Six steps back into the water

Longer and deeper already this time

Prior to the current episode, UK investors had suffered nine bear attacks since 1965. The median mauling lasted 192 trading days and took the Datastream Total Market index – which is similar to the FTSE All-Share index – down by 29 per cent. At its recent lows in November, the UK market had fallen 46 per cent from its peak over 376 trading days.

That already makes this bear market longer and deeper than the average. This fact might be a clue that we are closer to the end of the sell-off than to the beginning. However, it's worth pointing out that equities can plunge much more in times of crisis, such as we are currently experiencing. In the early to mid 1970s, the UK stock market plunged by more than two-thirds – its worst showing in the post-war era.

Cheap but not extremely cheap

Cheapness is an obvious measure of when the stock market may be at or nearing a bottom. And the price-earnings (PE) ratio is probably the most widely followed measurement of valuation. Since 1965, the UK stock market has traded on an average PE of 13.7. At the end of the nine sell-offs over that period, the market's average multiple has been just 10.7. However, if we look only at the four bear markets that were associated with recessions, the average multiple at the bottom was just 6.8.

As of 2 December, the UK market was trading on a PE of 7 – its lowest for this bear market. While that's not far off the average ending level for a recessionary sell-off in equities, it's not yet at extreme levels. At the market's nadir in 1974, the ratio fell to just 2.8.

We get a similar story if we look at the market's dividend yield. The last nine major bottoms in British equities have been accompanied by an average yield of 6 per cent, and a yield of 7.7 per cent at the low points of recessionary bear markets. The 6.1 per cent yield recorded on 2 December is already in line with average bottoms, but not quite yet at panic extremes.

The recession could still be in full swing

Baron de Rothschild remarked that "the time to buy is when blood is running in the streets". That's because the stock market is forward-looking: what's happening today is much less relevant to share prices than what's likely to happen in the next six or 12 months. So you should ignore today's bad news and focus on a possible recovery a few months down the line.

Six of the seven recessions in the UK since 1956 have occurred around the same time as an equity bear market or a near-bear market. The last two recessions – in the early 1980s and early 1990s – ended more than one year after their associated bear markets. Prior to that, however, the recessions often came to an end before their associated bear markets.

A more detailed history is available for the United States. According to the National Bureau of Economic Research (NBER), there were 28 recessions in the US between 1871 and 2001. Eighteen of these recessions occurred around the time of bear markets. On 13 occasions, the bear market ended before the recession. The average time lag between the two was 4.7 months, but several times it has been more than a year.

The NBER recently announced that the latest US recession began as long ago as December 2007. Since the Second World War, US slumps have lasted an average of 10 months and 16 months at the most. While that tentatively suggests a possible trough for the economy in April of the coming year, there’s a strong chance that the duration of the current bear market will set a new post-war record. Nouriel Roubini – one of the few economists who correctly predicted the slump – has said it could last two years.

Assuming Professor Roubini's analysis is correct, we should probably wait a few more months to buy shares.

Momentum recovers ahead of the market

Technical analysis – or 'charting' – is probably the purest way of spotting turning points in financial markets. Chartists look not only at price, but also at price momentum, which measures the strength of market moves. Towards the end of bear markets, the speed of the price decline tends to slow down. So, even though the market may be at an all-time low, the momentum line will actually be on an improving trend.

There are lots of different ways to measure momentum. A simple approach is to calculate the gap between the market's price today and moving averages of its recent prices. A price well above its moving average indicates an overbought market, and a price well below indicates an oversold one.

Looking at the UK stock market's price in relation to its 21-week moving average, momentum has bottomed out before price in five of the last nine major sell-offs. On four of these occasions, it picked up more than 30 trading days ahead of the low in the actual market. During the 2000-03 equities meltdown, it picked up several months before – see chart, 'Momentum recovers ahead of price'.

Having plunged to an extreme low in October, momentum has improved of late. At its lowest ebb, the UK market was trading some 31 per cent below its 21-week moving average. That had improved to 21 per cent below on Friday 5 December. While this could presage a new bull market, it at least points to the likelihood of a further short-term upwards correction.

Where credit leads, shares follow

The credit crunch triggered the current bear market in equities and the economic downturn. It is very likely, then, that when the credit crunch comes to an end, the bear market will come to an end soon after.

The experience of past bear markets in the US supports this theory. The S&P 500 index has suffered eight major sell-offs since 1962. In every case, investment-grade corporate bonds have rallied – and yields have therefore fallen – in advance of the stock market reaching rock bottom. This bond rally typically began four months before the end of the bear market, with a minimum lead time of one month and a maximum of 10 months.

This time around, the credit crunch is particularly severe. While government interest rates have come down dramatically, the rates paid by banks, companies and consumers remain very high. As well as looking at top-rated corporate bond prices or yields here and in the US, we should also keep an eye on British mortgage lending, for signs of an upturn in lending.

The sectors to buy for a new bull market

On the last nine occasions that the UK stock market hit rock bottom after a major sell-off, it gained an average of 31.3 per cent in the following 12 months – even after adjusting for inflation. So, when you believe a bottom has been reached, you can simply buy into a FTSE All-Share tracker and sit back and enjoy the gains. But for really high-powered returns, you could consider buying into those areas of the market that are likely to do best.

Historically, the most consistent performer in the first year of a new bull market is the construction & building materials sector. It has beaten the wider UK index eight times during year one of the last nine bull markets. On average, it has outpaced the market by 13 per cent during these episodes. Travel & leisure, support services and aerospace & defence also have a solid record in the early stages of new bull markets – see table below.

Economic sensitivity could explain these industries' outperformance in a new bull market. As investors anticipate better times ahead for the economy, they may buy into sectors they expect to benefit most as things pick up. Interestingly, though, there are a number of other economically sensitive industries that don't do well early on in bull markets.

Table 1: Bear market days

Table 2: Early bull market winners

The sectors to avoid in a new bull market

Industries with less sensitivity to the economic cycle figure prominently in the list of early bull market losers. The tobacco sector is the worst performer of all, having failed to beat the market in the first 12 months in every one of the last nine bull markets. While they haven’t been listed on the stock market for nearly as long, the electricity and gas, water & multi-utility sectors are also ones to avoid when the bull charges once again.

By contrast, chemicals, oil equipment & services, general industrials, and industrial transport are all economically sensitive sectors, but all tend to lose out early on in bull markets. This could be because these industries do better in the later stages of the economic cycle and hence are more likely to outperform the market further into the bull market.

Table 3: Early bull market losers