The Jonathan Davis Column: October can be a cruel month

OCTOBER, as anyone with a cursory knowledge of stock markets is concerned, is the month of the year that carries the serious historical baggage - witness the events of October 1929 and October 1987. But August has arguably been an even worse month for the stock market.

Remember the Mexican crisis of 1982? Or the 1990 pre-Gulf War panic in the markets? Both were August events. And it seems likely that this August, which started with the Russian default, and soon became the great hedge fund crisis, will go down in history as one of the pivotal moments in the late 20th century history of financial markets.

Will it turn out to be the moment when the great bull market of the late 20th century came to an end? It is still too early to say. A lot now depends on how the world's monetary authorities react to events.

Two events of the past couple of weeks have already given us a pointer to the way that this latest drama may play out. In quick succession we have seen the Japanese government announcing the first step in a loosening of the monetary reins in Japan - a highly symbolic step, given its past reluctance to contemplate such a move, despite six years of recession - and the Federal Reserve in the US cutting interest rates for the first time in three years, explicitly in response to its growing concerns about the stability of the global financial system.

If such pointers are the first steps in what turns out to be an enduring change of policy, then the consequences could be profound.

Two things support the view that we have reached an important turning point. One is the sudden and dramatic increase in volatility in all the major financial markets, which has afflicted equities, bonds and derivative markets alike.

Anybody who follows share prices on a daily basis will be aware of the dramatic movements in quoted prices that have been taking place from day to day, with major companies and banks commonly suffering price movements of 10 per cent - and often much more - in a single day.

The second is the extraordinary global nature of the current crisis. Contagion is an easy word to throw around, but the chain of events since the seemingly innocuous event of the Thai government's devaluation just over a year ago has given us an object lesson in what the term actually does mean.

The experience of the world's stock markets is instructive. Despite their recent sharp falls, both the UK and US markets have merely retreated to their levels at the start of the year. Around the world, though, the picture looks much worse. Something like two thirds of the world's stock markets are now trading below their levels of a year ago. No fewer than 30 of the world's 75 largest stock markets are down by more than 25 per cent; in 20 of these, the year's fall is greater than 45 per cent.

The figures for the past three months are even more dramatic. Only six stock markets, none of them major ones, are up (they include Cyprus, Morocco and Iceland). Thirty markets are down by more than 17 per cent. What it means, notes Robin Griffiths at HSBC Securities, is that countries representing some 40 per cent of the world's economy have suffered a stock market fall equal in scale to that which the US suffered in 1929.

The proximate causes of the turbulence of the past two months include the Russian government's default on its debt and the near-collapse of Long Term Capital Management, the splendidly misnamed hedge fund in the US. Both are symbolic events, whose significance outweighs their size in global terms.

Because they both raise worrying questions about their impact on the banks which so improvidently lent them money, both events raise doubts about the stability of the world's financial system. The Federal Reserve's action in cutting interest rates is a testament to the extent to which it is taking such concerns seriously. The worldwide "flight to safety" which has sent the long bond yield in America below 5 per cent this week shows how panicky investors are.

It is the combination of a slowing world economy, troubles in the banking system and jittery investors which makes the current situation so potentially dangerous. They are the ingredients of which economic slumps are made, though there is nothing inevitable about such an outcome. In stock market terms, the events of the past few weeks have merely demonstrated the truth of what realists have long been saying: that the markets were overvalued and that the investors who were blithely bidding up prices were blinding themselves to the risks inherent in buying financial assets at those ridiculous levels.

What has happened in the past few weeks is that those risks have turned out to be real after all. It is small comfort that those who misread the risks turn out to have included two distinguished economists who won the Nobel Prize in Economics for their work in devising effective risk management formulas.

It is fair to say that we don't yet know exactly where Long Term Capital Management, in which the professors were partners, went wrong in its complex computer-driven arbitrage activity. We know that they were taking bets on the spread between the yield on European and US government bonds continuing at its current levels - ironically, a bet on normality continuing as before.

The Russian debt default and its fallout demolished this assumption almost overnight, but it was the leverage, not the derivative instruments they were trading, which did the real damage.

For investors, the message seems clear. It is fundamentally good news that markets have corrected to more sensible and sustainable levels, and are reflecting a more realistic assessment of current global economic prospects.

The speed and intensity of the falls we have experienced does, however, create new dangers all of their own, and - markets being what they are - there is every chance that they will overshoot in the opposite direction. (It seems odds on that the current bull market in bonds will eventually go too far, just as share prices have done).

Both Wall Street and the London markets are approaching important support levels on the way down, so we face some anxious weeks before we know whether the bear market has shot its bolt, or has further to go. We need to hope that August really has taken over the mantle of notoriety that October has carried for so long.