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Rudi’s View: Who’s Afraid Of The Big Bad Bear?

FYI | Jan 28 2016

This story features BLACKMORES LIMITED, and other companies. For more info SHARE ANALYSIS: BKL

By Rudi Filapek-Vandyck, Editor FNArena

Amongst all the silly rules and the myths that continue to exist in the financial sector, surely the silliest amongst the silliest is that a bear market starts when prices fall by 20%.

History shows financial assets do not often fall by 20% and when they do, they are more often than not closer to the bottom of the downward spiral, effectively providing those investors brave enough to buy when others are fearful with an attractive long term entry point. If we stick to equities, the last time a fall of this magnitude hit US stock markets was in 2011 when disintegration of the European Union became a potential prospect. From top to bottom, between 2nd May and 4th October, the S&P500 index lost 21.58%. Australian shares posted similar losses at that time.

Did you spot the irony?

What exactly is the logic of declaring a bear market for US equities when there's but 1.58% left to the bottom? Would it not have made a lot more sense to declare THE END of the bear market when the down trend hit the 20% mark?

Of course, there are alternative versions too. The 20% fall pre-2011 takes us back to 2008-2009 when US equities lost more than half of their value measured from the October 2007 peak. Back then, 20% was barely half-way on the way down. Why wait until you're half-way down Armageddon to declare the bull market is over?

With 100% hindsight, and I am sure everyone agrees on this, the perfect scenario would have been to identify the bear market while financial markets were near their top. It would save us all a lot of money if we can just get out near the peak and back in close to the bottom. Alas, here too the financial sector excels in weakness. If we'd paid attention to every forecast made since 2011 about the next bear market unfolding, we'd been in and out constantly and never made any real money in between.

Let's forget about all these silly rules and bad predictions and go straight to what matters most for you as an investor: share markets globally are in a bear market.

To be precise about it: global equities have been in a bear market since the middle of last calendar year. Despite what many commentators and experts would like us to believe, bear markets never follow the same script. This one has gradually sneaked up on us, creating confusion and diversions along the way, which is why it has taken this long for most experts and investors to (finally) catch up to it in the opening weeks of calendar 2016.

You don't necessarily have to take my word for it. The price chart below should speak for itself.

Australian indices took a tumble in late April last year, then -without recovering from the first tumble- sold-off again in early August, then again in the first three weeks of 2016. Volatility has picked up significantly with the ASX200 since the August sell-off effectively moving up and down inside a trading range between 4900-5350, occasionally trying to break out to the downside.

Over the period, banks (and other financials), mining stocks and energy companies, including the telecom sector have all plunged by more than 20%. Even if we simply apply the silliest of all financial rules, any objective observer would have to conclude three quarters (approximately) of the Australian share market is in a bear market, and has been for a while.

But you would not know any of this if all your money was in Blackmores ((BKL)) shares, up 500% over the past twelve months. Or take ResMed ((RMD)), up some 12.90% in January with the broader market deep in the red.

The same pattern has played out in overseas markets too. In the US a small number of stocks has kept major indices not too far away from the all-time record high, but underneath the surface a different trend has taken shape. Close to half (47%) of all large cap stocks in the US is trading at or below their share price level from two years ago. This is similar to banks & financials, miners and energy producers in Australia.

But you wouldn't know it if your focus was solely on Netflix, or Alphabet (new parent for Google), or Facebook.

One possible conclusion is thus that whatever is worrying investors today has already been impacting on the weaker sectors and the weaker stocks in the share market since mid-2015. The majority among us is only paying attention now on broad indications that, maybe, what is weighing upon the banks and the resources stocks has started to affect the rest of the market too?

So what exactly is causing all of this?

A badly timed bad combination of things. Most economies are operating below potential, and they have been for a while, irrespective of central bank policies. Now many economies (including Australia and China) are slowing down further when central banks already are employing extreme stimulus measures. At the same time, bond yields near zero have created a layer of debt, leverage and complacency inside the global corporate sector nobody's really certain or comfortable about. We know about US shale producers that are under duress to pay back their debt. But Chinese companies, including many miners and steel manufacturers, also have a lot of debt and cannot pay it back either and there's stress on various regional borrowers inside the country too. The Federal Reserve would like to move away from its emergency interest rate setting, which is strengthening the US dollar and tightening USD liquidity elsewhere around the world.

