Rats fearing a sinking ship

Yesterday's abrupt fall in the UK stock market has been met with a number of explanations ranging from the conventional to the weird and wonderful.

There are those who swear by such unlikely influences as sunspot activity and astrology. Take, for instance, the fact that the Chinese Year of the Rat has just begun. Everyone knows that the Year of the Rat is "ruled by the cold of winter and the darkness of night" and that it is typified by wild market fluctuations. You have been warned.

More routine is the recognition that markets are driven by investor psychology. In late 1986, the FT-SE 100 index burst out of the doldrums to produce a rally of 62 per cent before it peaked in July 1987. We all know what happened after that: the stock market crashed.

That 62 per cent is one of the magic numbers discovered by a 13th-century Italian monk called Fibonacci. It seems to have a remarkably powerful and widely recognised significance for the way that markets work. Take, for example, Nasdaq, which is now the busiest US stock market. On the 23 February, the Nasdaq index touched a level that represented a 62 per cent gain from the important low that it reached in mid-1994. It has not regained that level since. A few people at least may have read the worst from the omens. When the markets in the US grew shaky, those who are prepared to combine the musings of a 13th-century monk with the implications of a Chinese year sign would not have been surprised.

These weird theories aside, however, the reason for London's weaknesses is in fact painfully simple. London fell because Wall Street fell. But, that merely begs the next question: "What went wrong on Wall Street?"

One theory is that the problem lies in the US economy: it appears to be doing too well. Bill Clinton is probably over the moon. After all, it isn't every day that you discover - as he did last Friday - that your economy has created more than 700,000 new jobs. That was roughly double the increase that the markets had been expecting. Then, apparently in defiance of commonsense, the US stock market went into an instant tailspin.

There is, however, a rational explanation, namely the fear raised by the figures, that strong growth could cause the economy to overheat and so lead to a build-up of inflationary pressure.

This economic "explanation" sounds plausible, but there are one or two problems with it. Above all, the evidence of a rebound in growth and inflation is far from convincing. Other economic indicators suggest that the 705,000 figure is a freak.

The real answer may well lie closer to the markets' home. The trouble is that at the beginning of the year the markets had all reached the same conclusion at the same time: growth would be subdued; inflation would not be a problem; the dollar would be strong; interest rates would continue to fall.

Most of those assumptions were probably right. That was not the problem. The problem arose from the unanimity. When investors form a view they quite naturally act on it; and the natural thing to do was to buy bonds, especially US bonds. The world and his dog started buying US Treasury Bonds like there was no tomorrow.

This enormous appetite for bonds naturally drove their prices upwards. But, when a bandwagon is that full, there is sure to be trouble. There is no one left to get on board, and without that additional demand, prices begin to sag. That is exactly what started happening during January. All around the world, bond prices began to fall. Only gently at first, but that was enough to put immense pressure on those people who had bought bonds with borrowed money. They were forced to sell, adding to the downward pressure. And, by last Friday, the bond markets were full of investors who had become worried about their investments. When that US employment statistic was published, they were ready to panic.

So the truth behind the sell-off may be almost as bizarre as the wacky theories involving the Chinese New Year. What the last few days have demonstrated - yet again - is that it is as easy to lose money on the markets by being right as it is by being wrong.

The author is chief economist at stockbrokers Panmure Gordon.