April 16, 2012
History is as good a guide as any to predict where the next trend in global markets lies, writes Matthew Kidman.
An orderly correction never happens in a sharemarket. It just sneaks up and goes whack.
It happened in the US sharemarket again last week, with the benchmark S&P 500 index falling just shy of 5 per cent in five days. The trigger for the reversal was the sickly US March jobs figure that blindsided the average investor who was cruising into the Easter long weekend.
There was no time to prepare and most of us had to simply wear the consequences. The Australian market, like a good servant, followed the trend but only gave up 3 per cent as the Australian dollar softened.
Now the US and, to a lesser extent, the Australian markets have had the correction they had to have, the question becomes what unfolds from here? Does the liquidity fuelled rally in the US simply resume, dragging the local bourse higher, or has the trend changed for good?
There was only the slightest chance the US market could keep rallying at the pace it set from October last year through to the end of March this year, when it gained some 33 per cent. These types of gains happened in 2003 and 2009 but have been on the back of major bear markets when valuations were at multi-year lows. The US and Australian markets were well off their lows when the rally fired up last year.
History tells us the US market should be nearing the end of its current surge. If this, as most market watchers believe, is the third secular bear market in the last 80 years the pain is not over. A secular bear market is an extended period of negative returns for investors. It must be distinguished from a cyclical bear market that is measured by a straightforward 20 per cent fall.
A cyclical bear market can be over in weeks, while a secular bear market lasts for many years and can contain many rallies and many declines.
In the horror period following the 1929 sharemarket crash the Dow Jones Industrial Index fell, once inflation is taken into account, by 67 per cent over 19 years. During this period the US economy experienced four official recessions (a period of two consecutive quarters of contracting gross domestic product).
From 1966 the US sharemarket fell an inflation-adjusted 62 per cent over 16 years. Again the economy had to endure four recessions in this period. This horror stretch for equities was also characterised by historically low stock valuations and monster rallies that all petered out. In all, the market attempted to break out of its downward trend some five times in 16 years, coming up short each time.
In comparison the current secular bear market in the US has been mild. The official starting point was in March 2000 when the Dow Jones Industrial index and the broader S&P 500 index peaked following a technology turbo-charged 18-year rampaging bull market. We have just celebrated the 12th birthday of this secular bear market. So far the market has fallen, inflation adjusted, by 30 per cent and the economy has encountered just two recessions. Given that stock valuations in the US are sitting at about long-term averages and company profit margins are at a record level, it may be difficult for the bear to leave the table just yet. Therefore, history tells us that more time and, unfortunately, more financial pain must take place for this secular bear market to replicate the past.
This does not mean the US can't power higher and put to bed the current secular bear market by year's end. With the Federal Reserve's chairman, Ben Bernanke, prepared to stand like Atlas and hold up the heavens you cannot discount a positive outcome. This though would defy historical trends. The sharp decline experienced last week may not necessarily be the beginning of such a pullback. It could, however, be the start of a more volatile market that is invariably a precursor to a directional change.
If history is an accurate guide the US market will again experience a northern summer of pain and a retracement of something like 20 per cent is a distinct possibility. This would in turn set up a fabulous buying opportunity that many would ignore because of the treachery of the past 12 or so years.
What then of the Australian market? The colossal bounce in share prices in the US since October has been followed only meekly here. Our index only managed a 13 per cent bounce from October to March, weighed down by relatively high official interest rates and a soaring Australian dollar. It would be justified for investors to believe the local market would not fall as much as the US market, given the rise has been more sedate. This though cannot be guaranteed and a lower dollar and a series of interest rate cuts would be needed as an insurance policy.
Critically, history also tells us that if the Australian market does flounder for the remainder of this year, it will be the perfect set-up for a major rally. In Australia's previous secular bear markets of the 1970s and after the 1987 crash, five years elapsed before the pain was over, followed by inspiring rallies. This November is the five-year anniversary of our bear market.