31/07/2008
Many investors find it difficult to cope with bear markets. Not only are plummeting prices unnerving, and the loss of wealth painful, but these events often coincide with recession. Nevertheless, bear markets are a common feature of investing, in any asset where investors are paid to take risk and sometimes suffer the consequences. Indeed their volatility creates opportunities for some investors to pick up distressed assets. To give one example, those brave enough to invest in the UK stock market at the end of the bear market in March 2003 would have doubled their wealth by March 2007.
In this article, we examine some questions commonly asked by clients: are we in a bear market, what are the causes, what will bring it to an end, and what should I do with my portfolio?
Is the UK in a bear market? The simple answer is yes, as share prices have fallen over 20% from last June’s highs. In common parlance, a fall of 10% is seen as a correction, while over 20% is a bear market. Such terms are more widely used by journalists than strategists. After all, the UK stock market plunged 35% in October 1987, yet recovered fully within 18 months. For this reason, we use behavioural finance to look carefully at the actions of the marginal investor. At the peak of a bull market, say property or emerging markets in 2007, investors often exhibit euphoria and greed, while brokers justify high valuations with optimistic projections. A growing realisation about overly high prices is followed by demoralisation, even repugnance towards the asset class. At the end of the 2001-03 bear market, a large number of retail investors were so hurt that they withdrew for a lengthy period, preferring ‘safe’ alternatives such as housing!
Bear markets start when an asset is over-valued. To simplify enormously, share prices are determined by two factors: future earnings and the confidence which investors place on them. Some firms, such as a regulated utility, have a steady revenue stream, while others, such as an investment bank, exhibit cyclical earnings. At various times, investors become more confident about future profits. In the late 1980s, the PE of the UK stock market was relatively low, about 10-12, a consequence of several decades of stop-start policy making. A move to a smoother business cycle, and the ‘NICE’ decade of controlled inflation, helped the PE to reach a peak of 27 during the TMT bubble.
Today’s investors are very unsure about tomorrow’s earnings. The equity bear market began in global credit. Financial institutions have so far written off about $400bn of bad debts, but some estimates for total losses top $1tn. A second worry is the regulatory environment. As the FSA in the UK and its counterparts in other countries tighten their control, the opportunities fade for banks to make super-normal profits. At its peak in 2006, the US financial sector contributed about one third of total profits. A third concern is recession, spreading from the US to other countries. Initially, housing and consumer related stocks were hit, then cyclical stocks such as industrials. If high oil and food prices result in sufficient demand destruction, then the energy and materials sectors could be the next to suffer.
How long do bear markets last and how deep can they go? History helps but cannot provide a definitive answer. The 1973-74 bear market was unusually steep, with a peak to trough decline of some 70%. The 2001-03 bear market was unusually long, as investors fretted about the Iraq invasion. Looking over seven previous bear markets, on average the MSCI world index fell 31% over 14 months, so history would suggest a further fall of 10% and a trough towards the end of 2008.
Averages can mislead! The forthcoming recession could be moderate, as in 2001, or deeper and more prolonged, as in the 1970s. An effective policy response is important. One reason for the lengthy 2001-03 bear market was a series of accounting scandals, making investors much less sure about the true state of earnings, irrespective of historically low interest rates.
How does the current cycle compare with its counterparts? The answer is mixed. Yes, global equities trade on 14 times trailing earnings, similar to the early 1990s recession. A further 10% decline in share prices would open up value opportunities. However, the longer a bear market goes on, the more investors often look for deep value. A trigger for the end of the 2003 bear market was dividend yields matching the return from cash; the current yield of about 4.5% is well away from LIBOR rates about 5.75%.
In this cycle, an ineffective policy response is a concern. While some central banks have cut interest rates, the actual cost of borrowing for most companies and households has risen, not fallen, over the past year. The wide spread between official and market interest rates will continue until banks have recapitalised. In addition, few governments have room for manoeuvre, such as a fiscal stimulus. The UK is a classic example, wasting years of solid economic growth by running large deficits rather than building up public sector surpluses. Golden Rules or the Maastricht criteria can be broken, for short term political gain, only at the expense of destroying the carefully cultivated picture of ‘prudence’.
On top of those self inflicted problems comes the ultimate dilemma for central banks: whether to focus on inflation or growth risks. It is no surprise that the MPC, the Fed and the ECB talk hawkishly, trying to dampen inflation expectations, without following through with aggressive rate increases. The risks to an already weakened financial system and housing market are too great to contemplate. All in all, the world economy faces a lengthy period of sub-trend growth, while imbalances in the housing markets, consumer debt and the banking sector are slowly worked through.
How investors should respond depends on the answers to two questions: what is your time horizon, and what liabilities are you investing for? Some investors are in difficulty, say relying on stock market gains to pay off a mortgage. Cash flow must adjust - Mr Micawber style! Other investors will be more forward looking. The paper loss of wealth in a bear market can be horrendous, and it may be some years before share prices return to their previous highs, but safe stocks provide a dividend stream. If an investor has determined their liabilities, and created an appropriate portfolio of assets including bonds and cash, with a lifestyle overlay as they approach various draw down points, then it need not be a knock out blow. Indeed, some investors welcome bear markets as an opportunity to buy distressed assets. A prime example amongst corporate investors would be Banco Santander’s bid in July for Alliance & Leicester after its share price collapsed.
In conclusion, the good news is that price action and valuations mimic, in scale and timing, the 1990 bear market. The bad news is that various problems limit the ability of the authorities either to turn around the financial sector crisis, cap inflation pressures or restore future profits growth. This suggests that while the current bear market need not be both deep and long, investors should be prepared to wait either for a much more effective policy response, a major turnaround in inflation fears, or good value opportunities before they put their cash to work.
Andrew Milligan, Head of Global Strategy, Standard Life Investments.
This was published in Financial Adviser on 31st July 2008.
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