Another storm is about to hit the eastern seaboard of the United States; let’s hope that its impact on life and property is minimal. Most of those who experienced the hurricane winds that battered the south east of England in October 1987 will be unable to forget the power and subsequent devastation wreaked by the unseen (and unforeseen) force of nature. A relatively rare event for this relatively sheltered part of the world; by contrast, other countries and peoples are more acclimatised to such events – be it strong winds in the Caribbean or excessive rainfall in India.
It wasn’t just trees that came crashing down on 16 October 1987
Co-incidentally, the UK stock market came ‘down to earth with a bump’ as it experienced a dramatic retracement of the inexorable rise seen earlier in the year. What was essentially a global event began in Asia (probably in Hong Kong), before going on to impact Europe and the United States in pretty quick order. Although commentators disagree on the precise cause of the collapse, there are two contributory factors which are generally agreed: electronic trading programs and asset overvaluation.
Of course, there had been a previous ‘Big Bang’
A day in the year before, on 27 October 1986 to be precise, marked a major change in the structure – featuring significant deregulation - of financial markets in the City of London. (Canary Wharf had only been a dream of property developers back then). The introduction of electronic platforms (replacing the face-to-face ‘open outcry’ means of trading) meant that volumes rose markedly, and private investors enjoyed lower costs (as fixed commission charges were abolished). Institutional traders developed sophisticated program trading systems to expedite investment opportunities, notably to arbitrage pricing across different exchanges (for example dual listed securities, with ADR quotes on the US markets). As a consequence, computer systems were primed to generate trades electronically (without human intervention) in response to any pre-set change in value or statistical event, creating a ‘domino effect’ on market values as and when programs sought to eliminate any perception of anomalous price (arbitrage).
By October 1987, valuations had become disjointed from reality
Beyond arbitrage, and the exacerbating factor of providers of portfolio insurance having to sell futures to maintain their proposition’s strategy (which caused markets to fall considerably further than their ‘fair value’), a more considered and fundamental reason for the equity market’s collapse surrounded its valuation. No-one should ever expect market commentators to agree on what might represent a reasonable price for an individual company share or a basket of the largest hundred listed stocks (the FTSE100 index in the UK), but most agreed that at a time of rising inflation both fixed interest bonds and equities were inherently expensive. The ‘bigger fool’ perspective (a theory which suggests: irrespective of general agreement that prices appear rich, another buyer would push them higher) had stretched valuations. Something witnessed again, when technology-related issues propelled the FTSE100 index to its all-time high on the last day of the old millennium.
Short term investor panic
Perhaps inhibited by an inability to take action on big positions, but recognising that a ‘long position’ was a natural residence, the actual volume of trades effected by serious institutional investors in the month of October 1987 was not as high as one might expect. However, many short term private individuals – some having borrowed in order to trade what was then a fortnightly account, rather than a three day, settlement - had their ‘fingers proverbially burned’ in a dash to the exit. Besides those forced sellers, it is almost inevitable that many inexperienced or nervous investors will have been swayed by the front page of newspapers and other media reports proclaiming a ‘financial Armageddon’.
Long term goals
In that one month of October, UK shares fell 26% but the stock market ended 1987 no lower than it began the year. As it turned out, there was no financial meltdown and investors regained their poise – much as has happened since the global financial crisis twenty years on. Instead of invisible electronic program trades, we grappled with no less invisible assets and liabilities on banks’ balance sheets and more recently with the shift of such opaque debt onto public (government) books. It is to be hoped that prudent long term investors will have retained their nerve and realistic targets - while being mindful of the valuation of UK equity, relative to the most obvious comparator assets – over these difficult times. Trying to sell high (booking a partial profit) and buy low makes eminent sense – albeit only obvious with the benefit of hindsight – but clearly this requires a ‘head over heart’ approach to avoid being lured into adopting an emotive (and usually erroneous) response to market developments.
This week brings further evidence on banks
For the jury on the health of the clearers and the wider country’s economy to consider: via interim management statements from Barclays on Tuesday, the Lloyds Banking Group on Thursday and the Royal Bank of Scotland on Friday. While investors can be prejudiced by history, markets are more forward-looking and, besides assessing the respective trading performances of these three domestic leading lenders over the past quarter, their view will be on the outlook for next year. In the case of Barclays, the focus will be on any strategic changes which the new top management may instigate (particularly in terms of business mix and medium term priorities, post the recent acquisition of ING’s UK savings and mortgage book). Lloyds and RBS are expected to show further progress in reducing their dependence on state support and evidence of improving profitability (prior to a probable hike in provisioning for mis-sold PPI) in their core businesses. However, post RBS’ flotation of Direct Line and Lloyds’ sale of 632 branches to the Co-operative Bank, further corporate offload action is required from the former to satisfy European Commission ruling surrounding their branch network: with Virgin favourite to acquire RBS’ bundle of unwanted branches.
Elsewhere, looking at the Week Ahead
We get trading updates from two companies featuring resilient business activities: Imperial Tobacco Group (which was featured in the 24 September blog of cautious blue chips) on Tuesday, and the BT Group on Thursday. The latter is maintaining market share in domestic broadband, via its high speed Infinity offering, and has won plaudits for keeping a lid on its huge cost budget, but the global services division has consistently disappointed despite several changes in top management within the IT-oriented big corporate customer division. BT is likely to be challenged on the merit and payback period of the recent strategy of buying into TV sporting rights – as it seeks to progress its domestic multimedia proposition, via a £738 million spend on Premiership football – on the day of BSkyB’s AGM. Both stocks appeal on several core valuation metrics, are especially favoured by dividend seeking investors, but remain under constant attack from ethical (plain, reduced branding, packaging for IMT) and regulatory (price constrained BT) groups.
Trading results aplenty from FTSE100 constituents
Analysts’ expectations for earnings in the third quarter of 2012 – both in the US and across Europe – have generally been met and perhaps, on balance, slightly exceeded by corporate announcements made to date. The following week will put this to a more rigorous test as a number of the UK’s leading businesses provide investors with an update; these include pharmaceutical giant GlaxoSmithKline, retailer Next, financial groups Standard Life and St James’ Place, and media business Aegis on Wednesday. On the following day, natural resource businesses BG Group, Glencore and Royal Dutch Shell, insurance group Legal & General, publisher Reed Elsevier and health specialist Smith & Nephew are due to report. Leading motor car insurers, Admiral Group and Direct line Insurance Group provide interim management statements on Friday.
But perhaps most interesting
Could be Glencore, who might have a further update for shareholders on its proposed merger with Xstrata – which the European Commission has determined must be decided by, or on, 8th November. However, the writer suggests that most attention will focus on the oil giant BP, who are due to provide a quarterly trading update on Tuesday and – post the recent shuffle of its Russian assets – may be close to being able to provide its investors with a clearer picture of its portfolio. The latter will include a stake in Kremlin-controlled oil & gas business Rosneft, worth approximately £6 billion pounds and, following receipt of the remaining consideration for the sale of its stake in the BP-TNK joint venture, an indication of how the £10.7 billion cash will be spent (with a partial return to shareholders anticipated). Rather like BT, BP stock also appears attractively valued on many fundamental considerations but undoubtedly features a relatively high level of uncertainty. As do the inhabitants of the east coast of America; hoping that fear exaggerates the likely outcome, our thoughts are with them this week.
The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.
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