Have equity markets escaped the bears yet again? Global stocks started 2016 with a swift fall of more than 10 per cent — the worst start to a calendar year in history — but have regained all of it. This also happened last summer, with markets performing a similar swan dive followed by a brisk recovery.
The dramatic swings have prompted questions of whether the bull market that started in March 2009 is on its last legs. Both US and world stocks remain below their record set 10 months ago, and the anxiety that drove two sell-offs remains palpable.
But the debate goes deeper. Even though US stocks have tripled since their low in the financial crisis, some suggest that the upward streak of the past seven years was not a bull market at all. Indeed, there are experts who argue that the bear market that started when the Nasdaq dotcom bubble burst in 2000 is still going on.
In the shorter term, debate hinges on the economy. As long as there is no clear evidence of an imminent recession in the US, it is harder for stock markets to turn decisively down. James Breech, head of Cougar Global Investments, says: “Bull markets don’t die of old age. It’s always recessions that kill bull markets. And we have zero per cent chance of a recession in the next 12 months.”
James Paulsen, chief investment strategist at Wells Capital Management, says the market behaviour of the last year can be “characterised not by a bull nor by a bear, but rather by a bunny”. He suggests that such a market “hops about a bit but really doesn’t go anywhere”, characteristics that often dominate the stock market during the latter stages of recoveries. Bunny markets require nimble and opportunistic behaviour by investors. “We’re biased because the last two times we had a bull market, it went straight up and then, when it ended, it ended,” he adds, referring to the market crashes of 2000 and 2008. “We lost the feel for a meandering market which is still in a bull.”
In the short term, traders refer to a cyclical bear market when a fall of 20 per cent from peak to trough is registered. On that basis, large US stocks, as measured by the S&P 500 index, have avoided the bear. They have never been down more than 15 per cent from their record set in May last year.
But industrial and transport stocks, and smaller US companies, all seen as leading indicators of where the rest of the market is heading, were down more than 20 per cent from their highs during the worst of the action in February.
Even if the S&P 500 did not fall by as much as 20 per cent, it may therefore make sense to call this a cyclical bear market. Scott Minerd, head of investment at Guggenheim Partners, says: “You can make a good case that there was a bear market in the first quarter — but it needs to be better defined.”
Whether the pause in the market’s onward march was enough to allow another upward leg of the bull market is also, he says, hard to answer.
The critical variable is the US economy. John Higgins, chief market strategist at Capital Economics in London, suggests that US stocks can continue to muddle along if the country can avoid a recession. He notes the dollar has started to weaken, flattering the overseas profits of large US companies.
“To see a bear market, we have to be wrong about the US economy, and to see a stronger dollar. The effect of the stronger dollar on overseas earnings would be a very big deal, and the structural forces that pushed up the market — globalisation — could be seen to go into reverse.” Mr Higgins says the key is unemployment. On each of the eight occasions since the second world war when joblessness has dropped below the ‘Nairu’— the rate higher employment begins to drive accelerating inflation — the labour share of the economy began to rise at the expense of capital, squeezing profits.
The US jobless rate is at 4.9 per cent, and a strong rise in hourly earnings for December helped drive the early-year sell-off. It has since fallen back.
A sharp rise in inflation would force the Federal Reserve to abandon the low interest rates that have helped to finance the boom in stock markets, and could also push up bond yields. Historically low rates have been critical in supporting the equity bull market.
David Bowers, head of research at Absolute Strategy Research, agrees: “The core risks are around where unemployment is going. If the unemployment rate is going down, it’s still an environment where stocks can do well, certainly relative to expensive Treasuries.”
Outside the US, which accounts for 43 per cent of global stock market value according to Datastream, the story is clearer. Stocks rose to a post-crisis peak in 2011, and have been mired in a bear market ever since.
In emerging markets, according to the latest regular Bank of America Merrill Lynch survey of global fund managers, investors are their most underweight in 15 years, a classic sign that a bear market bottom may be near.
Here, markets are following a familiar pattern seen after previous crashes that followed speculative bubbles, such as the Wall Street crash of 1929, the Japanese bubble that peaked in 1989 or the dotcom bubble that peaked in 2000. In all cases, markets shed about 60 per cent, and then moved sideways for many years before bottoming out.
In the US, where stocks are far above their pre-crisis highs in 2007, the question is how they managed to avoid this pattern. Some financial historians question whether market cycles are linked to the economy. Rather, they tend to see markets following longer secular — not cyclical — bull and bear trends, influenced by social mood, economic and profit cycles and, most importantly, swings in valuation.
Russell Napier, a stock market historian and author of Anatomy of the Bear, says both bull and bear markets are long, drawn-out affairs. The bottom of bear markets, which see a steady collapse in equity valuations, is only hit when all hope in equities has been lost, and there were only four such low points throughout the 20th century. “Very high and low valuations can’t just be attributed to the business cycle because they are too rare,” he says.
He adds that March 2009 was not a true bear market bottom because equities were not cheap enough, implying that stocks will need to fall back to that level. To measure these broad cycles, he uses cyclically adjusted price/earnings multiples, which correct for the business cycle by comparing share prices to the average of earnings over the previous 10 years. A measure known as Tobin’s Q, which compares the value of companies with the total replacement cost of their assets, yields a similar conclusion.
