Black Monday. Originally, the term was applied to the events of 19 October, 1987. The United States economy was moving from a rapid recovery to a slower expansion. During the previous year, the oil price had decreased by more than 50%. As the markets opened that Monday in the Far East, stock markets began shedding value, spreading west to Europe and eventually hitting the US after all the other markets had cratered. The Dow Jones Industrial Average fell 508 points in a single day. Sounds familiar?
Black Monday, 24 August 2015. The United States economy has been sluggish lately, following the rapid recovery after the 2008 Financial Crisis. Over the past year, oil has slumped almost 50% from its highs. As the markets opened in the Far East, stock markets began shedding value in a global panic. The panic soon covered Europe, and spread to the United States. The Dow Jones Industrial Average fell 588 points by the end of the day.
As Elim Garak so deftly put, “I believe in coincidences. Coincidences happen every day! But I don’t trust coincidences.” In fact, this should be followed Tuesday by the classic dead cat bounce in the markets, before the deflation of the bubble continues. This dead cat bounce, derived from fact that even a dead cat will bounce if it falls from a sufficient height, is often seen after a fall in share prices.
All bubbles eventually pop. Bubbles have been around at least as long as there has been a financial market. The earliest, most notable example was the Dutch Tulip bubble of 1636, which had the value of a tulip trading as high as six times the annual average salary. Almost a hundred years later, the South Sea bubble of 1720 had thousands of people losing their life savings based on speculation on the South Sea Company in England. Closer to the present, we are all familiar with the late 90’s internet bubble and, of course, the US housing bubble which precipitated the 2008 financial crisis.
Economic bubbles are created via the basic economic principles of supply and demand. In other words, more people want to buy (demand) than there are people selling (supply). We know a bubble has formed when the price of an asset has increased well above what it’s intrinsic or fundamental value indicates. This is generally simplified as the net present values of future cash flows. If your asset is, say, a rental property, this would be calculated from the expected monthly rental you’d receive from the property. With shares, you can generally use dividend pay outs or the company’s earnings as a basis for the calculation.
In the wake of the financial crisis, most of the more developed economies rushed to try and ‘stimulate’ the market and prevent a recession. Their method? Low interest rates. When you can borrow money at a low rate, and invest it at higher rates, you effectively make money from nothing – which is what the governments were striving to accomplish. In financial terms, this is called leverage. With banks and corporations able to lend on the cheap, there was a veritable rush to buy any financial instrument that can earn a greater yield than the rate they were lending at. This ‘demand’ has been pushing stock prices upwards for years.
Every return, unfortunately, has a corresponding risk inherent to it. You cannot earn greater returns without greater risk. When, as it must, one of the returns is less than the interest you have to pay on the loan you took out to purchase it, you have to sell to cover your loan. When you multiply this by a thousand or more investors all suddenly having to sell at the same time...
Supply and demand shifts the other way. And the bubble pops.
When you look at the S&P 500’s Price Earnings Ratio (basically, how many years’ earnings are included in a share’s price), it peaked at about 21.28 this year. Black Monday brought that down to 19.46. Its historical average is at about 15.55. This bubble’s deflation clearly has some ways to go still.
This, of course, is terrible news for people who borrowed money to invest. Also for fund managers and the like, who are paid bonuses and performance-related fees. But for the average investor, whose investments are what has been saved, well, the economy is still the same. None of the fundamentals have been changed for the companies you invested in – they’ll keep doing business the same way they’ve always been doing.
Stock market investments are long-term investments. Markets go down, but eventually, they’ll go up again. As long as you don’t need the money now, say, to pay off any loans you took out to invest, you should be safe just sitting back, and waiting for the market to recover.
As John Lennon and Sir Paul McCartney so famously wrote, “When I find myself in times of trouble, Mother Mary comes to me. Speaking words of wisdom, let it be.” Words of wisdom, indeed. Let it be.
No comments:
Post a Comment