FYI | Apr 06 2009
(This story was originally published on Wednesday, April 01, 2009. It has now been re-published to make it available to non-paying members at FNArena and readers elsewhere.)
At the end of August last year I came across a study by the institutional desk at GSJB Were. From the moment I read the report I had a strong suspicion the potential scenario suggested in it might prove to be highly accurate. That’s why I decided at the time to keep the story I wrote for paying members at FNArena only, and we sent out a special email alert to make all members aware of the fact we had published a story they should all pay extra attention to.
Just to refresh everyone’s memory: in August last year it seemed share markets were stabilising after months of hefty losses. Early positive returns had triggered calls from investment strategists, stockbrokers and market commentators that a bottom might have been reached.
Before March 2009, August (seven months ago) was the last month equity indices posted a positive monthly return. Yes, the previous paragraph sounds all too familiar doesn’t it?
Before we ask the same question again, let’s have a look first at what the institutional desk at GSJBW had discovered at the time. The following paragraphs are taken from my story on August 27:
“Apart from the fact that September is often one of the worst months in the year for US share markets, research by the institutional team at GSJBW suggests things could get far more worse this year.
“Historically, whenever the Dow is down by more than 12% for the year when September arrives, things are likely to get much uglier, reports the team. It happened so far 14 times since 1900 and in 11 out of those 14 times September proved an absolute disaster month, with US shares falling on average an additional 9%. In each of these years the Dow entered the new calendar year at a lower level than where it was in August.
“The Dow is currently down more than 13% so that would make this year potentially number 15.”
Every single sentence in the three preceding paragraphs has been proved correct. And to top things of, the same report also suggested October months often bring about a strong rally post the share market carnage; this again proved correct.
Last August the Australian share market tried to stabilise around the 5000 level. This time around, after an exceptionally strong performance in March, the ASX200 index is oscillating around the 3600 level.
Similar to back in August, I have again discovered a research report I think deserves extra attention from investors in the share market. But contrary to last year, I have decided to share this story with a wider audience (under the premise that there is absolutely no guarantee this report will prove as accurate as last year’s).
Analysts at Citi have studied bear markets in Australia over the past 130 years. As one would expect, no bear market is exactly the same, but there are nevertheless some conclusions that can be drawn from past experiences, and guidance taken from.
Let’s start with the bad news (so we have that out of the way): Citi analysts don’t think the share market has bottomed yet. Past experience indicates it is still too early to call a bottom. Just to make sure, the authors of the report asked Citi market strategists in the US and in Asia for feedback and it turns out they too were of similar opinion: too early for share markets to have reached a bottom yet.
Historically, states the report, bear markets last two to two and a half years. If we accept the current bear market started in August 2007 (when share markets sold off but rallied back strongly until early November) then we still have another four to ten months to go before the current bear market will morph into the next bull market.
Of course, history never repeats itself, but Citi analysts nevertheless believe there is a strong similarity between events now and what occurred back in the early 1980s. Back then the global banking sector was in total disarray (with problems originating in the US) and -believe it or not- Australian banks were relatively immune from the deep problems elsewhere. Similar to now commodities were in the early stages of a prolonged bull market caused by the awakening of a new economic giant: Japan.
So what if 1982 repeats itself in 2009? In that case, reports Citi, the rally we’ve just seen will soon give in to another leg down for share markets. The good news is, however, that under a repeat of the 1982 scenario the next leg down will bring us the bottom. Or as the report puts it:
“We see broad parallels between the March rally in 2009, and the April/May rally in 1982, i.e., most of the bear market was over by then, but there was a final washout still to come.”
Under Citi’s projected time-line share markets are likely to find their bottom in the September quarter this year.
The analysts make their prediction on the basis of a few key historic parallels, such as that share markets on average bottom 16 months before corporate earnings do and some 8 months before the economy (real GDP). This falls in line with their expectation that earnings expectations will continue falling throughout the remainder of calendar 2009.
