Monday 19th October

Monday 19th October

14 Oct 2015

Next Monday is an evocative date for those of us who worked in the City of London in 1987. The nineteenth of October became known as Black Monday (not the first or the last) as global stock markets went into meltdown. The Dow Jones Industrial Average fell by 22.6% in that single day. At one point during the trading day it was reported that the Chairman of the SEC (the U.S. Securities and Exchange Commission) had mentioned the possibility of suspending trading. Naturally this increased the level of panic.

It felt all the more dramatic because the previous Friday, the 16th, had seen the Great Storm that felled trees all over Southern England. My wife and I drove into work that morning through streets that had been laid to waste a few hours before. The City was spookily quiet and the stock market felt abandoned but was also very weak. It turned out to be an eerie harbinger of the full scale panic that was to follow.

If you search for explanations of Black Monday you will generally read that the stock market was overheated, partly inflamed by excited takeover activity. In September 1987, the ad agency Saatchi & Saatchi made an approach to buy Midland Bank. Nothing better exemplified the mood of the time – that anything was possible for the new money of the eighties. The Conservatives, led by Margaret Thatcher and Chancellor Nigel Lawson, had won the General Election on 11th June, seemingly confirming that the corpse of socialism had been buried and that capitalism could bring prosperity to anyone with the ambition to pursue it.

It is certainly true that the developed world stock markets had risen substantially in 1987. By mid-July the FTSE 100 was up by 45%.  In that sense, prices were high though of course that is not the same as saying that they were expensive. All value is relative, as we know.

As stock markets rose, bonds fell. This is a classic danger sign. Ten year gilt yields rose from 8.8% in May to 10.1% in September. High street savings accounts paid 9%. From today’s perspective, it seems incredible that equities were so popular. In relative terms, they really did look very expensive.

There are some parallels with October 19th 2015 as it approaches. The Conservatives have won an election. The corpse of socialism is wearing a beard and leading the Labour party. It’s forecast to be a bit breezy on Thursday night.

But that’s about it. One of the reasons for owning equities in 1987 was they could be seen as a hedge against inflation. The RPI was 17.2% in 1979, 15.1% in 1980 and 12.0% in 1981 meaning that investors were very wary of being stuck with negative real yields in gilts. Yet by 1986 and 1987, RPI was down to 3.7% and gilts yielding 10% were great value, even if that is only obvious in retrospect. In my view, the cause of the October 1987 crash was simply that equities were foolishly expensive. You can come up with any number of events to justify the panic but that simple background fact explains it. It was largely a one-of correction. The FTSE ended the year 30% below its July peak but still 2% above its level on 31 December 1986. Overall, it was a quiet year.

By the measures of 1987, equities look amazingly cheap today. Gilts and savings accounts pay barely 2%. In terms of income they were five times as attractive 28 years ago. The FTSE 100 today yields 3.85%. It looks dangerously like a no-brainer. What valuation comparison could possibly cause equities to crash on Monday?

In terms of probability, I feel on safe ground saying that a repeat of 19th October 1987 is unlikely. Yet we always live in potentially dangerous times. I mentioned earlier that in 1987 people owned equities as a protection against having the real value of their savings eroded by inflation. Yesterday the UK CPI for September was reported as -0.1%. On that basis, cash under the mattress looks like a relatively sound investment.  

The real threat of zero inflation or deflation is not that it makes cash look attractive. It is rather that it is a sign of very low or negative growth that implies that the size, earnings and value of global corporations could shrink. The value of equities as a static measure is absolutely fine. No problem at all. Today’s threat is based on a perception of contraction and is personified by what is at present mild panic about Chinese growth.

None of us reliably understands Chinese growth. A few people think that Chinese GDP numbers have been made up for some years. It may be that the global fall in commodity prices this year is a sign that China is bloated with unwanted inventory. We may never know.

What we can say with more confidence is that government bond yields have never been lower. They are discounting something close to economic Armageddon. If you fear a crash of prices in October 2015, maybe that’s where you should look.  

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