Wall Street wipe-out more a 1987 stock market crash than a global financial crisis

Wall Street wipe-out more a 1987 stock market crash than a global financial crisis

Wall Street wipe-out more a 1987 stock market crash than a global financial crisis

Updated 9 February 2018, 18:40 AEDT

The Wall Street wipe-out shows parallels with the 1987 crash, when a bloated Wall Street tanked and took global markets along with it, writes Ian Verrender.

Is this a re-run of 2008, when the global economy shuddered to a halt?

Not really.

What about the parallels with 1987, when a bloated Wall Street tanked and took global markets along with it?

Now, that's a better comparison.

Ask almost any "expert", and you'll be delivered the message to which US President Donald Trump is desperately clinging.

The US economy is in reasonable shape and is finally emerging from its post-financial crisis torpor while prospects for the global economy are the best they've been in more than a decade.

Having taken credit for the wild ride up, this week Mr Trump declared Wall Street had got it wrong — that it was ignoring all the good economic news.

That's fake analysis.

What he and many others fail to realise is markets — and particularly Wall Street — disconnected from economic fundamentals years ago.

And this week's sudden collapse, which overnight turned into a full-blown correction (a drop of more than 10 per cent from its peak) has been driven by the sudden realisation American stocks are wildly overvalued.

Just how overvalued?

One measure, known as the price-earnings (PE) ratio says it all.

It works like this:

Let's say a company earns $1 in profit.

Over the long term, investors would say the company was worth $15. That's a PE ratio of 15.

Wall Street, before last week's spiral began, was trading on an average of 26 — way above the historical average.

Australia, by comparison, was at the more sober 16 times earnings.

How did we get here?

The US boom initially was driven by an unprecedented flood of cash — almost $US4 trillion — unleashed by the US Federal Reserve over three separate programs since 2008 to kickstart the American economy.

With rates slashed to zero, the only place to park spare cash was the stock market.

More recently, it was fuelled by Mr Trump's hugely stimulative plans to slash taxes and pour trillions into a big-spending infrastructure program — including his much-touted wall.

In the past week, two things that have been bleedingly obvious for more than a year have suddenly dawned on traders.

The first is the US Federal Reserve not only hiking interest rates, last October it also began the process of gradually clawing back those trillions it injected into the system through its money-printing program.

That takes cash out, which also puts upward pressure on market rates.

Add to that the spectre of a rapid rise in inflation, which surfaced last Friday night with a sudden, but long-hoped-for, jump in wages.

While economists have been praying for higher wages, stock traders convinced themselves inflation would not return — that they could have strong economic growth and perpetually low interest rates.

They wanted the cake, and they wanted to eat it too.

If inflation already is stirring, the fear is a big-spending, tax-cutting fiscal program that blows out Government debt will turn a bushfire into an out-of-control inferno and the Fed will have no option but to fight it with much higher interest rates.

That's where the 1987 comparison is apt.

The global economy was in reasonable shape.

But markets had been on a tear for years, and with already-high inflation looking to get out of control, central banks and governments were leaning against it with higher interest rates.

While interest rates were much higher back then, the conditions and the trend lines were the same — markets were out of control and interest rates were being hiked to curb inflation.

What next?

This time around, Australia hasn't bought into the Wall Street madness.

Before this rout began last week, New York stocks had risen about 88 per cent from their 2007 peak — with more than 40 per cent piled on since the Trump election.

Our market has never even come close to breaching its 2007 peak of just above 6,700 points.

Our economy weathered the financial crisis and its aftermath, courtesy of a China-led resources boom.

And our interest rates, while at record lows, stayed well above the crisis levels of other major developed economies.

Logically, if we didn't ride the artificial market boom, we should be relatively safe from its collapse.

Unfortunately, logic and financial markets usually tend to avoid one another.

As we've seen from the past week, a serious Wall Street downturn immediately sends shockwaves across the globe — primarily because it's the world's biggest economy.

So far, our market losses have been limited to around 4 per cent. But should the rout continue, there is no doubt we will be caught in the crossfire.

Back in 2015, when the US Federal Reserve announced it would slowly ease back on stimulus, Wall Street chucked its famous "taper tantrum" and the Australian market shed 12 per cent.