Listener: 28 November, 1987

Keywords: Business & Finance; Macroeconomics & Money;

Don’t ask why the share market crashed at the end of October. Rather ask why it rose in the preceding months. It is easy enough to describe sharemarket booms and busts by the phrase ‘mob psychology’, but this is not an explanation. What if each individual behaves rationally? Could that produce a stampede?

One explanation makes a distinction between ‘fundamentalists’ and ‘chartists’. The former look at the underlying performance of companies and the economy. The fundamental value of a share reflects its ability to generate future earnings. By objective criteria neither the economy nor most companies are going to be buoyantly prosperous over the next few years. Yet by October share prices were wildly out of line with their earnings in relation to past performance.

Chartists are those who rely on charts, such as of share prices. As long as these show a rise, chartists reason they can profit by buying cheap and selling dear. Providing, of course, they do not get caught when the market turns down.

Most of us start off as fundamentalists, but as the sharemarket begins to rise a few become temporary chartists, investing in the expectation of further rises. This reinforces the rise, inducing others to join as temporary chartists. The cycle repeats itself. As the market rises, more fundamentalists become temporary chartists, who in turn become more committed. The bull market rampages upwards.

Most people know in their hearts that the market will turn down some time, although they may have little sense of history. Few dealers and investors can recall the 1929 debacle. Many would have still been at school when the New Zealand sharemarket crashed 40 percent in 1974. Henry Kaufman argues that while American operators are well trained in analytic skills ‘their entrepreneurial drive is not tempered with history’. New Zealand business students rarely get taught much financial history either.

The strategy of the temporary chartist is to be second out of the market, selling shares just after the market turns down. But everyone cannot be second. Some must get out later, and getting out of a market involves selling to someone buying in. Not surprisingly, the bear market collapses faster than the bull market grows, wiping out in a week what has been added in a year. Bulls go up the stairs, bears go down the elevator.

What triggers the switch hardly matters. For months the bull may have been vulnerable. Then a small event will transform it into the bear. There is no relevance in the special factors which are alleged to cause the sharp downswing. Each has a converse as important in an upswing. If our sharemarket follows the US market down, then surely it had followed it upwards. If it is all to do with computer trading, mutual funds, trading on the margin, or forward markets, then they equally explain the rises.

Asymmetry is important. Sharemarkets tend to bubble and pop, not fade to a level well below fundamental values and then blow up. Asset strippers will buy and break up companies whose shares become too cheap. But a share portfolio can be sluggish for a very long time. It took our sharemarket till 1980 to rise again to its 1973 peak. By then consumer prices had more than doubled.

There is another asymmetry: bankruptcy. Some investors may have over-borrowed, finding their shares are not only worth less than what they paid for them, but less than the debts they owe. This may not be as serious a problem in New Zealand because the earlier shakeout this year may have left our investors cautious. But bankruptcy has been significant in almost every sharemarket collapse I have read about.

There may also be improbity, either deliberate or in an attempt to shore up a desperate position. The impression is that incarceration is more common than suicide in sharemarket busts.

Good monetary management can prevent a financial collapse – providing the bankruptcies are not too widespread but it will not prevent losses by innocent parties.

This sharemarket behaviour sheds light on the reliability of private, market decision making. Given that on 20 October business reduced its valuation of its shares by almost 15 percent in a matter of only six hours it is hard to credit the market with a high degree of fundamental rationality.

By focusing on fundamentals, however, the government is likely to outperform the chartists’ alleged business wisdom – promoted, one notes, by that self-same community.

This is not to advocate that the government should enter the sharemarket, although cheerful scepticism towards the claims of operators may dampen some of the wilder speculation and discourage some of the more naive investors.

Where the analysis is most relevant is in foreign exchange markets. Indeed the fundamentalist/chartist analysis has been developed in greatest detail for these. Combined with sharemarket behaviour, it tells us that while the government may not know more than the private market, it is less likely to forget fundamentals in favour of market bubble and crash. That is why throughout the world, governments usefully intervene in exchange markets. At some stage, no doubt, our government may come to learn the same lesson.