Last year saw global equities fall by a shocking 42 per cent. Many commentators are asking whether, after this turmoil, now is the time to buy back into equities. By comparing the current bear market with others since 1929 and by looking at historical valuations, a picture falls into place of when equities may start to see a sustained rally.
After a terrible period of performance, equities ended the year on a marginally positive note in December. By mid-January, these gains had again been wiped out. The main equity markets were down in November, and October's declines of more than 20 per cent produced the worst monthly performance since the stock market crash of October 1987. Further to the 42 per cent decline in global equity indices last year, the emerging markets were even harder hit as investors - particularly leveraged hedge funds - withdrew from risk across the world.
Comparisons with bear markets of the past
The recent turmoil has boosted volatility. By the end of 2008, the volatility of the S&P 500 reached the highest it has experienced since the stock market crashes of 1987 and 1929 (which preceded the 1930s Great Depression). When volatility shoots up in this way, it tends to cluster or persist as the shock to the system wreaks havoc on the real economy, so high volatility is expected for a while longer.
This is worse than the bear markets of 1987, 1990 and 1999, and arguably on a par with 1972. However, it is not as bad as the horrendous bear market of 1929 and the early 1930s when the Down Jones Industrial Average lost nearly 90 per cent of its value.
The difference this time is that authorities have intervened to prevent a deep depression from happening again by introducing massive liquidity injections, capital injections into banks, deposit and interbank loan guarantees, and interest rate cuts.
In the 1930s, governments did the opposite: they believed in the self-correcting mechanisms of classical economics and allowed monetary and fiscal policy to tighten; they allowed approximately 8,000 banks to fail; and they increased tariffs on imports, which prompted increased protectionism across the world. Consequently, this pushed the global economy into a downward spiral of economic contraction. The US economy shrank by 30 per cent, unemployment rose to a quarter and international trade fell by 30 per cent. Authorities were so scarred by the Great Depression that this time they have done everything in their power to prevent the past from repeating.
At the heart of the problem is counterparty trust, particularly after the Lehman Brothers bankruptcy. Banks have stopped lending to each other, which in turn has choked off credit to the real economy and threatened a prolonged downturn. These strains have manifested themselves in the Libor rate - the rate at which banks lend to each other.
Under normal circumstances, the Libor rate trades close to the three-month Treasury bill rate. However, after the failure of Lehman Brothers and the initial rejection of the US Targeted Asset Relief Programme, the spread blew out massively to more than 4.5 per cent. Since the start of government interventions, the spread has narrowed but still remains above normal, suggesting risks remain in the system.
While the risk of complete financial failure has abated, corporate failure risk has escalated as the shockwaves of the credit crisis spread to the real economy. As the probability of global recession has increased, the likeliness of default has also grown, causing credit spreads on high and low-grade bonds to blow out to unprecedented levels, thereby increasing the cost of longer-term credit despite cuts in short-term interest rates.
What about company valuations? After the massive sell-off we have seen recently, equities are starting to look cheaper relative to the last 20-year historic average and appear to be valued fairly, even over a much longer period of time. Similarly, on a price-to-book basis, equities are beginning to look relatively cheap on a 20-year view, although they were cheaper in the early 1980s.
When can we expect a sustained rally? The good news is equity markets are generally forward looking and tend to anticipate economic recoveries approximately three months before turning points in GDP growth and seven months before turning points in unemployment data.
According to research conducted by Goldman Sachs, the US economy is expected to move into a severe recession by the fourth quarter of 2009 and not to start recovering until the third quarter of 2009. Likewise, unemployment is forecast to continue rising until the end of 2009, moving to a level higher than in the previous two recessions. Both of these points suggest that equities should rally by mid-2009.
The Federal Reserve has been proactive in cutting interest rates early. In the UK and eurozone, however, intervention has been slower, which means the economic problems in these regions may be worse and last longer than in the US. Therefore, from a relative point of view, it makes sense to position portfolios overweight the US.
In the short term, uncertainties created by the credit crisis and the ensuing negative economic newsflow will continue to put pressure on equities and cause volatility to remain at elevated levels. However, we are in the midst of a massive policy response: huge cuts in interest rates, massive liquidity injections into the money markets, capital injections into banks to repair their balance sheets, and the recent Term Asset-backed Securities Loan Facility initiative in the US to bypass the banking system and target longer-term credit and mortgage rates directly.
This - combined with the collapse in commodity prices, which will reduce the cost of raw materials and energy prices, plus huge government infrastructure projects and tax cuts - will ensure that economic activity stabilises and equity markets recover in advance of the real economy, in anticipation of better earnings ahead.
If forecasts predicting the massive monetary, fiscal and commodity stimulus will stabilise economic activity in the latter part of 2009 are accurate, we should expect a sustained rally in the equity markets around the middle of this year.
Neil Michael is head of quantitative strategies at Spa ETF
