October is a month of unpleasant anniversaries. The crash of 1929 occurred in October. And this month is also the 20th anniversary of the 1987 crash; 19 October saw a drop of over 22% in the Dow Jones index, the worst single-day decline in its history. The FTSE 100 lost 11% that day and 12% on Tuesday as it reacted to Wall Street’s slide. So could it happen again?
The global backdrop was similar to today’s: oil was on the rise, the dollar was under heavy pressure, and interest rates had been rising. That stoked fears of a slowdown crimping earnings, while stocks looked expensive on a p/e of 23. “So the conditions for a correction – if not a crash – were certainly there,” says James Moore in The Independent. And a technical factor exacerbated the slide. In 1987, computer-driven portfolio insurance was all the rage: when stocks fell, index futures were automatically shorted to hedge positions. But when most big investors tried to short the market at once, the original falls ended up massively exaggerated.
Analysts point out that the main reason this can’t happen now is that US stocks are cheaper than they were. But look at the cyclically adjusted p/e ratio, which smooths out the ups and downs of the profit cycle over the past ten years, and valuations are “above the levels associated with the top of a bull market”, says John Authers in the FT. And contagion could prompt falls of Black Monday’s magnitude, reckons William Strazullo of Bell Curve Trading. We can’t predict what could spark a plunge, but once it starts, “you have a bunch of investors playing with borrowed money… heading for the exits in London, New York and Tokyo”.
The crucial worry for investors now, however, is that market conditions are resembling August 2007 in all sorts of ways. Risk-aversion has returned, with short-term US government bond yields up sharply last week and high-yield corporate debt spreads registering their biggest weekly jump since July. American stocks posted their worst week since late July last week and the FTSE also lost 3% over five days.
Yet more lousy housing data – September housing starts in the US have slumped to a 14-year low – and weak earnings reports lie behind the latest jitters. Industrial bellwether Caterpillar said several of the sectors it supplies are in recession. This stoked fears that the housing slump is spreading, while profit slides at Bank of America and Wachovia have undermined the assumption that the credit losses are somehow contained.
The superfund set up last week to stabilise the market for commercial paper – often backed by subprime mortgage assets – by preventing fire sales has backfired. Not only is it a reminder that credit markets are still a mess, but it is obvious that the bail-out could delay the necessary marking-down of assets. There is a suspicion that “the big four US banks are trying to hide their debts”, says Hans Redeker of BNP Paris. What’s more, says Liam Halligan in The Sunday Telegraph, with subprime defaults set to rise as low introductory interest rates start expiring, “bank balance sheets will start looking even worse”.
US profits are now set to shrink for the first time since 2002 in the third quarter. As the prospect of a sharp slowdown grows, the expected earnings rebound to over 10% in the fourth quarter looks ever more optimistic. That’s especially the case because margins are historically high and thus ripe for mean reversion; according to Rob Arnott of Research Affiliates, earnings are 60% above their ten-year average – a level that implies zero earnings growth over the next ten years. So, says Authers, even if America avoids recession, “there is every reason to fear that earnings growth will fall sharply next year”. And “rare is the day”, says Merill Lynch’s David Rosenberg, that earnings are heading south and the market isn’t doing likewise.