Introduction
In the fourth year of my career the share market crashed. In one day, US shares fell 20% and the day after Australian shares fell 25%. From the months just before to the months just after US shares had a total 35% fall and Australian shares had a 50% fall. So, over the space of a few months $1000 invested in the Australian share market had fallen in value to $500. Some lost their fortune including an older friend of mine (because he wasn’t diversified) who had to come out of retirement. The 1987 share market crash – with the one day falls on 19 October in the US and 20 October in Australia and the peak being in August/September 1987 - has become a part of share market history along with events like the 1929 crash, the 1973-74 plunge and the GFC.
But each October (or starting in August) many including me have a certain apprehension about markets. This year has been no exception with US, global and Australian shares having falls of around 8% to their recent lows from their highs in July and some citing parallels to 1987. So why the concern now? What’s the risk of a re-run? Does the surge in oil prices and conflict in Israel add to the risk?
Rising bond yields
We thought this year would be okay for shares as inflation would likely fall and recession would likely be avoided. So far so good, although Australian shares have been poor. But the big surprise has been a resumption of the rise in bond yields from April which has taken Australian bond yields to their highest since 2011 and US bond yields to their highest since 2007.
This has been mainly due to stronger than expected economic activity keeping interest rate expectations elevated (with the Fed and other central banks flagging that they will keep interest rates “high for longer”), along with the deteriorating US fiscal situation and increased bond issuance and Japan relaxing its limits on its bond yields.
Now, the back up in bond yields this year – being based more on stronger than expected growth and hopes of a soft landing – is less threatening for shares than was the rise in bond yields into last year, which was more driven by rising inflation. But it’s still putting big pressure on share market valuations as highlighted by the deteriorating risk premium that shares offer over bonds. This is proxied in the next chart by the earnings yield on shares (12 month ahead consensus earnings expectations divided by share prices) less the 10-year bond yield. It has fallen to its lowest in over 20 years in the US, and in Australia to its lowest since 2010.
Feeding into the mix are another bunch of concerns including:
• the still high risk of recession in the US;
• sluggish growth in China and worries about its property sector;
• messy US politics with Republicans beholden to a small group of fiscal conservatives seeing the removal of the House Speaker, a high risk of a government shutdown next month & uncertainty over fiscal policy;
• a surge in oil prices on the back of production cuts by Saudi Arabia and Russia, with fears this will be made worse by war in Israel.
So far shares have been relatively resilient. However, the risk of further weakness remains. Naturally in times of uncertainty it’s tempting to look at past periods of major market falls. The GFC (which saw 50% or so falls) is still fresh but there has been no similar build up in risk in debt markets as there was with the US housing/subprime boom into 2007. Similarly, unlike the dot-com/tech boom of the late 1990s that led to the tech wreck (again with 50% or so falls in global shares) US tech stocks are now making good profits. But some do see parallels with the 1987 share crash.
1987 – what happened?
From mid-1982 to August/September 1987 global and Australian shares experienced a powerful bull market. This came on the back of recovery from the early 1980s recession and optimism about the economic de- regulation and reform of the 1980s and a re-rating of shares on the back of…