Is the recent bounce in equity markets the start of a new bull run or a bear market rally 
(27/05/2009)
In early March, we noticed a curiosity in the equity performance tables: for several months, the average fund had been out-performing a falling market. The only explanation for this was that funds had high cash levels and so were positioned for market weakness. With valuations at extreme lows and pessimism rife, this was the signal we had been looking for. Markets usually make a fool out of consensus positioning and the fact that most investors would only outperform if markets fell suggested to us that they were going to rise.
Since then, markets have risen strongly, taking the doom-mongers, the media and most investment professionals by surprise. Investors have been left on the sidelines with too much cash and dismissing the gains as a “dead cat bounce” or a bear market rally. They are now fervently hoping for a correction so they can buy in at the prices they have missed. The weight of money waiting for such a correction strongly suggests that it will not happen; a better strategy would be to add to exposure now as we believe that the likelihood of medium-term rewards more than compensates investors for the short-term risks.
We firmly believe that this has been the start of a new bull market and do not see a significant correction happening until higher levels are reached. The bears take comfort from evidence that the rally has been led by low quality, bombed-out stocks and that volumes have been low. An avalanche of equity issuance looms, the market could run too far ahead of earnings and economic recovery is likely to be interspersed with setbacks, so the upward path will almost certainly not be a straight line. However, the fact that equity issuance has been greeted with enthusiasm and share prices have responded well to quarterly results which were no better than expected suggests that a change in market leadership and a return of confidence will be seen at higher, not lower levels.
There are tentative signs of an improvement in the global economy, heralded by an upturn in leading indicators and by a number of positive data surprises (i.e. not as bad as expected). However, equity markets do not require a dramatic improvement in the macroeconomic outlook to perform strongly. Our view has been that the US, Asian and emerging economies would bottom in the current quarter, Europe and Japan in around six months’ time and the UK early next year. That timescale remains on track but, after an initial bounce-back, the upturn is likely to be held back by an aversion to debt, by consumers rebuilding savings and by government retrenchment. If this happens we would expect unemployment to continue to rise and living standards to be squeezed, meaning that it will be a long time before consumers are confident again.
A slow steady upturn may not suit the general public but it is more positive for companies than a jump in demand which they do not have the capacity to cope with. This could mean margins and returns on capital returning to the high levels seen before the bear market. A slow steady recovery should also keep inflation down and encourage a market re-rating. The fact that the market upturn started in March, some six months before a likely global economic bottom, is not as surprising as is widely thought. In eight out of the last nine recessions, markets have bottomed before the economy. We believe that this episode will make it nine out of ten.
At the market low, investors were taking an apocalyptic view about corporate earnings. These had fallen 25% in 2008, were expected to fall another 10% in 2009 and to recover by over 20% in 2010. However, a global market p/e ratio of 13.3 for 2009 and 10.7 for 2010 was in our view discounting much worse – a further 17% drop in 2009 earnings and only a 6-7% recovery in 2010. The recent strength has raised the 2009 p/e to 15 and 2010 to 12, but these figures are far from excessive as the outlook for corporate earnings is starting to improve.
Overall, first quarter results came out well ahead of reduced expectations and this pattern is likely to continue. Companies have preserved profits by cutting both wage costs and investment aggressively. The combined effect is estimated at $250 billion annualised for US companies, worsening the economic downturn but leaving the corporate sector in good financial shape. Despite this, analysts have continued to cut earnings forecasts, now expecting earnings to fall 12.5% this year but recover over 25% next. Analysts’ forecasts usually lag the market and this cycle is proving to be no exception. Forecasts appear to be very close to a bottom and are likely to start being upgraded soon. Already, 44% of estimate changes are upgrades, a proportion which is likely to rise well above 50% in a month or two. This suggests that equities are still good value. If the earnings outlook starts to improve and a strong recovery in 2010 looms closer, there will be plenty of room for further market upside.
We have serious long-term concerns about the damage to economies and markets from excessive government borrowing, mis-regulation, a new found enthusiasm for meddling in the corporate sector and monetary policies that are too lax, though these issues only apply to developed markets (especially the UK) rather than to Asian or emerging markets. Along with the low yields on offer, this partially accounts for our aversion to government, but not corporate bonds. For equities, these are worries for the future; for now, we are at the early stages of a bull market.
Volatility and corrections are inevitable but we prefer to focus on the long-term story. At the start of the year, Barclays Capital projected annualised returns of over 12% per annum in dollars over the next 10 years and more for the UK, Europe, Asia and emerging markets. The model they used is based on well-regarded inputs and has a highly impressive record. We agree with their conclusions and think that global equity returns comfortably in double figures are conceivable, implying a multiplication in index levels over 10 years.
Research by the London Business School shows that the current decade has included two of the four worst bear markets in the past 109 years. Indeed, they calculate that, on a global level, 2007-9 was the most severe of all, slightly worse than even 1929-31. Inevitably, investors will spend the next 10 years and more worrying about the next bear market but our suspicion is that they will be modest affairs for a long time to come. After all, two world wars in 30 years resulted in everyone spending the next 30 years worrying about the third. More than 60 years on, it still has not happened.
Related categories: Invest in Financial derivatives Invest in Financial products Invest in Hedge funds Invest in Venture capital
