Wednesday, December 17, 2008

How bad can a fall in share prices be?

Frequent comparisons are made between the current financial crisis and that of 1929. In one aspect this is misleading. In 1929 there was not merely a financial crash but an extremely severe downturn of production. At present, given the dynamism of the Asian economies, there is no reason to believe that the world economy as a whole will see a severe decline in output - or indeed that the world as a whole, as opposed to some individual countries, will suffer any decline in output at all.

This, however, does not mean that the financial depression of share markets cannot potentially be very severe. This is particularly relevant to the various plans now being unveiled for governments to purchase shares in banks. Indeed it is disturbing that one of the erroneous aspects of media coverage of these proposals is that they frequently implicitly assumes that bank share prices in the future must rise.[1] This leads to wrong evaluation of risk.

If bank shares must inevitably rise, after a period of falls that has already taken place, then there is evidently no significant risk for the taxpayer in buying them. If, however, bank shares may fall further, and remain depressed for a prolonged period, then the risk is great. It is therefore illustrative to make a comparison to risk following periods of exceptional financial turmoil created by asset price bubbles.

Figure 1 therefore shows the percentage decline in the Dow Jones Industrial Average from its maximum value in 1929, on 3 September, to its minimum value in the decline following this - on 8 July 1932. The fall of the Dow was 89.2 per cent in a little under three years.

Figure 1

Dow Jones 1929 2007    

Also shown for comparison in Figure 1 is the current percentage decline of the Dow since its high on 3 October 2007 until the end of trading on Friday 10 October 2008. As may be seen the decline after October 2007 initially was slower than in 1929. However, the decline accelerated rapidly last week. Last Friday was the 255th trading day since the 2007 peak of the Dow and by that point the Dow had fallen by 40.3 per cent. In comparison 255 trading days after the peak in 1929 the Dow had declined by 35.7 per cent. That is, in the current decline, the fall of the Dow since 2007 is slightly greater than following 1929.

What marked the historic scale of the 1929 fall, however, was not only the severity of the decline but its duration. By 255 trading days after the peak of 1929 the Dow had not even fallen by half the amount that it was eventually to drop. After 255 days of trading following the 1929 peak the Dow was down 35.7 per cent, while the eventual fall was to be 89.2 per cent. That is, 255 days into the decline what looked like a severe fall was, in fact, more towards the beginning of the decline than the end.

Figure 2 shows the overall historical pattern of the Dow post 1929 until its eventual recovery. It took until 23 November 1954 for the Dow to rise to its 1929 peak level in nominal terms - as inflation occurred in the intervening 25 years the real level of the Dow in 1954 was, of course, still below its level at the peak in 1929. It would have taken 25 years, even in nominal terms, for an investment made at the peak of the market in 1929 to have been recovered.

Figure 2

Dow Jones 1929 -1954  

However, as some significant decline in share prices has already taken place in the current cycle, assume that an investment had been made on the 255th day of the decline of the Dow after 1929 - that is on 10 September 1930. The Dow did not recover to that level until 15 January 1951. That is, it would have taken 21 years for the original investment to have recovered to the same level even in nominal terms - and longer in real terms.

It may be argued, however, that 1929 was a wholly exceptional event and therefore such a pattern could not possibly be repeated. Apart from the fact that the present crisis is the worst since 1929, and one should therefore not make any such assumptions, experience of other countries shows that repetition of comparable patterns is quite possible.

Figure 3 shows the movement of Japan's Nikkei 225 share index since it reached its peak on 29 December 1989. The maximum fall of the Nikkei after this was only marginally less than that for the Dow following 1929. The maximum percentage fall of the Nikkei so far, following its peak, was 80.5 per cent - compared to an 89.2 per cent decline for the Dow following 1929.

The bottom, so far, of the Nikkei following this peak was reached on 28 April 2003 - that is the Nikkei continued to fall for almost 14 years after its peak.

Again, to make a comparison to the current situation, the 255th day of trading of the Nikkei after the peak was on 17 January 1991. By that time it had declined by 39.7 per cent - entirely comparable to the 35.7 per cent fall of the Dow on the 255th day of trading after its peak in 1929 and the 40.3 per cent fall of the Dow on the 255th day of trading after the 2007 peak.

Again, to make comparisons, this means that on this comparable day of the decline after its peak the majority of the fall in the Nikkei was still to come.

Figure 3

Dow Jones & Nikkei  

What is striking about the Nikkei pattern, however, is two further trends.

First, it may not be the case that the bottom has yet been reached. As may be seen, by the end of trading on 10 October 2008 the Nikkei was again moving downwards towards its minimum level - on 10 October the Nikkei was 78.7 per cent below its 1989 peak compared to the maximum fall recorded so far of 80.5 per cent.

Second, and most important for present purposes, the length of the depression of the Nikkei is even longer than that for the Dow following 1929.

10th October 2008 was the 4,624th trading day after the peak of the Nikkei in 1989. On the 4,624th trading day on the Dow after the Great Crash the Dow was 55.0 per cent below its peak. In comparison the Nikkei after the same interval was 78.7 per cent below its peak. That is, in terms of length of the decline, the depression of the Nikkei has so far been more severe than the decline of the Dow after 1929.

