uncompetitive, putting both their profits and their share prices in doubt.

Sentiment also shrugged off the threat that the Government may have to raise interest rates further to curb windfall-induced shopping sprees, which some economists think stoke inflation.

And it has completely disregarded the Government's decision to abolish the tax credits that many of the big City share-buying institutions used to get with their dividends; at a stroke, that cut their income from shares by 20 per cent.

With such a powerful list of reasons why shares should not go up, it was perhaps hardly surprising that the crowd in the stock market should be looking for reasons to sell. The problems of Hong Kong and a collapsing US stock market provided the perfect excuses, with perhaps the 10th anniversary of the Black Monday crash a subconscious reminder of what happens when share prices get out of hand.

But how similar are this week's events to past crashes, and what should investors do now? The run-up in US shares between 1995 and the middle of this year was uncannily reminiscent of previous crashes. The only other times this century that prices have doubled in under three years was in the lead-up to the collapses of 1929 and 1987. The big question is whether the latest dip heralds a major economic slump, as happened in 1929 (and again in 1974), or will turn out to be just a "correction" like 1987, which merely blew the froth off some very overblown share prices.

Luckily for investors, most evidence at the moment points to the latter view. As in the early 1970s and in 1987, the average price-earnings ratio of UK shares has been as high as 19, which is well out of line with the historic average. Although this suggests that shares are overvalued, the traditional linkage between the dividend yield on shares and the yield from government bonds, or gilts, is pointing in the other direction. A rule of thumb says that when the gilt return rises much above 2.2 times the yield on equities then shares are looking over-valued. On this measure UK shares are not expensive, with the ratio standing at around 1.9 compared with over 3 in both the early 1970s and just before the 1987 crash.

But there are two problems with this analysis. One is that the removal of tax credits has cut the real yield from most institutions' shares to 2.8 per cent, below the lows hit in 1972 and 1987. This pushes the underlying gilt-equity ratio to something more like 2.3 times and into the danger zone. The other is that the economic outlook remains murky. If interest rates do have to rise more than expected then gilt prices will fall and yields will shoot up, stretching that key ratio even further.

Richard Jeffrey, a bearish economist at stockbrokers Charterhouse Tilney Securities, points out that over the past few years shares have produced returns well above the average for this century. The principle that returns revert to the mean suggests they will have to fall to maintain their traditional performance. On the other hand, if you had been brave enough to invest pounds 1,000 in the Footsie in November 1987, it would now be worth nearly pounds 3,000.

If the storm now seems to have passed, we could merely be experiencing what the Americans call a "sucker's rally" before the next dive.

Markets will certainly remain nervous, but any real recession is probably a year or two off, suggesting shares will soon be worth buying again.

News
Russell Brand was in typically combative form during his promotional interview with Newsnight's Evan Davis
peopleReports that Brand could stand for Mayor on an 'anti-politics' ticket
News
The clocks go forward an hour at 1am on Sunday 30 March
news
Arts and Entertainment
The Doctor finds himself in a forest version of London in Doctor Who episode 'In the Forest of the Night'
TVReview: Is the Doctor ever going stop frowning? Apparently not.
News
Voluminous silk drawers were worn by Queen Victoria
newsThe silk underwear is part of a growing trade in celebrity smalls
PROMOTED VIDEO
Sport
footballMatch report: Real fight back to ruin Argentinian's debut
News
Candidates with surnames that start with an A have an electoral advantage
newsVoters are biased towards names with letters near start of alphabet
Arts and Entertainment
Isis with Lord Grantham (Hugh Bonneville)
TV
News
Rainbow List
Arts and Entertainment
Jay James
TVReview: Performances were stale and cheesier than a chunk of Blue Stilton left out for a month
News
ebooksAn unforgettable anthology of contemporary reportage
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Compensation and Benefits Manager - Brentwood - Circa £60,000

£60000 per annum: Ashdown Group: Compensation and Benefits Manager - Compensat...

