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Friday, February 22, 2013 - 18:37
Greed and fear

Last October marked the 25th anniversary of one of the biggest stock market crashes ever: 20th October 1987 is known in international circles as “Black Monday”, where in one day the US market lost over 20%; and between 14th October and 19th October prices fell 28.5%. Over this period, the value of all US shares lost almost $1 trillion.


Explains Ian de Lange of Seed Investments, “A stock market crash is an event where there is a sudden price decline across a broad section of the market, where prices are driven down sharply by negative psychological sentiment. The history of publicly quoted market prices is one which is littered both with price bubbles and with spectacular crashes.”
For many investors it is this possibility of a meltdown in prices that scares them from investing a reasonable proportion of their capital. “Indeed, it is healthy to have a sceptical attitude towards quoted prices because,” he says, “while fundamentals ultimately drive prices over the longer term, it is also important to understand that the emotional factors of fear and greed can drive prices far away from their true values.”
Twenty-five years ago on Monday the 19th, panic set in and everyone turned seller, resulting in the Dow Jones Industrial Average plummeting 22.6% on the day. This was the biggest single decline since 1929 and was the subject of plenty of debate including a detailed report to the US president titled the, “Presidential Task Force on Market Mechanisms”.
Prices had been driven up over 40% from the previous year to August 1987. Over a 5 year period from August 1982, the Dow had risen by a compounded 28.5% to its then peak in August 1987. Despite the spectacular October crash the Dow Jones Industrial Average ended up slightly for the year.
The benefit of hindsight and a large degree of rationality allowed market participants to investigate some of the reasons that may have sparked the panic. Some of the reasons put forward included:
• On Friday 16th October 1987, UK markets were closed due to a major storm;
• In the week prior to the crash, an unexpectedly large US trade deficit was released, which led to the possibility of a decline in the dollar relative to other currencies;
• The most widespread explanation was so called program trading, which is computerised trading by large institutions using buy and sell levels;
• Another major cited factor was the increased use of derivatives. Typically futures and options are used as portfolio insurance, but the writers of these were forced to sell as prices plummeted, further exacerbating downward pressure; and,
• Relatively expensive valuations. PE ratios had expanded to a level of 20, from a long term average of 15.

The long term log chart of the Dow Jones Industrial Average puts the crash into perspective (see graph). Devastating at the time, with the benefit of hindsight, this particular crash was relatively short-lived and had very little impact on the economy.
Chart : Dow Jones Industrial Average

Says De Lange, “There is never one specific cause of a market crash and indeed, while some have predicted previous crashes including that in 1987, this is near impossible with any degree of regular success. The market decline in 2008 was as a result of a whole different set of circumstances.
“We believe that the single biggest factor that investors need to pay attention to is valuation. This in itself is not an absolute, as emotions of greed can, and often do, stretch valuations. Reducing exposure as valuations become stretched may initially hamper performance, but it often proves beneficial as prices fall back to more normalised levels.”
 

Copyright © Insurance Times and Investments® Vol:26.1 1st January, 2013
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