Share turbulence – a correction or a new bear market?

Shares have had sharp falls over the last few weeks as the panic in US credit markets spread. While there have been nice bounces over the last few days, further falls are possible.

Introduction

The US sub-prime mortgage crisis has triggered sharp falls in share markets in recent weeks on fears that the boom in private equity takeovers is over and that the slump in the US housing market will depress profits.[1] From their recent highs to recent lows US, European, Japanese, Asian and Australian shares have fallen around 8% to 9%. But is this just another correction or the start of a major bear market?

Share market falls may still have further to go.

While shares have had a good bounce in recent days – recovering about a third to a half of their losses – and there are signs the credit market turmoil may be settling down, it’s too early to say the falls in shares are over:

·       The news on the US economy will likely get worse with mortgage delinquencies heading higher in response to scheduled resets to higher interest rates, tighter lending conditions and falling house prices resulting in a vicious cycle which will likely dampen consumer spending.

·       Just as we have seen during past financial panics such as that following the collapse of LTCM in 1998 (which saw credit spreads widen by far more than has been the case lately and US shares fall 21% in 6 weeks) investors are unclear as to how severe the problems are. This is made worse by the preponderance of geared exposures to complicated credit products. You could spend weeks just trying to get your head around all the jargon in credit markets these days – CDOs, CLOs, LCDX, OAS, ABX, etc. This is an ideal environment for panic driven selling of investments leading to a big undershoot in asset values, which is what we have seen over the past few weeks.

·       The August to October period is often tough for shares.

There is a risk this bout of share market weakness will be deeper than those of the last few years. The key US economy is more vulnerable. The bull market is further advanced, more investors are on board the share market train and there are more leveraged positions all making the damage from an accident potentially greater. Also, interest rates are higher and profit growth is slowing. Corrections in share markets have been getting deeper over the last few years. In 2004 the biggest correction in Australian shares was 3.5%, while 2005 saw two 8% corrections and last year shares had a 12% correction. On this pattern a 15% or so fall this time around would not be surprising.

Some observations on corrections and bear markets

Before going further, some observations on corrections and bear markets may be of use. There is no agreed definition of a correction versus a bear market. My preferred approach is that a correction is limited to sharp falls, up to 20% or so, across a few months after which the rising trend in share prices resumes, taking shares back to new highs within say six months of the low. By contrast, a bear market sees falls lasting many months or years and it takes shares more than a year to gain new highs. The next table shows 10% plus falls in Australian shares since the late 1980s. Following this definition bear markets are highlighted in bold, corrections in blue. I have not shown falls less than 10% as they occur too frequently to be of interest. On this basis the latest 8.5% top to bottom decline in Australian shares is too modest to make the table.

Falls in Australian shares greater than 10% since 1989

Source: Bloomberg, AMP Capital Investors

In the case of the US share market, since 1990 it has experienced 7 falls of 10% or more. Of these, only the 50% fall between March 2000 and March 2003 would be classified as a bear market, whereas those in 1990, 1994, 1996, 1997, 1998 and 1999 were corrections as the rising trend quickly resumed. There are several points to note about all this:

Firstly, falls of 10% or more are not unusual. Most of these occur within a still rising trend which is re-established reasonably quickly. Only a small proportion become bear markets. Australian shares had a decent (10% plus) correction in every year from 1996 to 2001 and yet made new highs within 6 months each time and each year saw shares deliver a positive return.

Second, while it is reasonable to worry that recent share falls might be a warning of an approaching economic slump, the track record of share markets in foreshadowing recessions is not good. Of the ten share market falls in Australia noted above, only that in 1989-1991 ushered in a recession. In the US, only the 1990 and 2000-03 share market falls ushered in recessions.

Thirdly, bear markets are generally characterised by preceding share market overvaluation and/or threatened inflation problems which lead to significant monetary tightening, recession and a slump in profits.

Finally, bull markets are characterised by steady advances and occasional sharp setbacks which often become more intense as the bull market gets older. This is because more and more investors become exposed to shares and are liable to take fright when bad news comes along.

A correction, not a bear market

Our view for some time has been that we have entered a more volatile period for shares and that in this context the occasional decent correction could be expected, but that the trend would remain up. This remains the case:

·       Firstly, global growth is likely to remain solid. While the US economy will slow further and the US consumer is vulnerable, the US corporate sector is in good shape with low gearing levels and strong profits and is not dependent on borrowing to fund capital spending. Moreover, unlike the situation in 1998 at the time of the LTCM hedge fund crisis this time around the rest of the world is strong providing a big offset to US weakness.

·       Secondly, with global inflation remaining low the interest rate backdrop will remain benign. The move to higher interest rates remains very gradual in Japan and Europe, and in the US the Federal Reserve is gradually moving towards a rate cut later this year. The increasing prospect of a Fed rate cut is putting downwards pressure on global bond yields. So while the spread between corporate borrowing rates and government bond yields has widened during the recent credit turmoil, the actual increase in corporate borrowing rates hasn’t been that much. With US inflation fading there is lots of scope for the Fed to cut interest rates if the current credit problems for low quality mortgage and high yield corporate borrowers turns into a full blown credit crunch threatening the US financial system. This is what happened in 1998.

·       Thirdly, corporate profits remain solid. This has been the main factor underpinning the bull market in shares – and while profit growth is slowing the recent June quarter profit reporting seasons in the US, Europe and Asia have all been stronger than expected.

·       Fourthly, while private equity support for shares has retreated for now, the overall liquidity backdrop remains favourable. The flow of capital from China, Asia and other surplus countries will be with us for some time to come and companies are cashed up with strong balance sheets and in many cases don’t need to borrow to fund takeovers or share buybacks. In fact despite the turmoil in credit markets US companies have been buying back their shares at a near record rate over the last two weeks (which is the opposite of what they would be doing if they are fearful of the future). This has meant that the stock of US shares on issue has been shrinking at a rapid rate (around 5% pa this year). Finally, while the flow of credit to private equity deals may have dried up for now, the fact that Blackstone has just raised $US21.7bn from investors and the fact that corporate borrowing rates still remain low relative to the earnings yield on shares indicates that private equity may not be out of action for long.

·       Finally, share markets never became overvalued and after recent falls and the decline in bond yields are now cheap again. Australian shares have now fallen back into the lower half of their value range.

Source: Thomson Financial, AMP Capital Investors

Concluding comments

While the ride is likely to be rough over the next few months and further declines are possible, the recent slump in share markets should not be seen as the start of a bear market. The low inflation global economic expansion is likely to remain intact. While growth has shifted away from the US to the rest of the world, the global interest rate backdrop remains benign, the corporate sector is in good shape and share markets are not overvalued. The historical record indicates that corrections up to 20% are not unusual in the context of cyclical bull markets and so investors should not get too alarmed by the recent turbulence. Corrections are healthy in the sense they ensure share markets don’t get too exuberant.

Finally, while much has been made of the losers from the recent credit debacle, including investors in various yield focused “hedge funds” in Australia, there has been little focus on the “winners”. Some hedge funds have been known to have short positions in sub-prime assets (and so have profited from declines in their value) and several hedge funds will make good money for their investors by buying into the assets that have been sold down so heavily (and in the process they are helping markets adjust more smoothly). So while there are a lot of lessons to be learned (or relearned) from the recent problems (eg, about the need for diversification, and the dangers of excessive financial engineering and leverage), hedge funds are likely to come through it better than currently being portrayed.

By Dr Shane Oliver, head of investment strategy and chief economist with AMP Capital Investors.*