Data Analyst/Planning and Performance – Surrey – Up to £35k

£30000 - £35000 Per Annum plus excellent benefits: Clearwater People Solutions...

IT Systems Business Analyst - Watford - £28k + bonus + benefits

£24000 - £28000 per annum + bonus & benefits: Ashdown Group: IT Business Syste...

Markit EDM (CADIS) Developer

£50000 - £90000 per annum + benefits: Ampersand Consulting LLP: Markit EDM (CA...

Day In a Page

Wilko Johnson, now the bad news: musician splits with manager after police investigate assault claims

Wilko Johnson, now the bad news

Former Dr Feelgood splits with manager after police investigate assault claims
Mark Udall: The Democrat Senator with a fight on his hands ahead of the US midterm elections

Mark Udall: The Democrat Senator with a fight on his hands

The Senator for Colorado is for gay rights, for abortion rights – and in the Republicans’ sights as they threaten to take control of the Senate next month
New discoveries show more contact between far-flung prehistoric humans than had been thought

New discoveries show more contact between far-flung prehistoric humans than had been thought

Evidence found of contact between Easter Islanders and South America
Cerys Matthews reveals how her uncle taped 150 interviews for a biography of Dylan Thomas

Cerys Matthews on Dylan Thomas

The singer reveals how her uncle taped 150 interviews for a biography of the famous Welsh poet
DIY is not fun and we've finally realised this as a nation

Homebase closures: 'DIY is not fun'

Homebase has announced the closure of one in four of its stores. Nick Harding, who never did know his awl from his elbow, is glad to see the back of DIY
The Battle of the Five Armies: Air New Zealand releases new Hobbit-inspired in-flight video

Air New Zealand's wizard in-flight video

The airline has released a new Hobbit-inspired clip dubbed "The most epic safety video ever made"
Pumpkin spice is the flavour of the month - but can you stomach the sweetness?

Pumpkin spice is the flavour of the month

The combination of cinnamon, clove, nutmeg (and no actual pumpkin), now flavours everything from lattes to cream cheese in the US
11 best sonic skincare brushes

11 best sonic skincare brushes

Forget the flannel - take skincare to the next level by using your favourite cleanser with a sonic facial brush
Paul Scholes column: I'm not worried about Manchester United's defence - Chelsea test can be the making of Phil Jones and Marcos Rojo

Paul Scholes column

I'm not worried about Manchester United's defence - Chelsea test can be the making of Jones and Rojo
Frank Warren: Boxing has its problems but in all my time I've never seen a crooked fight

Frank Warren: Boxing has its problems but in all my time I've never seen a crooked fight

While other sports are stalked by corruption, we are an easy target for the critics
Jamie Roberts exclusive interview: 'I'm a man of my word – I'll stay in Paris'

Jamie Roberts: 'I'm a man of my word – I'll stay in Paris'

Wales centre says he’s not coming home but is looking to establish himself at Racing Métro
How could three tourists have been battered within an inch of their lives by a burglar in a plush London hotel?

A crime that reveals London's dark heart

How could three tourists have been battered within an inch of their lives by a burglar in a plush London hotel?
Meet 'Porridge' and 'Vampire': Chinese state TV is offering advice for citizens picking a Western moniker

Lost in translation: Western monikers

Chinese state TV is offering advice for citizens picking a Western moniker. Simon Usborne, who met a 'Porridge' and a 'Vampire' while in China, can see the problem
Handy hacks that make life easier: New book reveals how to rid your inbox of spam, protect your passwords and amplify your iPhone

Handy hacks that make life easier

New book reveals how to rid your email inbox of spam, protect your passwords and amplify your iPhone with a loo-roll
KidZania lets children try their hands at being a firefighter, doctor or factory worker for the day

KidZania: It's a small world

The new 'educational entertainment experience' in London's Shepherd's Bush will allow children to try out the jobs that are usually undertaken by adults, including firefighter, doctor or factory worker