This comparison shows clearly that the post-1929 fall of the Dow is not at all an unparalleled event following the collapse of a major asset price bubble. On the contrary Japan is living through a share price collapse that is of entirely comparable dimensions.

Again a comparison to the 255th day of trading in the current cycle, that is the situation on 10 October 2008 compared to the Dow's peak in October 2007, is revealing. By the 255th day of trading after the peak the Nikkei had fallen 39.7 per cent. The eventual maximum fall was to be 80.5 per cent. That is 255 days into the fall not even half of the eventual decline had taken place.

What conclusions follow from this? First, it should be stressed that what has been looked at above is the movement of share indices, not of the shares of individual companies. No mechanical comparisons should be drawn - bank shares have fallen more than the Dow or FTSE 100 for example so a greater part of the decline might be behind. But, equally, it is entirely possible for the value of shares of an individual company to in effect fall to zero - as occurred with AIG, Lehman Brothers, Bradford and Bingley, and Northern Rock - whereas, even at their worst, it is entirely implausible that a share index will lose all of its value, that the value of all quoted companies falls to zero.

The downside risk on individual shares, may be seen by considering the arithmetic of the proposals announced today for the British government to purchase shares in the British banks Royal Bank of Scotland (RBS), HBOS and Lloyd's TSB.

Alistair Darling, the British Chancellor of the Exchequer (finance minister) announced on radio, just after 8pm today, that the government would purchase RBS shares at 65.5p. The government has also stated it will purchase HBOS shares at 113.6p. It is, therefore, entirely possible that share prices in RBS and HBOS may decline further, even to zero, and the tax payer will lose that investment - that is, major taxpayer risk has been assumed.

What is notable about the case of RBS is that, as the private sector was unwilling to subscribe the necessary capital at 65.5p a share, the private sector, that is the market, rates the shares of RBS as worth less than 65.5p a share. The government is therefore forcing the taxpayer to undertake an investment which the market itself is not willing to take - i.e. the government is taking an investment position riskier than the market. The potential for loss in such a position is evident - and strongly illustrated by the fact that those who invested in the earlier rights issue of RBS this year had lost £8 billion by 10 October 2008.

What is the consequence of assuming this risk? The 'taxpayer' is not an abstract entity but consists not only of individuals but of profitable, that is viable, companies. Therefore the risk the UK government has taken has been put onto the shoulders of individuals and viable companies, instead of it being concentrated on RBS, HBOS, and Lloyds TSB shareholders. This is damaging to other viable companies and to individuals.

While it would be extremely unwise to judge such a fundamental issue by short term market movements nevertheless the scale of the risk was illustrated even on the morning of 13 October - following the British government announcement. The RBS share price fell to as low as 49.6p by 11 45 am - a price that would have entailed large losses for the taxpayer on any shares purchased at 65.5p. HBOS was trading at an even lower level, falling to a low of 83p – that is 27 per cent below the price at which the government proposed to buy shares.

The British government, of course, had to state that it was ready to step in to take over RBS, HBOS or Lloyd's TSB to ensure their orderly functioning and guarantee deposits - as it did with Northern Rock or Bradford and Bingley. But that would occur in conditions in which, in essence, the market concluded that the value of the shares was zero – in which case zero would have been a fair price.

This loss would have course been borne by RBS, HBOS, or Lloyd's TSB shareholders. But losses would have been focussed on them - in accord with market operations. Instead, now, the potential for large loss for individuals and viable companies (that is taxpayers) has been assumed by buying shares at prices which are judged by the market to be above their value.

This also illustrates the mechanism by which viable companies and individuals are placed at risk. The injection of capital by the government will necessarily raise RBS share prices - not necessarily eventually compared to the 65.5p share purchase price by the government but compared to the real eventual market value (which may be as low as zero). Existing shareholders will therefore be able to sell at above value prices while the government is unable to sell its stake - suffering severe potential losses for taxpayers if the price is below 65.5p. Taxpayers would thereby lose while existing shareholders would gain.

The government, evidently, hopes bank shares will rise and this loss for the taxpayer, that is viable companies and individuals, will not occur. It may be fortunate. But there is no justification for risking taxpayers money in purchasing bank shares at what are above the market values if such an intervention had not taken place. This is to assume great risk for which viable companies and individuals may suffer.

The data given above on movements of share prices after the collapse of major asset bubbles clearly gives no justification for a belief that shares have necessarily reached their bottom and the only potential is up and not down. Comparison to previous falls in share prices after the collapse of asset price bubbles, on the contrary, shows there is considerable potential for further losses. If banks can raise private capital they should, of course, do so - as with Barclays and HSBC. However the assumption of considerable risk to individuals and viable companies by the government in purchasing shares in RBS, HBOS and Lloyds TSB, rather than standing entirely willing to take over the orderly and guaranteed running of these companies if they prove unviable, is therefore not justified.


[1] To take one example the Observer’s editorial on Sunday morning stated: 'the banks should not treat the government's equity stake like a simple loan. They cannot expect that, when the current crisis has passed, government will step back from its investment without extracting a profit. Having part-nationalised the banks, the state must manage its shareholding to yield the best return for the taxpayer'.