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.