Against the background of all of this, the global corporate sector is facing its Fourth Industrial Revolution, with new technologies and new business models disrupting (and threatening) established market dynamics and business strategies. At a time when large demographic shifts are taking place, not only in developed countries, but in China too. Governments across the world are struggling with rising expenses and lower income. Their reactive policies and market interventions add a new constraint for businesses.

In Australia, the impact of all these factors has manifested itself most clearly at the top of the market, which is why the Top20 last year was the worst performer amongst all indices, followed by the Top50. This marks a major reversal from previous bear markets when investors would seek safety among the so-called Blue Chips in the market. Not all of them, of course, but during times of low risk appetite (which is essentially what makes a Bear) large companies tend to perform better than their smaller peers. Bear markets do not by definition follow an identical blueprint. This one is different from 2008-2009 and from 2000-2003.

(Last year I wrote and published a book about the many changes taking place around the world. It's available in eBook format via Amazon and most other online distribution platforms. It comes as a free bonus with a paid subscription to FNArena).

Probably the biggest misinterpretation of events has been the tumbling oil price. Most experts regard this as a positive for the global economy as cheaper oil increases the spending power of both businesses and consumers. But it takes a while before such benefit shows up in actual spending and it's not like businesses and consumers have nothing else to worry about. What had been widely ignored is the energy sector has been an active contributor to economic growth and investment in recent years and its absence now is going to be felt first.

Sovereign wealth funds of oil producing nations have reportedly been among the big sellers of global equities and other financial assets in January, creating a double whammy effect for financial markets.

Most experts and commentators turn to precedents from the past as to how best to deal with a prolonged period of sharply reduced investor risk appetite, but as said, I think this one is different. I believe many of the answers investors are looking for can be found in the price action since late April last year. Over the past nine months, CSL ((CSL)) shares have appreciated by 20.50%, while shares in Sydney Airport ((SYD)) are up 31.50%. Clearly, this Bear Market is impacting more on some shares than on others, and on some shares not at all.

What are the selection criteria?

When risk appetite flees the markets, investor focus makes a radical shift from potential return to maximum security. This means stocks with too much debt, a bad track record, a doubtful outlook or any degree of too much uncertainty become a whole lot less attractive. Instead investors will flock to stocks that offer a whole lot certainty and security. This on the basis of the sector in which they operate, the health of the balance sheet, the ability to generate cash, degree of pricing power and/or customer loyalty and management's track record during testing times.

"Valuation" as such is a much less reliable indicator as shown by the fact that BHP Billiton ((BHP)) shares have kept falling from $30 to below $15 despite many experts calling them "cheap" at just about every level during the process (continuous falling commodity prices and a major disaster in Brazil will do just that).

Looking at price action of the past nine months, it is clear investors remain willing to back strong, multi-year, solid looking uptrends including infant formula food products into Asia/China, outdoor advertising, aged care and cloud services. The main danger for companies like Bellamy's ((BAL)), Ooh!Media ((OML)) and TechnologyOne ((TNE)) seems to be more related to share prices potentially rising too fast, too high than otherwise.

Yield stocks remain in high demand, but not every yield stock is equal. Compare Sydney Airport, Transurban ((TCL)) and Goodman Group ((GMG)), all supported by strong, solid looking growth trends, with the banks and most insurers and there's no denying the difference. REITs too have significantly outperformed in recent years and sector analysts still believe most REITs in Australia remain poised for 5-10% return by year-end.

