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Black Monday – 25 years on

The international stock market crash of 1987, or “Black Monday” as it is referred to in the financial world, was the largest one-day decline in the history of the stock market. The Dow Jones in the US declined by an astonishing 22.6 per cent in just one day – Monday, October 19, 1987.

The 1987 crash looks insignificant on a long-term chart today
- Edward Rizzo

In the UK, the FTSE 100 plummeted 11 per cent that day and a further 12.2 per cent the following day. It has been 25 years but that financial meltdown still continues to grab the headlines of major financial journals in view of the extent of the crash that sent shock waves around the world.

To try to analyse the reasons behind the steep decline, one would need to understand the economic backdrop and the performance of the major stock markets in previous years. A bull market had started way back in 1982 fuelled by a low interest rate environment, a succession of takeovers and mergers, and a multitude of new initial public offerings. All were very successful with numerous investors seeking to get hold of minority stakes in various new public companies, including privatisations of large well-known government-owned companies, especially in the UK.

Investor sentiment was generally euphoric leading to strong gains in equities in 1986 and 1987. In 1986, the FTSE 100 in the UK had advanced by 19 per cent while in the first nine months of 1987, the UK benchmark index had already rallied by a further 37 per cent before the market crash.

Similarly, the Dow Jones in the US had climbed by 44 per cent reaching its highest level in August 1987. An interesting indicator showing the extent of the sharp rally is that at the time of the market peak in the summer of 1987, dividend yields on equities were only approximately one-third of the yields on bonds. The opposite holds true today with yields on certain equities above the returns provided by bonds as the sharp declines in interest rates and resultant higher bond prices have led to very low returns on bonds. Is it now likely that the bond market is about to crash rather than the equity market?

Back in 1987, the high rate of economic growth in the US economy led to inflationary concerns and overheating in various sectors of the economy. To prevent higher inflation and to protect the value of the US Dollar which had been on a steady decline, the Federal Reserve raised interest rates in rapid succession.

This dampened investor enthusiasm and created tension among other G7 members leading to a 17 per cent decline in the Dow Jones from its August peak. Moreover, a few days before Black Monday, data in the US indicated that economic growth was softening and this led to renewed caution among investors.

Some market followers recently commented about their experiences of 25 years ago and point to an incident in the Persian Gulf as a determining factor when two US warships had attacked an Iranian oil platform. Equity markets are normally vulnerable to a sharp setback when several incidents threaten to take place concurrently. Investor concerns on fears of a war breakout and the other factors at play at the time led to the buildup of the stock market crash in October 1987.

Black Monday actually started early morning in Hong Kong, spreading quickly to Europe as the markets opened, and likewise in the US as the Wall Street opening bell rang. On the day, the Dow Jones Industrial Average collapsed by 22.6 per cent and the markets in Hong Kong and Australia lost more than 40 per cent. Share prices in nearly every country worldwide plunged in a similar fashion as panic selling was the order of the day.

The Federal Reserve intervened to prevent an even greater crisis unfolding. Alan Greenspan, who had taken up his post as chairman of the Fed only two months earlier, lowered interest rates and promised to save any US institution suffering liquidity problems to counteract a potential recession and banking crisis. After hitting their lowest levels in November, markets recovered rather quickly from the crash as companies started buying back their own shares following the sharp falls in prices.

A sequence of interest rate cuts brought relief to the markets. Within two years, the FTSE 100 had regained its pre-crash level. This is possibly one of the major lessons that investors ought to bear in mind from such an incident. Investors should not panic when such a widespread downturn takes place since the losses will be crystallised once the sale of an investment takes place. The same recovery pattern was also evident in late 2008 and early 2009. Maintaining calm is much easier said than done, and with most investors normally shocked at a crash, few take immediate action to accumulate shares that would have fallen rapidly.

Ideally investors should wait for markets to calm down before deciding on any further action. Investors who panicked and sold out amid the downturn must have remained very disappointed over the years after having missed out on the strong recovery in the equity markets since then.

Another lesson to remember from the crash of 1987 and the more recent downturn of 2008-9, is that investors should take a long-term perspective when taking an exposure to shares. The 1987 crash looks insignificant on a long-term chart today even though the huge fall in values must have been hard to digest at the time. Similarly, markets recovered fairly quickly from the initial reaction to the bankruptcy of Lehman Brothers in September 2008 although the ensuing international financial crisis gripped world economies in a much more severe fashion than in 1987.

This setback will probably also be seen as a largely insignificant downturn in 20 years’ time. Share prices generally reflect a company’s fundamentals, hence irrational market behaviour caused by such incidents create attractive opportunities for seasoned investors.

Few readers recollect that as all company shares declined rapidly in 2008-9, the share price of Apple Inc had dropped from the peak of $200 in late 2007 to almost $80 in October 2008.

After recovering slightly by the end of that year, this level was reached again in early 2009. However, by the end of 2009, the share price of Apple had surpassed the $200 level and has risen steadily since then. Clearly, investors who panicked in 2008 and sold their shares lost heavily, whereas those who held on to their shares were amply rewarded. The same holds true for many other blue chip companies listed on the main international stock exchanges. Apple shares today, four years after the latest downturn, are trading at around $620 having hit a high of $705 quite recently.

To take advantage of such situations, investors should maintain some readily available cash to fund an acquisition of shares when unexpected price declines occur.

Moreover, it is also important for investors to be aware of companies which could be worth including in their investment portfolio given their interesting longer-term outlook. Such a watch list would help investors act swiftly when setbacks take place and avoid rash decisions which may not have been sufficiently researched amid the panic.

A widely held view among many value investors is that one should avoid investing based on emotions and common beliefs. Contrary to conventional spending patterns, retail investors tend to favour shares when prices are rallying and shun them when prices are falling.

Investors should behave in the opposite manner and look favourably towards an investment when prices are low as opposed to when prices are peaking.

This is one of the key investment practices commonly used by some of the world’s renowned long-term investors like Warren Buffett. His article “Buy American: I Am” published on October 16, 2008, when markets crashed following Lehman’s bankruptcy initially drew lots of criticism since the markets had continued to decline until March 2009. However, with hindsight, Mr Buffett was yet again on the right side of the trade with strong capital appreciation in just a few years.

The crash of October 1987 was basically the result of a stock market bubble created over many years. All bubbles eventually burst causing a black day on the stock market.

However, such events could have a silver lining as they throw out opportunities for brave and contrarian investors.

Rizzo, Farrugia & Co. (Stockbrokers) Ltd, RFC, is a member of the Malta Stock Exchange and licensed by the Malta Financial Services Authority. This report has been prepared in accordance with legal requirements. It has not been disclosed to the issuer/s herein mentioned before its publication. It is based on public information only and is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments.

The author and other relevant persons may not trade in the securities to which this report relates (other than executing unsolicited client orders) until such time as the recipients of this report have had a reasonable opportunity to act thereon. RFC, its directors, the author of this report, other employees or RFC on behalf of its clients, have holdings in the securities herein mentioned and may at any time make purchases and/or sales in them as principal or agent. Stock markets are volatile and subject to fluctuations which cannot be reasonably foreseen. Past performance is not necessarily indicative of future results. Neither RFC, nor any of its directors or employees accept any liability for any loss or damage arising out of the use of all or any part thereof and no representation or warranty is provided in respect of the reliability of the information contained in this report.

© 2012 Rizzo, Farrugia & Co. (Stockbrokers) Ltd. All rights reserved.

www.rizzofarrugia.com

Mr Rizzo is a director at Rizzo, Farrugia & Co. (Stockbrokers) Ltd.

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