Lest We Forget

This story features BHP GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: BHP

This story was first published two days ago in the form of an email sent to registered FNArena readers.

By Rudi Filapek-Vandyck, editor FNArena

I am shocked by events from the past ten days. No, I am not referring to the fact that Australia’s S&P/ASX200 index has sunk below the psychologically important 5000 level. That I expected to happen. What I did not anticipate, however, was the fact that this event triggered responses from stockbrokers, market commentators and investors who all seemed genuinely surprised by it.

I think many people have allowed to let their judgement and their views getting clouded by various micro-events and -analyses, and this has caused them to lose sight of the broader picture, which is that we still are, and will likely remain for a while yet, in a bear market for global equities.

A few months ago I wrote down a few basic tips for investors willing to play the share market during a bear market period. Here’s an update for those who’ve missed that story (or need a reminder):

– Valuation has little value (if any). Stocks trade on sentiment. Make sure you don’t get caught in any valuation traps. Because the overall trend in a bear market is negative, what appears valuable today might turn out a lot less valuable tomorrow. Once a stock collapses in price you will be fighting the iron law of mathematics: remember that a stock that has lost 30% of its value needs to rise by 42% just to take you back to break-even.

– Always keep in mind: the overall trend is negative. If you want to keep the trend as your friend (and that only seems like the most sensible thing to do), you’re better off being in the market short or for a short time only. (Yes, there is a longer term approach, but I’ll come back to this later).

– Bear market rallies are fierce. We know from past analysis that most big share market rallies take place in a bear market. Conclusion: there is still money to be made, but you’ll have to seek out the right momentum at the right time. Don’t pay any attention to people who point at valuations. Previously I suggested that every morning after you get out of bed you should repeat to yourself: “Value is of little value” (three times every morning before breakfast). This still seems like the most appropriate vaccine against all those valuation opportunities you will come across. (Most of them will instantly turn your punt into a long term investment).

– All negative things are magnified in a bear market. Make an error during a bull market and you might still see a profit. In a bear market any error, no matter how small, is a virtual guarantee you will suffer losses. The same principle applies to sectors as well as to individual companies: once the trend has turned negative there’s no forecasting how bad things can ever become. Most of the time things get worse before they get better, and in almost all cases they ultimately end up much worse than previously thought possible.

– Whatever you do, don’t try to be a hero in a bear market. Heros occasionally become rich and famous in a bull market, and then only occasionally, but during a bear market all heros die an anonymous, shameful and torturous death. (They either suffer great losses or they have to tell themselves all investments made are “for the longer term”.)

– Bear markets are ruthless and show no mercy. If one of your investments is being hit by a negative event, don’t think twice, run! Analysis by Credit Suisse has shown that companies that disappoint during results season in a bear market typically underperform by 100%, or more. In many cases these companies remain out of favour for years, not just months. Remember: negative things are magnified and there’s no telling how bad things will turn out to be.

– in a bull market almost anything works, from technical analysis to paying attention to company directors buying their own shares to insider tips from your brother in law at the family BBQ, to the most odd and exotic ways to pick your next investment (Throw a dart? Choose the first one from the top?); in a bear market, however, virtually nothing works (except when you’re extremely lucky, and then only just once). Sentiment and momentum are key. Make sure you pick those rallies. And good luck (you’ll need it).

– Better keep in mind that bear markets seldom allow for exceptions. BHP Billiton ((BHP)) shares are trading below the $40 they were trading at in February and Rio Tinto ((RIO)) shares are below the $127 they were trading at when BHP launched its idea of a tie-up between the two. Do I need to say more?

– The current bear market has the extra-complication that there are no defensive stocks, or sectors. Say thank you to all those experts and market commentators who told you otherwise and kept you invested in the biggest valuation trap since the dot com craze, the banks.

– It is universal knowledge that each and every bear market creates fertile ground for the next bull market (but not before it has run its full course).

How do we know when this bear market ends?

We don’t necessarily need technical chartists to answer this question for us. As long as the overall risks to corporate earnings (thus economic growth) and share price valuations (based upon forecasts by securities analysts) remain tilted to the downside, we are and will remain in bear market territory. To make the transition into the early stages of the next bull market, a majority of investors (not just one or two brave share market gurus) will need to be genuinely convinced that the odds have clearly turned in favour of likely surprises to the upside for both corporate earnings and share price valuations. Until then, and not one moment earlier, investors will have to continue reminding themselves the bear market is still alive and dominating.

In my view, investors should approach this matter not as a punter, but as the bookmaker who has to make sure he puts up the right odds so he makes money, instead of losing it. Wouldn’t you have loved to take all the bets from those hopeful punters who were willing to bet between April and May that all this would soon be over? When the moment comes that you feel the odds have clearly shifted and you are more likely to start losing money on those “all will soon be over”-bets, you can probably start betting on a sustainable recovery for the share market yourself.

But until that moment arrives, the future remains negative with global financial institutions struggling with balance sheet weakness, declining asset values, higher wholesale funding costs and a global economic slow down that will predominantly manifest itself in all major developed economies. Add higher than usual costs for base metals, agricultural products and oil plus the prospect of higher interest rates across the globe and it should be clear to everyone we are just at the beginning of a turning point still. Analyst expectations remain way too high, and will have to come down, and come down a lot. And as those forecasts come down, so too will valuations, price targets and recommendations. Until they are so low that upside surprises will become more likely than not.

Only then will the last bear market rally prove to be the first one into the new bull market.

What about taking a longer term view, I hear you ask? Shouldn’t smart investors dive in when “there’s blood in the streets” – or like Warren Buffett once famously said: be greedy when others are fearful?

There is little doubt that for longer term oriented investors the current market offers plenty of cheap entry points. And many financial advisors and stockbrokers will tell you that is exactly how you should approach this market. My main fear is, however, that many investors underestimate the fact that risks are still heavily skewed to the downside, and how much of an impact this can have not only on corporate earnings in the years ahead, but also on valuations for stocks.

I hear on a daily basis how “cheap” stocks are valued in sectors such as consumer discretionary and media, but nobody knows just yet exactly how hard times will become in 2009 for these sectors. Probably best to read “longer term” as “at least three years, preferably for longer” – and that is not taking into account the mental strength investors will have to display when several of these longer term investments could well remain underwater for many months if bought today.

Better make sure you have a thorough understanding of “longer term” before jumping on any “through the cycle”-opportunities.

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