My post-GFC analysis suggests we are witnessing a golden era for All-Weather Performers(*) -stocks whose growth outlook remains independent of the economic cycle or pace of GDP growth- and the past nine months have simply further reinforced this view. Observe how ARB Corp ((ARB)), CSL, InvoCare ((IVC)) and Carsales.com ((CAR)) have held their own during the January turmoil. Hospital operators Ramsay Health Care ((RHC)) and Healthscope ((HSO)) on the other hand have lost some of their gloss because the government is looking into cutting healthcare costs and this means too many question marks at a time when investors are looking for safety and certainty.

One easy to make observation is these stocks might not be 100% immune when investor anxiety hits peak levels, but their falls are more shallow and the subsequent recoveries much quicker. Observe how Domino's Pizza ((DMP)) shares are trading in positive territory year-to-date, and the same goes for Hansen Technologies ((HSN)) and IPH Ltd ((IPH)).

Of course, one obviously different approach is to jump on board when shares appear at their lowest point, taking advantage of the fact that share prices always fall too far when fear and discomfort over-rule everything else, and simply await for better times to arrive. No doubt, this is also the approach applied by most investors with a long term horizon who've been caught out by the downtrend over the past nine months.

One oft quoted Wall Street saying states that if you want to panic, you better do it early. Arguably, investors have missed that opportunity. (This does by no means imply portfolios and strategies cannot still be amended and re-adjusted – they can. It's never too late to re-assess, re-position and re-calibrate).

Traditionally, when equities are no longer in a solid, up-trending bull market, volatility tends to spike and share prices start making big moves to the downside and to the upside. Many an investor responds by taking a shorter-term, more trading oriented approach. It goes without saying those shares that fall the deepest can rally the most when market direction turns north, as witnessed by recent price action for Slater & Gordon ((SGH)), LNG Ltd ((LNG)) and Santos ((STO)), to name a few.

Gold has seen its own bear market unfolding after surging to US$1900/oz in August of 2011. The subsequent multi-year decline has seen the price of bullion deflate by some 45%. History shows a bear market for equities tends to go hand-in-hand with a rise in investor interest for gold. Thus far price action in gold has remained fairly benign, but one can take the view gold appears to be forming some kind of a bottom. In January last year gold surged to US$1300/oz and the price today still remains below this level.

Gold producers in Australia were very much in demand in 2015 but that was driven by a weakening Aussie dollar, not by gold priced in USD which still experienced a negative year. Gold remains poised to step back into the limelight when times get genuinely tough for risk assets and investor angst and anxiety surge (even if it's only temporarily). Rising US bond yields and a stronger US dollar are the to be expected headwinds for gold.

Recent research by Morgan Stanley suggests the median bear market for US equities lasts 272 days and pushes down the index by 28%. Research by Cornerstone Macro puts the mean duration at 8 months and the median duration at 7 months. The mean decline, reports Cornerstone Macro, is 33.37% and the median decline 31.12%. Research by Credit Suisse suggests Australian equities, once down 20%, either rally by on average 24% in the following year, or they fall by another 20%.

These numbers are very much dependent on where analysts pick starting points and what exactly are their criteria for bear markets. I doubt whether many place the start of the current bear market in late April last year. Besides, historical averages are just that, averages. Apart from this, US equities are thus far only down by some 12% from last year's peak, versus 18% for Australian equities and larger falls for equities in Japan, China and in Europe. Strictly taken, according to that silly 20% rule the current down trend doesn't yet register as the next bear market.

While the magnitude of declines for the likes of BHP Billiton, Woodside Petroleum ((WPL)) and Origin Energy ((ORG)) have surprised many, valuations for the banks in Australia are now back to levels last witnessed during the 2008-2009 bear market. On a relative basis, vis-a-vis the broader market, Goldman Sachs analysts believe banks are now the cheapest in 25 years.

I use the banks as a broad indicator for investor sentiment so it's probably fair to say the sector is now priced for a prolonged period of low risk appetite, which is in my view the correct definition of a bear market. This also suggests further downside might be dependent on whether analysts forecasts can remain at present levels or whether they will be negatively impacted by future developments. There's a lot of chatter about ANZ Bank ((ANZ)) and National Australia Bank ((NAB)) potentially having to cut their dividends, so this remains very much an open question at this stage.

