The recent turmoil in global stock markets re-awakened briefly fears of a stock market crash of such proportions that it would lead to a slowdown in the rate of global economic growth. And even though markets have settled down somewhat, considerable nervousness remains.
The most infamous crash occurred in 1929, of course, and that was followed by a severe and prolonged global depression. In more recent times the stock market crash of 1987 was in fact followed by two quite buoyant years of economic growth in 1988/89.
History shows that the 1987 crash was no more than a downward blip in a steadily rising stock market.
Although economic fundamentals in the US and Europe are exceptionally favourable, it must be remembered that stock markets are often driven by their own internal logic which can at times seem quite irrational. For much of the time movements in share prices are fuelled by investor sentiment. Investor sentiment boils down to the forward momentum of a rising stock market (and the downward momentum of a falling market).
As share prices move higher, more and more money is sucked into the market in the belief that prices will continue to move higher still. As long as the financial system creates sufficient liquidity this can become a selffeeding process which pushes prices to unsustainably high levels.
Essentially, investors buy shares not because they believe that they offer value but because they believe that someone else will soon pay a higher price for the same shares. As long as this belief holds sway any falls in share prices tend to be seen as a buying opportunity ensuring that any corrections are short-lived.
Until recently, the stock markets in the industrialised world have quickly recovered from any setbacks during the current bull run. However, investors should adopt a much more cautious approach to the current conditions for three key reasons:
The turmoil in Asia is not just the result of speculators getting the upper hand. The region is suffering from a variety of fundamental problems. Japan is in recession and is struggling to support a weak financial system. The series of currency shocks in most of the region's smaller economies is only the first shot in what is likely to be a prolonged period of economic and financial restructuring. The Hong Kong dollar is estimated by some commentators to be 50 per cent overvalued on a purchasing parity basis.
Stock market valuations are at historically high levels in the US and in many European markets. Declines of the order of 10 per cent are required in many markets to bring share prices back to levels where they will offer reasonable long-term value.
Major turning points in stock markets are often presaged by increases in volatility and in the volumes of shares traded. In the past few weeks particularly last week we witnessed record daily swings in the Hong Kong market, and of far greater significance, in Wall Street. These gyrations have been accompanied by huge volumes of share trading.
Overall a market crash of 1987 proportions seems unlikely given the strong positive fundamentals of low inflation and solid economic growth. However, the risk of a significant correction of about 10 per cent in the major Western markets is extremely high.
Of course, volatile market conditions can throw up attractive buying opportunities. For example, the Hong Kong Stock Market has been in the eye of the current storm. While it would take a brave investor to buy into the current Hong Kong stock market, there are a number of FTSE-100 stocks which have substantial operations in Hong Kong.
Hong Kong and Shanghai Banking Corporation (HSBC), Standard Chartered Bank (STAN) and Cable and Wireless (CW) are three major international companies. They are reliant on the Asian region for more than half their profits. Not surprisingly, their share prices have fallen significantly.
Although, the share prices of the two banks have fallen very sharply investors would be well advised to refrain from buying just yet. If Hong Kong slips into recession bad debts in the region could rise dramatically which would severely dent the two banks' profits leading to further falls in their share prices.
For banks, the greatest area of exposure is to property related loans. However, a telecommunications company like Cable & Wireless would only suffer marginally from a recession. Given the favourable long-term prospects for telecommunication services in the Far East, the weakness in these shares should be seen as a buying opportunity. But overall, it is a time for investors to be cautious and to pick stocks wisely.
