Magazine article The Spectator

Twelve Steps to Market Meltdown

Magazine article The Spectator

Twelve Steps to Market Meltdown

Article excerpt

At times of financial crisis there is often a feeling that all the old certainties have been blown away. But what is striking about the entire history of stock-market crises is that they fall into a pattern -- and this pattern makes it possible to make broad predictions about the panic cycles that have been remarkably consistent for more than a century.

American experts have dominated the sub-genre of identifying panic cycles, notably the market historian Charles Kindleberger and the economist Hyman Minsky. Based on their work, it is possible to identify the stages of the cycle -- but not, to pre-empt the obvious question, to know exactly when it will end. So, here's a 12-point guide.

Stage 1: all cycles can be said to begin with buoyant equity markets fuelled by a major development which stimulates at least one sector of the economy. In recent memory, one such stimulus was the development of the internet that led to the dotcom boom. In the most recent cycle the stimulus was clearly provided by the provision of cheap and plentiful credit to businesses and individuals, largely as a consequence of US monetary policy.

Stage 2: what all these stimuli have in common is that they lead to the expansion of money supply and of bank credit -- spectacularly so in the current period. Stage 3:

the cash swilling around the system induces irrational euphoria, producing heavy speculation and excessive borrowing. Stage 4:

the entry of large numbers of market novices into the stock market is the most visible characteristic of this next stage. Tales of fortunes made stimulate even greater risk-taking, combined with a reckless belief that this time it will be different. The classic example was the statement by Irving Fisher, the renowned Yale University professor, who said, just ahead of 1929 crash, 'Stock prices have reached what looks like a permanently high plateau.' It took two and a half decades for that plateau to be reached again.

Stage 5: once stock-market news, and news of property prices, moves from the business pages of newspapers to the front pages, the die is cast. Stage 6: as the market heats towards boiling point, there is increasing detachment between stock prices and the underlying value of the assets they represent. Shares trade on daunting price-earnings ratios and 'old-fashioned' ideas such as the relationship of share prices to their yields -- that is, their dividend payments -- are widely scoffed at. Stage 7: as investors scramble for shares, issuers obligingly produce all kinds of new issues to cater for this demand. As demand for conventional financial instruments rises, new and ingenious derivatives are brought to the market, allegedly for the benefit of more sophisticated investors. But the truth is that they become so complex that even so-called professionals have trouble understanding them.

The key problem here is that these derivatives are, almost by definition, margin plays:

as the bubble begins to burst there is a rapid and brutal demand for repayment by lenders who have funded the growth of the derivatives markets.

Stage8: things start unravelling as a number of outright scams and dubious practices come to light. Stage 9: the more savvy investors start making their way out of the market, while newer players fret and wonder what to do. As prices fall, lending institutions become more insistent on repayment of loans and make conditions more onerous, forcing sales of assets, which leads to greater downward pressure on prices. …

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