Needless to say, I don't think there's anything "wrong" or "right" about current market valuations for bank shares in Australia. It's simply a reflection of the risk aversion that has come to dominate general market dynamics.

How long is this period of subdued enthusiasm for all things risky going to last? Credit Suisse strategist Damien Boey has made the effort to construct a proprietary econometric model of risk appetite based on bond and commodity market pricing, which supposedly correlates reasonably well with risk appetite six months ahead. The model continues to point to negative risk appetite over the next six months, albeit at less negative levels than in the opening weeks of 2016.

We all know this model is probably not going to be 100% accurate, but it provides us with some sense of direction, far better than simply sticking one's finger in the wind and plucking an opinion out of thin air.

Whatever your own views, goals and horizon, hope is seldom the best strategy, and neither is plain ignorance. Expecting the next sustainable uptrend to commence imminently simply does not seem like the smartest option available.

Notes:

(1) I published a book in December last year, Change. Investing in a low growth world. It is available in eBook formats through Amazon and all major online distribution networks. FNArena subscribers receive their copy for free. Feedback and reviews to date have been extremely positive. The book covers pretty much all the issues that are impacting on global equities this year, plus it outlines the sectors, stocks and strategies I believe are most suited to the current macro environment.

(2) My research post-GFC has identified All-Weather Performers as the prime go to stocks for investors in the post-GFC era. Apart from a series of eBooklets, which are all freely available to paid FNArena subscribers (Make Risk Your Friend, parts 1 & 2), the research has led to the publication of an eBook (see above) and to the establishment of an All-Weather Model Portfolio in late 2014. The portfolio has significantly outperformed the broader market in its first year of existence, including the opening weeks of 2016.

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)  

P.S. I – All paying members at FNArena are being reminded they can set an email alert for my Rudi's View stories. Go to Portfolio and Alerts in the Cockpit and tick the box in front of 'Rudi's View'. You will receive an email alert every time a new Rudi's View story has been published on the website. 

P.S. II – If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.

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CHARTS

ANZ ARB BHP BKL CAR CSL DMP GMG HSN IPH IVC NAB OML ORG RHC RMD SGH STO SYD TCL TNE WPL

For more info SHARE ANALYSIS: ARB - ARB CORPORATION LIMITED

For more info SHARE ANALYSIS: BHP - BHP GROUP LIMITED

For more info SHARE ANALYSIS: BKL - BLACKMORES LIMITED

For more info SHARE ANALYSIS: CAR - CARSALES.COM LIMITED

For more info SHARE ANALYSIS: CSL - CSL LIMITED

For more info SHARE ANALYSIS: DMP - DOMINO'S PIZZA ENTERPRISES LIMITED

For more info SHARE ANALYSIS: GMG - GOODMAN GROUP

For more info SHARE ANALYSIS: HSN - HANSEN TECHNOLOGIES LIMITED

For more info SHARE ANALYSIS: IPH - IPH LIMITED

For more info SHARE ANALYSIS: IVC - INVOCARE LIMITED

For more info SHARE ANALYSIS: NAB - NATIONAL AUSTRALIA BANK LIMITED

For more info SHARE ANALYSIS: OML - OOH!MEDIA LIMITED

For more info SHARE ANALYSIS: ORG - ORIGIN ENERGY LIMITED

For more info SHARE ANALYSIS: RHC - RAMSAY HEALTH CARE LIMITED

For more info SHARE ANALYSIS: RMD - RESMED INC

For more info SHARE ANALYSIS: SGH - SLATER & GORDON LIMITED

For more info SHARE ANALYSIS: STO - SANTOS LIMITED

For more info SHARE ANALYSIS: SYD - SYDNEY AIRPORT

For more info SHARE ANALYSIS: TCL - TRANSURBAN GROUP LIMITED

For more info SHARE ANALYSIS: TNE - TECHNOLOGY ONE LIMITED

For more info SHARE ANALYSIS: WPL - WOODSIDE PETROLEUM LIMITED