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Histrionics

Created:

7 April 2008

Written by:

Simon Thompson

The Met Office warning last week not to expect a long hot tropical summer may have dampened spirits, but the sun has been shining brightly on equity investors in the past fortnight. In fact, global indices have posted double-digit gains since bottoming out in mid-March in the wake of the collapse of US investment bank Bear Sterns and news of a massive rights issue at Swiss investment bank UBS to cover sub-prime mortgage losses. However, storm clouds look to be heading our way, too, if our history books are any guide, with mounting evidence to suggest that the current rally is no more than a 'get out of jail card' rather than the start a new bull market.

Bear market rallies and seasonal investing

The fact that equity markets are rallying is not unusual. For instance, in the three years from October 1929, the Dow Jones Industrial Average fell about 90 per cent in total, but it enjoyed five rallies of between 16 and 48 per cent. More recently, in the three years after the dot-com bubble burst in March 2000, the technology-laden Nasdaq fell almost 80 per cent, but still had four rallies of at least 22 per cent.

It's worth noting that seasonal investing plays a part in the timing of rallies, too, with April a very good month for equity investing. The FTSE All-Share index has posted a positive gain during the month in no fewer than 31 of the past 37 years since 1970. So far, it has risen by 12 per cent since hitting its low of 2728 in January and further upside seems likely given this up move from a base formation came off very oversold conditions. In fact, FTSE All-Share point-and-figure breadth indicators from Investors Intelligence (and available on the IC website) are still some way short of the 70 per cent level seen in the rallies during the 2000-2003 bear market.

Moreover, given the strength and momentum behind the all important mining sector, it is highly plausible that a rally to 3150-3200 on the FTSE All-Share and 6100-6250 on the FTSE 100 could be hit during April which would satisfy the percentage upmoves of previous bear market rallies and take the breadth indicators to levels marking previous peaks, too.

But if you are playing the upside, don't get too carried away because we also know that the six-month period from the start of May to the end of October is the worst time of the year to be invested in the market with the FTSE All-Share index rising by a pitiful 0.25 per cent on average in this six month period since 1990. By contrast the period from the start of November to the end of April has recorded an average gain of 7.1 per cent in the past 17 years. That's one very good reason to be cautious once the current rally peters out.

Bear markets retracements

In the circumstances, to be invested in equities beyond the end of April takes a huge leap of faith that the market lows hit on 22 January actually marked the end of the bear market. Unfortunately, that faith would be misplaced if our history books are any guide because there is a direct correlation between the length and depth of a bear market in relation to the preceding bull market. In effect, the longer the bull market, the deeper the subsequent retracement.

Since The Great Depression there have been no fewer than 21 bull markets in the UK, of which two thirds ended within two and a half years. In virtually all the subsequent bear markets which followed these 14 short bull markets, the declines were less than 25 per cent from the peak of the previous market top to the trough of the bear market.

However, the bear markets that followed the seven longer bull markets were a different breed entirely. Research from stock market historian David Schwartz shows that in three of these seven bear markets, the UK stock market recorded falls of between 25-30 per cent, in two the market fell by 31-40 per cent with the other two bear markets posting declines of over 40 per cent before bottoming out (including the 51 per cent fall in 2000-2003).

It's therefore worth remembering that the last bull market - which posted a 119 per cent rise from trough-to-peak - started on 12 March 2003 and had run for a lengthy 51 months when the FTSE All-Share index peaked out at 3490 on 18 June 2007. Since then the index has subsequently slumped to 2728 on 22 January - a fall of 21 per cent. This decline clearly falls short of the minimum peak-to-trough falls seen in any of the other seven bear markets that followed long-running bull markets, suggesting that we have not yet seen the bottom of the current bear market.

