J P Morgan decided it was time to sell in 1929 when his shoeshine boy started to exchange share tips with him. Those worrying signs are back, says David Smith.
October, Mark Twain once said, is a dangerous month to buy shares, the others being January, February, March, April, May, June, July, August, September, November and December. Anyone heeding the great comic writer's advice and keeping their money under the bed, at least in the past few years, would have no reason to thank him. Global financial markets have shown alarming turbulence in recent weeks. If the stock market crashes, can recession be far behind?
The great bull market, for that is what it was, has carried all before it. Even the crash of October 1987, Black Monday and all that, looks like a blip on the charts.
It is easy, looking at its day-to-day performance, to regard the stock market as being as divorced from the real economy as the National Lottery. Certainly, there are times when share prices appear to move in a highly perverse way. News of a slowdown in growth, which in time must surely impact on corporate earnings, is greeted with euphoria, because it is seen as easing the pressure for higher interest rates. Perhaps it is true that we are all short-termists now.
Nation of shareholders
There are, however, powerful feedback mechanisms between the stock market and the rest of the economy. Alan Greenspan, the chairman of the Federal Reserve Board, has said that household assets in the US have risen in value by $12,000 billion (£7,250 billion) since 1994 as a result of the booming stock market. To put that in perspective, US gross domestic product is about $8,000 billion.
Most of these gains are, of course, unrealised. There is no doubt, however, that rising stock-market wealth has been a powerful factor sustaining the US economy. Bill Martin of Phillips & Drew estimates that, without it, America's gross domestic product would be 3% lower than it currently is. Wall Street's recent rise, in other words, has been worth about a year's economic growth.
The effects are not so large, or so direct, in Britain. Although we have become more of a nation of small shareholders, notably through privatisations and demutualisations, most of our stock-market wealth is tied up in pensions funds or other long-term investments such as endowment policies.
Yet how long can Wall Street and, by extension, London avoid a fall that is more than a blip on the chart? Further, if and when it comes, how serious would the economic effects be? Both the US and and the UK have been moving closer and closer to what, in the modern era, is something akin to full employment. In this situation, the price of labour is bid high, as employers compete for what has become a scarcer resource. Normally, the price of goods and services would rise in response.
Yet if, for various reasons, firms are restricted from raising prices, perhaps because of international competitive pressures, perhaps because of fragile markets, the rising cost of labour means a squeeze on profits.
This is certainly happening in the UK, exacerbated by the strength of sterling. Combined with the Asian effect, it is starting in the US too.
The bull phase of any stock market is when profits come in ahead of expectations.
The time to get worried is when the profits warnings start coming in by the day.
Interest rates tip the balance
This does not, of itself, mean the stock market is about to plunge. Investors are good at looking through adverse news and on to the next upturn. There is, however, another factor that could tip us into the next bear market.
Greenspan has been the Wall Street investor's favourite uncle, warning from time to time about irrational exuberance and some future inflationary risk but not doing anything about it in the form of putting up US interest rates. The moment that happens, all the other bad news will somehow seem a lot worse.
How much damage would a big fall in share prices - say 25% or 30% - inflict?
'Why read the crystal when we can read the book?' asks Nye Bevan, the legendary Labour politician, during a debate on sterling in its devaluation year of 1949. The book, in the context of what can happen when financial assets really tumble, has been open in Japan for some time. The bursting of its bubble economy eight years ago left investors facing ruin and exposed weakness in banks and other financial institutions.
Too much tied up in stock
There is not the same underlying weakness in the US or the UK but there is no doubt that a stock-market crash would have a decisive, negative impact. The kind of worries that were around in October 1987, when it was feared that so-called negative wealth effects would produce a world slump, are much more pertinent now because the amount of wealth tied up in the market has grown so much. In America, measured in relation to household income, there is twice as much wealth tied up in the stock market. J P Morgan decided it was time to sell in 1929 when his shoeshine boy started exchanging share tips with him. The equivalent of that shoeshine boy has been in the market for some time. Thanks to globalisation, he exists all over the world.
According to Phillips & Drew's Martin, the equivalent of the October 1987 stock-market fall, in percentage terms, if it occurred now, could be enough to produce a fall in US GDP next year. Think about that for a second. Asia, overall, is a no-go area for economic growth. Europe is only just starting to get back into its stride. If US growth was knocked out of the picture, it would become difficult to see what would stand in the way of a world recession.
Gloomy? Perhaps. To paraphrase Twain again, the death of this long bull run has been greatly exaggerated on very many occasions. But as warning bells sound, get ready to run for cover. The stock market, to its critics, is just one big casino. That may be so but the stakes, for all of us, are extraordinarily high.
David Smith is economics editor of the Sunday Times.