Hamish McRae: Equity strength could mean the end of bear market


Outlook One of the continuing puzzles of the summer has been the continued solid performance of equity markets in the face of relentless, bad economic news. Of course that is not universal – the Greek market has bombed – and of course the main share indices remain below their 2000 peaks. But the relative strength in the face of dire news at least raises the question as to whether the 12-year bear market in developed country shares might be drawing to an end.

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Certainly a number of brokers have been arguing that equities at present levels are relatively cheap and are likely to bring greater returns than bonds over the next decade. Some asset managers are beginning to take the same line. But this bear market is "only" 12 years long and previous ones have typically lasted 15 to 20 years, so caution is advised. Still, given that other investments all carry risks, asset choice has become a beauty parade to choose the least ugly, and on that basis, the case is worth making.

One thorough recent such analysis comes from Chris Watling at Longview Economics and his ideas are worth a wider audience. He looks back over the past century and more to identify these long-term bull and bear phases and compares where we are now with where we were towards the end of previous bear markets.

Just to put things in perspective, the graph shows the last 100 years of US prices, as measured by the Dow in real terms, ie adjusted for inflation. As you can see, a bull phase ran from 1920 to 1930, then after the crash of 1929/32 had settled there was essentially a sideways movement until 1950. Then came another bull market until the late 1960s, a bear one until around 1983, and the bull one to 2000.

If the overall performance seems dispiriting given the growth of the US economy since 1910, remember these numbers are capital values and investors will in addition have received an income flow in the form of dividends.

Looking at this in very crude terms it would be plausible to expect another bull market reasonably soon, but "soon" might be five years off and way beyond most investors' horizon. The case from a shorter timescale is based on a number of things, but in particular the relative cheapness of equities versus bonds. If you take the US equity yield premium – the earnings yield less the real bond yield – shares are the cheapest they have ever been. But if you take price-earnings ratios they are priced around the middle of their long-term range, a bit above it in the US, a bit below in the UK. So you could say that while shares are not obviously out of line, they are not screamingly cheap.

Mr Watling concludes that while there are reasons for optimism there are three key ones on the negative side. The first is that the de-rating of equities has further to go: price-earnings ratios are not yet below their long-term average. The second is that US fiscal consolidation has yet to begin, and without any serious austerity measures the recovery has still been the weakest for the past century (that may suggest the policy to running such a huge fiscal deficit has been at best ineffective and at worst counter-productive but we cannot assume that).

His third reason for concern is that the US and other Western economies remain "financialised". By this he means the West has only just begun to cut debt levels – public, individual, corporate and so on – and we still have a long way to go before these are back to levels we have found acceptable in the past.

Mr Watling takes this whole argument further: that the present global monetary system faces some sort of radical change, and that until we know what that will be, a bull market is unlikely to begin. Until we see the reversal of the various quantitative easing programmes around the world, I don't think we can make a judgement on that. It may be that we can patch the present system and keep it going for a while yet. But he is right to point to the fragility of the fiat money system and the risks central banks are running.

Bottom line? Some sort of turning point for equities is coming closer, but for the moment the negatives outweigh the positives. On the other hand, turning points that signal the start of a bull market are hard to catch and you could say that it is better to be two years early than miss it and have to wait another 25 years for the next one.

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