At the moment, say the analysts, earnings expectations for Australian listed companies have fallen by 16%. Assuming their prediction is correct and expectations will continue falling during the eight months ahead, the fall in EPS expectations from top to bottom will amount to some 26%; all in the space of roughly two years.
One stand-out conclusion to draw from this is that the upcoming results season in August will prove to be worse than the one we witnessed in February. A second conclusion is that earnings expectations for FY10 still have a long way to fall. Citi analysts suggest the August results season may prove to be the catalyst for this to happen.
(Special note: the report warns investors should thus not get too carried away just yet and stick with a defensive bias ahead of the upcoming company result releases).
One other element that is still lacking in the current bear market is that valuations for shares still haven’t fallen low enough, say the analysts. Previous bear markets saw the share market fall to 15-20 times trough earnings. This time around the market is refusing to go lower than 25 times trough earnings. This too would support another leg down.
A third factor mentioned in the report is that consumer confidence tends to fall to extreme lows; this too hasn’t happened yet.
How do we know the share market has bottomed? Citi analysts suggest investors should keep a close eye on so-called Leading Economic Indicators (in Australia published by Westpac). Historical analysis has shown that share markets bottom on average around four months before Leading Indicators do.
(Note: Citi analysts already corrected their timing for the lag between when Leading Indicators actually bottom and when they are being released. So at the time of release, four months after the share market bottomed, Leading Indicators will confirm a bottom is indeed in place).
An important element in Leading Indicators, as well in the US as in Australia, is industrial production in the US. At present. the report predicts industrial production in the US will continue weakening, albeit at gradually slower pace, until the December quarter this year.
If correct, this would indicate Leading Indicators can potentially bottom from the fourth quarter this year onwards, but maybe more likely in the first quarter of 2010. This too suggests a share market bottom post the August results season is a real possibility.
Citi’s current preferred time-line is for share markets to bottom around August, followed by Leading Indicators bottoming in October-November and real GDP sometime between December and March 2010.
Maybe the most controversial conclusion made in the study is that investors can easily wait until the bottom has been confirmed by the turn in the Leading Indicators before re-entering the share market. Yes, say Citi analysts, it is true that by waiting the extra four months investors are giving up the early recovery gains for equities, but history shows giving up these gains (in exchange for extra confidence and less risk) pales in comparison with the gains that should follow next.
In the early 1980s for instance, investors would have lost out on the first 9% of the share market recovery, but should they really care given the share market returned a total of 164% over the next five years (of which 36% in the first twelve months post the bottoming of the Leading Indicators)?
There have been two exceptions, notes the report. In the early 1970s as well as in the early 1990s share markets did not bottom four months ahead of Leading Indicators, but simultaneously. This would even more strengthen the case for investors to wait and take guidance from the forward looking economic indicators.
The Citi report contains one major flaw, in my view. It is almost entirely based on historical averages. For instance, the average lag of four months between a bottom for share markets and for Leading Indicators has at times stretched out as far as nine months.
But most importantly, historic averages also conceal that back in the 1970s, when the economic recession was followed by a persistent inflation problem, the three-month period between share market bottom and Leading Indicators bottom generated a positive return of 27%. After that, share market returns remained dismal: 4% over the next twelve months; minus 34% over three years; minus 22% over five years.
Let’s hope Citi analysts have made the correct comparison and today’s bear market is more akin to the one in the early 1980s.
With these thoughts I leave you all for this week.
Till next week!
Your editor,
Rudi Filapek-Vandyck
(As always firmly supported by Andrew, Grahame, Greg, Pat, Joyce, Chris and George)
P.S. I add two charts today that both could potentially fit in perfectly with the 1980s scenario suggested in Citi’s report: China’s purchasing managers index retreating again in February and Baltic Freight Indices retreating again after a short lived bounce earlier this year.
(My apologies if you are reading this story through a third party channel as you may not be able to see these charts. You are always welcome to take out a free trial at www.fnarena.com).
