Are we heading for a 1987 style crash?

Investors should brace themselves for continuing uncertainty says volatility specialist Raymond Blondin.

Recent weeks have unnerved investors around the world, starting with U.S. markets gyrating wildly from a loss of 390 points to a gain of 480 points just last week. Such volatility, while not unique, has been a good predictor of major market events. Our study also reveals that the Hong Kong market has outperformed the U.S. recently even as its volatility drops below that of US markets.

While US markets called for calm, they emphasized the size of the gain, the second largest in history. Unfortunately, actual relevant statistics seem to have been lost in the melee. While a recent day's gain was indeed the second largest point gain ever, this translates into only the 23rd best gain in percentage terms. For those who insist that markets always recuperate, it would be wise to remember that the 1929 crash required 25 years to regain its losses.

Investors had not been unduly concerned after two consecutive years of stock market decline but recent volatility has stirred angst among many and not just investors but many brokers, traders and analysts. It is "irrational" market action that unsettles us most and which is the object of this analysis.

Since much of the volatility originated in the US, it is appropriate to begin our analysis there. A review of the DJIA shows that volatility has been increasing rather dramatically - ominous clouds building before a storm. Optimists will point out that events of recent months have been out of the ordinary and account for this trend. Much to our regret, this is not borne out by the facts. In fact, over the last 50 years the Dow Jones Industrial Average has exhibited increasingly large, cyclical variations.

Furthermore, it is somewhat disquieting to realize that of the top ten volatility peaks of the last 50 years, five have occurred since 1997, a stunning average of once a year. Only the infamous Black Monday of 1987 has surpassed the recent volatility. From a purely technical analysis of the market, the increasing amplitude and frequency of these peaks could well foretell something far more serious.

Given that Black Monday saw a loss of 22.6% in a single day and an upward correction of over 10% only two days later, recent movements should also be seen in perspective. If the past is any indicator of the future, 1987 started the year with a volatility approaching 5% and tested the 10% level several times before shattering all records at 45%.

Similarly, 2002 has seen volatility increase from 5% in January to the current 18%. While it would be highly premature to suggest another crash, investors should be braced for increasing volatility for the rest of the year as the divergence continues.

The current volatility trend for the DJIA reached a trough in December 1993 and has been increasing ever since, at a steep and regular rate. Average daily volatility for the January to June period nearly doubled from 4.5% in 1994 to 8.1% this year, reaching an average of 12.3% for July.

To put matters in perspective, US markets (as measured by its most conservative index, the DJIA) have only broken experienced volatility above 16% on four occasions in the last 50 years: the 1987 crash; the Asian crisis of 1997; the Russian default of 1998; and finally now in 2002. This can hardly augur anything good for the markets around the world.

In contrast, The Hang Seng Index has actually seen its volatility decrease since the 1997 crisis, reaching a new low of 4.4% as recently as June of this year before suffering contagion from U.S. markets. Aside from the events of September 11, the Hong Kong market volatility has been trending steadily lower.

Given that volatility is a component of the investment analysis, prices should correct on the upside as Hong Kong integrates further with the rest of Asia and away from US markets. The convergence of the US and HK markets' volatility may also indicate a new valuation model that has little to do with recent corporate scandals in the US. Instead, global flows of funds may well have created a more level playing field for everyone.

One may draw numerous conclusions from this study but the main fact that stands out is that, in spite of the influence of US markets throughout the world, Hong Kong has successfully decoupled from this monolith. Whereas the manifold problems of the US economy - low savings, unsustainable spending, soaring trade deficit, bubble investing - will likely cause continuing gyrations in international markets, Hong Kong continues to lead its own course and should represent a reasonably safe harbour in the event of a storm.

To extend a sailing metaphor, there may be waves and high winds but we will survive the typhoon brewing offshore. Even with its own set of problems, Asia should remain high on the list of international investment sentiment.

This analysis was conducted by Finasia from its database of companies throughout Asia. Finasia provides integrated data and software to financial institutions.

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