There's a bear in there (and it's not Play School)

OPINION: SHARE markets have had terrible falls since October/November last year. This has thrown up a whole bunch of questions.

Why have Australian shares fallen more than US shares? Will the Fed’s latest attempt to counteract the credit crunch work? Have we hit bottom? If not, then when? And why, what with all the problems around, won’t the bear market be long and drawn out? This note attempts to address these issues amongst other things. But first some background.

There’s a bear in there (and it’s not Play School)

After stabilising from late January till late February, share markets took a turn back down into early March. This saw several markets, including the US and Australian share markets, fall below their January panic lows confirming that the pattern of falling lows and falling highs (which defines a bear market) remains in place. See the next chart.

What’s more, the 200 day trailing moving average of share prices for both markets is still falling, providing further evidence that the trend is now down. This confirms that the situation now is far different to the modest corrections that share markets experienced during the bull market from March 2003 to late last year where markets quickly rebounded and a rising trend always remained in place. The key drivers of the bear market in shares include:

·       continuing bad news on the US economy;

·       ongoing problems in credit markets with the whole securitisation process (whereby individual loans are packaged up into securities) that has underpinned a lot of credit growth in recent years now in disarray, and the banks unable to take up the slack;

·       increasing worries that the US downturn will spread globally – with the slump in US employment confirming that the US downturn is likely to spread into consumer spending which in turn will have a big impact on Japanese, European and Asian exports; and

·       ever higher oil prices – there is an old saying that the oil price will keep rising until “it kills demand” and that certainly seems to be what’s happening now with oil prices now disconnecting from slowing global oil demand and being increasingly propelled by speculative activity. Higher oil and petrol prices will only tighten the screws further on US consumers already reeling from falling house prices and falling employment and Australian home borrowers under stress from high interest rates.

Why have Australian shares fallen more than US shares?

From their high on November 1 to their low earlier this week Australian shares have fallen 25%. By contrast US shares have had a 19% fall. This may seem surprising given that all of the problems are supposedly in the US. Several factors explain the greater fall in Australian shares:

·       Australian shares rallied harder out of the August low last year on expectations that global growth would hold up and hence they became more vulnerable to a fall;

·       many Australian sectors including banks were trading on higher price to earnings ratios than US sectors again making them more vulnerable;

·       the fall in the $US has been helping US companies but the rise in the $A has been harming Australian companies; and finally

·       whereas the US has been cutting interest rates providing a source of support for US shares, the RBA in Australia has been raising interest rates. In fact, it is interesting that in countries where interest rates have fallen in the last six months (such as the US, UK and Canada), top to bottom share price falls have been milder (with falls of 19% in the US and 17% in the UK and Canada). But in countries where interest rates have been on hold or rising such as Europe, Asia and Australia share prices have come off by more (with falls of 23% in Europe and 25% in Asia and Australia).

Our valuation indicators show that Australian shares are now cheaper than global shares. But this may take a while to be realised, particularly with the impact of higher interest rates still hanging over the Australian economy and shares.

Will the Fed’s latest efforts work?

In the last week the Fed and other central banks have been stepping up efforts to counteract the credit crunch. The Fed has made more money available for cheap loans to US financial institutions and will lend out $US200 billion of Treasury bonds for 28 day periods to US banks against high rated but out of favour mortgage backed securities that cash strapped banks can in turn lend to other firms in return for cash.

Quite clearly, the Fed is pulling out all stops to stabilise the mortgage backed securities market. However, the amount involved is relatively modest (compared to $US2.4 trillion of non-prime US mortgages) as is the 28 day loan period, so more action by the Fed will be required – maybe the Fed will actually have to start buying the so called “toxic debt” off the banks (but this involves all sorts or moral hazard and monetary policy issues).

Furthermore, the latest actions don’t do much to restore investor confidence in the broader US credit market. And they won’t prevent a further fall in US house prices, more mortgage defaults, falling employment and a cutback in consumer spending all of which is already in train. So in the short term it’s hard to get too excited. Ultimately some sort of US Federal Government bailout of the sub-prime mortgage loans may be required to stop the downwards spiral now occurring in credit markets.

Have we hit bottom?

After the Fed’s latest efforts, share markets have managed to bounce off their lows reached earlier this week. Shares had fallen sharply over the last few weeks (Australian shares fell nearly 11% in less than two weeks), and had certainly become oversold. What’s more, with shares down 20-25% from last year’s high they had become very undervalued.

So it’s possible that the bounce in shares after the Fed’s latest move was the start of a recovery rally. However, the more likely scenario is that it’s just another bear market short covering rally. Bear markets are characterised by a falling trend interspersed by occasionally sharp rallies as traders who have gone short (eg by going underweight shares or by selling shares they have borrowed) are forced to buy back in whenever there is some good news. During the March 2000-October 2002 US bear market, the market had four 10 to 20% rallies.

However, once the shorts have bought back in, if more bad news appears, the bear market then resumes. This is likely to happen this time around. The news on the US economy is likely to continue getting worse as the problem moves from the housing and finance sectors to consumer spending, not helped by the surging oil price.

Similarly credit markets are likely to remain in a bad way with house prices likely to fall further, foreclosures likely to keep rising & corporate default rates likely to rise. We are also yet to see the sort of investor capitulation that marks the end of bear markets. Australian shares also face the added burden of the fall-out from high local interest rates and the strong $A. So for these reasons we think it’s likely that we will see more weakness ahead.

So when will the low be and how much lower?

Our view remains that while there is likely to be more downside in share markets the bulk of the damage has been done and that shares should bottom some time in the next six months or so. Firstly, share markets have already fallen to levels where price to earnings ratios are back to levels last seen at the end of the last bear market in 2003.

On our calculations share markets in the US, Europe, Japan & Australia are factoring in a 20 to 30% fall in profit.

Secondly, while profits will weaken a slump of that magnitude is unlikely. Thanks to economic stimulus, low inventory levels, a lack of corporate overinvestment and a strong contribution to growth from exports the US recession is unlikely to be deep and should be over by year end. While growth in the rest of the world including Australia will slow it is unlikely to collapse.

Thirdly, the US share market normally bottoms out about 5 months before the recession ends. See the table below. (The tech wreck bear market bottomed out after the 2001 recession ended but that reflected an unwinding of excessive overvaluation associated with the tech bubble). So if the US recession ends by the end of the year then shares should bottom out by around mid year.

Finally, share markets have already had 20-25% falls which is a good way towards the average 30% or so decline in US shares associated with US recessions and the average 33.8% decline in Australian shares associated with US recessions. So a lot of the damage has already occurred and if the US recession is relatively mild as we expect, and given the absence of share market overvaluation, it’s likely that the total fall will be below the 30% or so average.

US recessions and share market falls

*As defined by the National Bureau of Economic Research in the US. Source: Thomson Financial, AMP Capital Investors

What should investors do?

While there is likely to be further weakness ahead, trying to time the bottom is impossible. The best approach for long term investors is to sit tight. For those wondering when it’s time to buy shares, the best approach is to average in rather than hope to be able to predict the precise bottom or alternatively to limit the impact of getting in too early.

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

Australian Property Journal