In a two-part series, Nick Dewhirst explores market categorisation and by using four examples of Wall Street crashes tries to determine the nature of the current downturn. This week, the falls of 1980 and 1987 are examined
According to the strategists, a blip is less than -10%, a correction is between -10% and -20% and a bear market is more than -20%. So, does this mean the 7% decline on Wall Street is a blip, the 12% fall in Asia ex Japan is a correction and the 25% drop among emerging markets is a bear market?
However neat this categorisation, it is not very helpful because it only tells us what has already happened. Categorising something as a bear market suggests prices may have a lot longer and a lot further to fall. What if the decline is already largely complete? If so, it would be foolish to sell at these depressed prices.
It seems more useful to use the words correction and bear market in terms of duration rather than extent. Here, therefore, I offer some historical perspective, based on four comparable corrections.
In 1980, Wall Street fell 20% in six weeks starting in mid- February. This correction was caused by the US dollar crisis.
There had already been two mini-crises in 1978 and 1979 as the dollar fell 30% from 2.4 to 1.84 deutsche marks. An initial policy of benign neglect was replaced by one of interest rate increases forced on the Federal Reserve Bank by the bond market vigilantes discovering their power. Despite the dollar crisis, the Standard & Poor's index managed to reach a new eight-year high in January, not far below its 1972 all-time peak.
During this process there was a change of control at the Fed, where the new chairman Paul Volker had to demonstrate his inflation-fighting credentials. Interest rates had already risen from 6% to 12%, but when another sinking spell sent the dollar to new lows in the spring of 1980, Volker acted by hiking interest rates to an unprecedented 15%. The market hit bottom in a classic one-day reversal, where volume surged 40% above average during the decline.
Within four months the dollar had rallied, interest rates fell back below 10% and the market had risen to an all-time high. However, the era of high interest rates caused lasting damage to money centre banks and the savings and loan industry over the next three years.
In 1987, Wall Street fell 34% in six weeks during September and October, of which 20% occurred in the last day alone. This was caused by portfolio insurance at a time of widespread overvaluation.
The economy had been growing steadily, if unspectacularly and there was ample spare capacity. Inflation had been brought under control, falling to a new low of 1.5% the year before, but had begun rising again and had exceeded 4%, a level last seen in 1984. In response the authorities raised interest rates modestly from 5.5% to 6.4%, back up to where they were 18 months earlier.
However, the stock market was at an all-time high, having more than doubled since 1981 on the back of the dis-inflation thesis. This drove P/E ratios over 17 times, the highest level since 1973. More importantly, as bond investors required more evidence to become convinced about the death of inflation, equity valuation had reached a record high of twice bond valuation, when measured by the Fed ratio.
So-called portfolio insurance had become a popular means for protecting against losing these capital gains, in that it appeared to be cost free. Rather than taking the expensive traditional route of buying put options, institutional fund managers gave advisers authority to place stop-loss orders in the futures markets against their entire equity portfolios. All assumed there would be sufficient liquidity for their own clients to exit the market, but failed to take into account the unsuspected large numbers of competitors operating on the same basis.
These became sell low, where daily selling peaked at 140% above the monthly average.
Once again there had been a change of control at the Fed, where Alan Greenspan replaced the retiring Volker. However, this time the new chairman was tested on his deflation-fighting skills. The Fed carried out its duty as lender of last resort, flooded the market with funds and lowered interest rates.
Within two years, the stock market was once more trading at new all-time highs. While financials suffered the most short-term, they rebounded disproportionately and no particular sector suffered lasting damage.
Next month will look at the 1990 and 1998 Wall Street falls of 20% in 10 and five weeks respectively.
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