The next crash: not the usual suspects
Traders are wiser and more diversified but still vulnerable to shock of the unknown
The City of London was another country 30 years ago. Banking and lunchtime drinking were both respectable activities and markets could crater impressively. Much analysis of what has changed since Black Monday begs one underlying question: what would it take for everything to crash again?
More than mere overvaluation. Equity multiples are elevated, at around 14.5 times forward earnings in the UK and 18 in the US. But technology and capital flows have connected markets in ways that reduce rather than amplify risk. Plentiful real-time data has replaced telexes, company handbooks and hearsay.
There is a risk of herding. Connectedness means common ideas and fads propagate. Yet there is a difference between markets drifting and bumping lower in response to new information, such as recession or falling profits, and a crash.
Broader international ownership of assets gives reason to think financial markets may be more stable than in the past. For instance, US investors increased their allocation to foreign companies from 8 per cent of their stock portfolios in 1997, to 29 per cent as of 2013, according to data from The Federal Reserve Bank of Kansas City, and Morningstar.
Combined with widespread use of passive investment funds, diversification should dampen extremes. A dip in one market, or in say, stocks versus bonds, starts an automatic process to rebalance portfolios, by buying what has become cheaper and selling assets which have held up in price.
Investors have also learned the lesson of the 2008 financial crisis, and subsequent wobbles, which is that buying when others appear desperate to sell can be highly profitable. To overcome this and spark panic will require a “black swan”: a left-field crisis few investors have allowed for, like the subprime meltdown. On battlefields, they say the shell that gets you is the one you do not hear coming.