Earnings growth to keep Black Monday in the history books

With the US subprime saga fresh in investors' memory and the JSE All Share Index setting new highs, some analysts have started drawing comparisons between the market dynamics that led to the market crash of 1987 and those currently at play locally and internationally.

Commonly referred to as Black Monday, 19 October 1987 marked the biggest one day stock market crash in history. On this day, 20 years ago, the Dow Jones shed 22.3% or US$500-billion off its value in a single day causing stock markets around the world to follow suit.

Graham Mason, CEO of Prudential Portfolio Managers in South Africa, says while there may be superficial similarities between the behaviour of the markets today and 20 years ago, namely that the stock markets have risen a long way, there is one key fundamental difference that will prevent history from repeating itself.

"Markets do not crash if the prices have risen a long way.  Markets crash if they are expensive, and the valuation of markets depends on both Price and Earnings. Looking back at 1987, before the crash the S&P500 was trading on a Price/Earnings (P/E) ratio of just over 20. The S&P500 had risen by 40% over the previous 12 months, and because this increase in share prices was not supported by earnings growth, which was rather pedestrian at 12% growth over the preceding twelve months, the P/E of the S&P500 had risen from 16 to over 20 in the space of 12 months.  With the valuation of the S&P500 being higher in 1987 than it had been for many decades, the elements were in place for a fall, which took place with the Crash of Black Monday."

Mason says the situation today is very different.  Even though the S&P500 has done well over the last twelve months, the earnings growth of the S&P500 has exceeded the growth in the index, with the effect that the P/E of the S&P500 has declined over the last twelve months.

"We therefore have the situation where, even though the S&P500 has gone up, in terms of valuation measures the market has actually become cheaper.  It is because of this that we are confident that there will not be a repetition of 1987, and we do not expect the US market to crash."

Historic highs dont translate to expensive  

At the beginning of the month the JSE All Share Index broke through to 30 000 level, but this does not make the local market expensive, says Mason.  "Despite the recent run, the JSE is still priced at a forward P/E of around 13, which is fair value. "

"Earnings growth is the key figure to watch.  As long as earnings are keeping pace with the growth in the stock market, valuations will remain fair and theres nothing to worry about. If markets do fall, it is not from an expensive base and the recovery period should be significantly shorter," says Mason.

He explains that margin expansions both locally and worldwide are responsible for the dramatic increases in company earnings. South African earnings over the past three years have consistently surprised on the upside, and earnings are currently 40% higher than twelve months ago. And globally, companies are also experiencing unexpectedly strong growth in earnings.

Mason says it is Prudentials view that the key drivers of earnings growth are here to stay, both globally and in South Africa. Therefore, he says, corporate profits should continue to underpin share prices. 

Having experienced the 1987 crash first hand, Mason recalls that in South Africa the All Share Index reached a (then) all-time high the day before the October 1987 crash.  However, as in the USA, the bull market in South Africa was accompanied by worsening market valuations as earnings growth had not kept pace with the rise in share prices.

The role of central banks

Mason says that the events of 1987 are also important because they marked the beginning of a more interventionist role for Central Banks in support of their responsibility for ensuring the efficient functioning of financial markets. 

"The actions of the Federal Reserve in 1987 were in stark contrast to their actions in 1929.  After the Crash of 1929 the Federal Reserve actually tightened the money supply, thereby greatly exacerbating the effects of the crash and contributing to Americas slide into the Great Depression. 

"In contrast in 1987, the Federal Reserve immediately pumped liquidity into the system, and stood ready to provide liquidity directly to market participants in the event that trading between counter-parties froze completely due to concerns over counter-party risk. 

In addition, he says, in response to the 1987 crash the Fed lowered interest rates, restoring confidence in both financial markets and the real economy.  In many ways, it was this immediate action by the Fed which prevented contagion from the financial markets from spreading to the real economy.  The result was that the real economy continued to grow in 1998, thereby allowing the equity market to make a full recovery.

Mason says since 1987 central banks around the world have had to step in on several occasions to ensure the efficient functioning of financial markets, including the crash of 1998, volatility at the turn of the millennium and the events of September 11, 2001. Most recently, central banks actively relieved pressure on money markets brought about by the defaults in the US subprime lending market.

Outlook

Mason believes that the structural characteristics of the local and global economy continue to remain favourable for equities. This does not rule out unexpected risk events from wreaking havoc in the markets from time to time 1998 and September 11, 2001 being prime examples - but Mason reiterates that earnings growth and strong economic fundamentals are likely to keep Black Monday in the history books.