Bear market & lower interest rates

OPINION: SHARES are still in a bear market, but if history is any guide the bulk of the damage is behind us. Whilst it may take a while for shares to regain previous highs, history tells us that the first 12 months of recovery will see strong gains.

Introduction

It’s now a year since the US sub-prime mortgage crisis really hit with a vengeance. Shares have recently made new lows indicating the ride remains harrowing for investors. This note reviews how the current bear market compares to past bear markets along with the implications for Australian shares of likely RBA rate cuts.

Still a bear market

Share markets in the US, Australia and elsewhere are still tracing out a classic bear market pattern of falling lows and falling highs. And the 200 day trailing moving average of share prices, which is a good guide to the trend, is continuing to fall. The rally into May proved to be a classic bear market rally with shares rallying up to around their 200 day moving average before commencing their most recent descent. The contrasts with bull markets where there is a pattern of rising highs and lows and where corrections generally see shares move back to their trailing moving average after which they rebound.

Source: Bloomberg, AMP Capital Investors

Putting the bear market in perspective

There is no agreed definition of a correction versus a bear market. Some people focus on the magical 20% fall as a demarcation but this measure seems rather arbitrary. My preferred approach is that a correction is limited to sharp falls, 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 a year or more to regain new highs. The next two tables show bear markets since 1960 for US and Australian shares.

Bear markets in US shares since 1960

Bear markets associated with US recessions are highlighted in red. Source: Bloomberg, AMP Capital Investors

Bear markets in Australian shares since 1960

Bear markets associated with US or Australian recessions are highlighted in red. Source: Bloomberg, AMP Capital Investors

Since 1960 the US and Australian share markets have experienced 8 and 9 bear markets respectively. The average duration has been 15 months in both markets with an average top to bottom fall of 32% in the case of US shares and 34% in the case of Australian shares. The average time taken to regain the previous share market peak is 24 months in the US and 41 months in Australia. Most bear markets are associated with a recession, although in the Australian share market’s case this may only relate to a US recession (such as earlier this decade). The average rebound in the first 12 months after the low is 33% in US shares and 32% in Australian shares.

There are several points to note in relation to this.

Firstly, with most bear markets associated with a recession the falls in share markets that we have seen suggest that the risk of an “official” recession is high, both in the US and Australia.

Secondly, there is good reason to believe the bulk of the damage is behind us. US shares have fallen 22% versus their average bear market decline of 32% and Australian shares have fallen nearly 30% compared to their average bear market fall of 34%. Of course these averages mask a wide divergence with the mid 1970s bear market which occurred at a time of severe economic problems (ie, double digit inflation and recession), the 1987 crash and the tech wreck boosting the averages. Given that a re-run of the 1970s economic shock is unlikely, and that we didn’t see the sort of share market overvaluation that preceded the 1987 crash or tech wreck, there is good reason to see shares falling by less than their bear averages this time.

Thirdly, while the past history suggests that it may take some time to regain previous highs, it is worth noting that once shares bottom, the rebound in the first 12 months is usually very strong with an average gain of 33% in US shares and 32% in Australian shares. Given that the rebound normally occurs against a backdrop of extreme uncertainty (with shares climbing the classic “wall of worry”) the obvious risk for investors switching to cash in the hope of getting back in when the outlook is clearer is that they simply miss out on the best part of the rebound.

What are the implications of likely rate cuts in Australia

The slump in the Australian economy and recent indications from the RBA suggest that local interest rates will start falling soon, possibly as early as next month. Falling interest rates are normally good for shares. They help future profit growth and make shares relatively more attractive than cash and hence are usually associated with higher PE multiples. The table below shows the Australian share markets response after the first rate cut at the start of an easing cycle.

Australian equity performance (ASX 200), %change, months after first RBA rate cut in an easing cycle

Recessions for the Australian economy are highlighted in red. Source: Thomson Financial, AMP Capital Investor

On average shares are up 3, 6 and 12 months after the start of rate cut cycles in Australia. As can be seen though the experience is mixed in times of recession/hard landing (as the experience of the US over the last year highlights). But with Australian shares having already fallen sharply and looking very cheap and with strong resource sector profits likely to underpin overall profit levels there is good reason to believe that shares will be up on a 12 month horizon.

One thing worth noting though is that commodity prices, notably energy, recently rose to a level that was starting to choke off global growth and they are now undergoing a correction. While this does not mean the end of the long term upswing in commodity prices (as the long term China story remains alive and well and supply is likely to remain constrained) the commodity correction is likely to have further to go in the short term. This is likely to mean that resources will be relative underperformers for a few months and given the relative importance of resources in the Australian share market, is likely to mean that Australian shares may under perform global share markets for a while. Asian shares are likely to be key beneficiaries of the correction in commodity prices given their economies high reliance on commodity imports.

Signs to watch for a sustainable share rebound

We are looking for the following signposts to be confident that share markets are on track for a sustainable rebound:

·       A sharp and sustained fall in the oil price;

·       A fall in inflation worries as represented in bond yields

·       A relaxation in central bank hawkishness;

·       A slowing in US house price falls; and

·       A sustained improvement in credit markets.

There is still little clear improvement in credit markets. But it’s interesting that some of these signposts may be starting to fall into place. The oil price is down substantially from its high. This in turn should help to reduce inflation worries and central bank hawkisness of which the turn towards relaxation in the case of both the Reserve Bank of New Zealand the RBA may be early warning signs (given that both were amongst the most hawkish central banks until recently).

Concluding comments

It’s increasingly looking like shares have put in a good low with more upside ahead with financials rebounding solidly from panic selling in mid July. Australian shares seem to have found strong support around the 4800 level. This may just be another bear market bounce though and we still see the next few months as being quite rough. However, with the oil price moving in the right direction with positive implications for inflation and interest rates there is increasing reason to be confident that shares will rally into year end.

While the likely shift to lower interest rates and a softer $A are good news for Australian shares, they are vulnerable to relative underperformance over the next six months as commodity prices correct further.

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

Australian Property Journal