What Black Monday taught me about stock valuation

TEN days after Black Monday a colleague returned from a holiday in central Africa, oblivious to what had been going on. He saw the ashen faces around him and exclaimed “at these valuations, why the hell aren’t you all buying?”

He was right. The market crash had been a wonderful buying opportunity and the UK stock market had recovered all its losses within two years. So why did so many of us miss it?

Human beings are built to survive in a predator-infested savannah where fear and panic keep us out of the jaws of marauding carnivores. But those emotions are a danger when investing. We sense the fear of the crowd and either rush for the exit or ignore tasty opportunities in front of our noses. We act irrationally.

The same malaise affected us when markets were on a steady rise in the run up to October 1987. The Conservatives had won the general election in May, volatility was low, benign interpretations were placed on economic and earnings data. There was talk of a mysterious “wall of money” poised to be invested in equities. If my colleague had returned from his trip to central Africa at that point, I wonder if he would have remarked: “At these valuations why aren’t you selling?” He would also have been right.

Look at any graph of long-term stock market performance now and you can hardly spot October 1987. But the lesson was vitally useful. Investors who did their sums and stuck to them emerged intact. They did not react to events and they knew not to crystallise losses by selling when negative sentiment plunged to new depths. If you set hard valuation triggers for buying or for selling you would have bought UK shares at mouth-watering prices in the days after Black Monday. By September 1988, you were sitting on a 23 per cent profit.

We also learned the importance of diversification. Black Monday saw world stock markets plunge almost in unison. But some asset classes proved more resilient – property for example, as it was again in 2000-2003. Today we have many more ways of achieving diversification than were available in 1987.

October 1987 was remarkable for the speed of the market fall. The UK lost 26 per cent in a few days, Hong Kong fell 45 per cent, Australia 42 per cent, and New Zealand’s market shed 60 per cent from its peak. Analysis afterwards identified programme trading, market psychology, overvaluation, and illiquidity as the causes.

Could it happen again? Certainly: In today’s markets, programme trading is more widespread, illiquidity was all too evident in 2008-2009 and market emotion seems to revisit more regularly. As for valuation, the usefulness of discipline in investing is undisputed for anyone seeking a long-term return.

The combination of low valuations and negative sentiment is a perfect buying opportunity. How did we all feel in early April 2009? Probably somewhere between rigid-with-fear, and deep gloom. Setting valuation triggers in advance gives protection from the savannah behaviour. Investing while terrified is never going to be comfortable, but it can be nicely profitable.

Sally Tennant is chief executive of Kleinwort Benson.