Another bear market rally or something more substantial? A year and a half into this equity bear market, investors, traders and advisers appear to have become conditioned to sell the rallies. Indeed, a number of high-profile individuals, investment banks and strategists have come out this week advising clients to sell this rally.
In the short term we'd agree. Nimble traders should take advantage of an equity market that is heavily overbought and due to give back some of its gains. Markets don't move in straight lines but ebb and flow and, after such a strong rally, some giveback is to be expected. Indeed, consistent with that, our risk appetite indicators, which have given timely sell signals throughout this bear market, are again back on sell (see chart).
Beyond the next few weeks, though, there is a growing case for expecting equity markets to perform well in both 2009 and perhaps into 2010. Technical, fundamental and valuation factors all conspire to suggest that this equity rally could have considerably further to go.
As a result of such falls in stock markets, equities are now attractive on most valuation measures. In particular, of the four main asset classes (equities, government bonds, cash and property) equities are the most attractive. Cash is yielding an effective zero return and is vulnerable to inflation eroding its purchasing power. Government bonds, especially since the introduction of quantitative easing, are close to multi-decade, low yield levels of around 3 to 3.5 per cent (UK 10-year bonds). Residential property remains expensive relative to average earnings while commercial property is offering an attractive yield, around 7 – 8 per cent. But current equity earnings yields of between 11 and 12 per cent (based on already dramatically reduced future earnings expectations) are therefore attractive when measured against other major asset classes.
Equity markets are also discounting machines. In that respect, they tend to move ahead of macroeconomic events, falling into bear markets before the start of recessions and generally beginning new bull markets around four to seven months ahead of the start of new economic expansions. This US bear market, which began in October 2007, is now the largest since the Great Depression. Peak to trough, US equities have fallen 57 per cent, more than during any bear market of the 1970s; more than the bear market at the turn of this millennium on the back of a stock market bubble and excessive valuation; and greater than both the 1937 bear market, when investors feared the return of Depression, and the 1907 banking panic. The same is true in the UK: since 1830, UK equities have only once suffered a meaningfully larger bear market than this current one – in the mid-Seventies they experienced a 73 per cent bear market.
Importantly, there are also grounds for expecting an economic recovery, starting in the US and China in the coming quarters and spreading to Europe in 2010. The economic adjustment is well advanced – this is most obvious in the US, which was the first to enter recession and will be the first western economy to come out of it.
US housing, where so much of the excess existed, has adjusted considerably. Housing starts which were running at more than two million a month at their height in 2006, are now running at approximately a quarter of that level – their lowest since records began in 1959. The non-financial corporate sector has been busy putting its own house in order – inventories have been cut aggressively, cashflows have been bolstered, while productivity has accelerated in this recession in contrast to the deep recessions of the Seventies and early Eighties.
Households have also retrenched swiftly, with borrowing cut aggressively and savings rates rising rapidly – from zero a year ago up to close to 5 per cent today. This compares to a long-term average level of 6.5 per cent ( see chart). The same is true in the UK where the economic adjustment, while behind that of the US, is also well advanced. All of which clears the excess out of these economies and prepares them, once again, to begin an economic expansion.
Critically, the western banking systems, having been aggressively recapitalised and supported by their governments, are starting to show signs of life. Competition is returning to the UK mortgage lending market, with HSBC's announcement this week of more competitive lending terms, mortgage lending has been edging higher. Commercial banks, in aggregate in the US, have not stopped growing lending levels. With a return to a functioning banking system this recession need not turn into a depression.
Over and above that, and often overlooked, the fall in the oil price is providing a far greater stimulus than government's fiscal actions. Having averaged over $90 per barrel in 2008, so far in 2009, oil has traded at an average of $47. Given the world consumes 31 billion barrels of oil per annum; that equates to a boost to purchasing power of approximately $1.7 trillion – around three times the 2009 combined G7 plus China fiscal stimuli packages. Naturally there are some losers, in particular the oil producing economies, but they are few and far between, as Saudi Arabia and Russia, for example, produce 25 per cent of the world's oil.
Finally, as well as fundamental and valuation factors supporting the case for buying equities, technical factors are also positive. Sentiment, a powerful contrarian indicator, at the early March lows was at its most bearish on record. Our proprietary primary trend indicator, designed to signal major changes in trends in equity markets from bull to bear markets and vice versa, threw off its first signal early this year since the end of 2002. On top of that, the participation in this recent rally has been the highest on record. High levels of participation often signal a major change in trend in equity markets (see chart). Previous record highs include August 1982, the start of an 18-year major bull market in equities; January 1975 as equities came out of one of their worst bear markets in history as well as January 1987 prior to the strong 30 – 40 per cent rally in equities ahead of the '87 stock market crash.
Consequently, while we have reservations about the long term implications of the policy response and expect inflation to become an issue in two to three years time, for now, events are conspiring to suggest that equity markets, which are, after all, a natural inflation hedge, should perform well over the coming year or two. Investors should view weakness as a buying opportunity.
The writer is chief economist at Longview Economics
Hamish McRae is away
The recession will reach bottom soon. Get ready for the upswing
The UK economy is entering its fifth quarter of economic contraction. Average UK recessions last seven calendar quarters. To date, the adjustment in the economy equates to a cumulative contraction in GDP of about 3.5 per cent. Measured on that basis, this recession is bigger than any UK recession since the early 1980s. By the end of this year, we might come close to that early 1980s record. Most importantly, though, the adjustment in the economy is well advanced.
House prices have already fallen (in real terms) 24 to 25 per cent from their highs, and while we expect further falls in real terms, the speed of the adjustment is likely to slow. Household borrowing growth has also adjusted back to longer-term normal growth rates; mortgage borrowing, which had been increasing at £10bn per month at its peak, is now growing at a more normal £1-2bn per month growth rate. Consumer credit is also now more subdued.
Most importantly of all, households are rebuilding savings. Household savings rates – which reached all-time lows of minus 1.2 per cent at the start of 2008 – are now normalising. Savings rates in the four quarter of last year reached 4.8 per cent. Given long-term UK average savings rates of 6 to 7 per cent, this adjustment is well advanced. While still below long-term average rates, a continuance of last year's rapid correction could result in savings rates that are notably above average by year end 2009.
The adjustment in the world economy, is also well advanced. With trade-weighted sterling having undergone one if its most dramatic falls on record, the UK is well placed to benefit on its export side from an upturn in global economic prospects.
The Bank of England should start thinking about raising interest rates over the coming months. Record low interest rates at emergency levels are no longer necessary and are likely to sow the seeds of our next economic crisis.Reuse content