To add further weight to the case that the January lows did not mark the end of the bear market, our history books reveal that since The Great Depression there have only been eight bull markets in the UK when shares rose by over 100 per cent. The 2003-2007 bull market was the ninth occasion this has happened. However, it is a little known fact, but in every one of the subsequent eight bear markets, prices fell by at least 25 per cent. Therefore, the 21 per cent declines in both the FTSE 100 and FTSE All-Share indices from their 2007 peaks to those January troughs again fails to meet the 25 per cent plus retrenchment levels that have marked market bottoms in every single one of these eight previous bear markets.

In addition, Mr Schwartz notes that in the past 100 years there have only been 10 occasions when the UK market has fallen by over 7.5 per cent in the first quarter of the year. Not only was a bear market running in every one of those cases, but nine of those 10 bear markets did not bottom out for at least another three months after the end of March. Worryingly, in the first quarter this year, both the FTSE All-Share and FTSE 100 indices fell by 11 per cent. So if 100 years of history are any guide, the odds look heavily stacked against the January lows marking the nadir of the current bear market.

Mid-cap conundrum

On the face of it, the FTSE 250 has already met the 25 per cent minimum peak-to-trough criteria needed to signal a bear market bottom. However, the major problem with making this assumption for the entire UK market is that the mid caps only account for a 13 per cent weighting in the FTSE All-Share index, whereas the FTSE 100 index has a hefty 84 per cent weighting. And the FTSE 100 index has certainly not fulfilled the criteria to mark the end of the bear market.

Indeed, the blue-chip index only peaked out at 6751 on 12 October - a 105 per cent rise since bottoming out at 3287 on 12 March 2003. Therefore, when the FTSE 100 fell 21 per cent to its low of 5338 in January, the bear market in the blue chips had only been running for 89 trading days - or just over three months - and had retraced 40.8 per cent of the gains made in the previous bull market. That's a worry if you believe that the January sell-off marked the low point of this bear market, because an 89 trading-day bear market is simply not long enough considering the previous bull market had been running for 1,158 trading days. Moreover, the 21 per cent decline in the FTSE 100 is not deep enough either.

So if the FTSE 100 has yet to make its bottom, then neither has the FTSE All-Share index given the blue chips' heavy weighting. And if that is the case, then it seems unavoidable - given the high correlation between market indices during bear markets - that the mid-caps will not test those January lows of 8900 once again.

Bull market signals

Mr Schwartz also notes a statistic that has proved to be a major buy signal to mark the start of a new bull market. Namely, the UK stock market has risen by at least 8 per cent in the first two months of a new bull market on every occasion in the last 14 bull runs.

With this in mind, it's worth pointing out that the FTSE 100 hit a low of 5338 on 22 January this year and had risen by less than 3 per cent to 5495 by Easter. The FTSE All-Share followed a similar pattern, rising by only 3.1 per cent in this two month period. In other words, unless the UK market is going to break a trend that has stood the test of time - with 100 per cent accuracy over the past 14 bull markets - then the lows for the current bear market have yet to be reached.

Catalyst for another down leg

As mortgage borrowers in the UK are finding to their cost, credit bubbles take time to unwind as the process of de-leveraging and repricing risk feeds through the financial system. And a credit bubble that has been inflated over the past decade is going to take far longer than just seven months to deflate.

That creates a problem with the current market rebound as forward looking investors are buying equities - industrials, financials and miners, in particular - on the basis that the worst is now over and a second half economic recovery is imminent. In other words, current market pricing assumes a V-shaped recovery that is completely at odds with the fact that the effects of the credit crunch are only just being felt on the real economy. In fact, conditions are likely to get worse before they get better as lenders continue to withdraw or tighten credit lines in both corporate and personal lending, increasing bankruptcies, liquidations and defaults, and in turn acting as a dampener on growth.

So with sales and margins set to come under pressure, the consensus for 5 per cent UK earnings growth in 2008, rising to 9 per cent in 2009, simply doesn't add up. Let's not forget that profits are earned from the real economy and if that economy is slowing rapidly then it is irrational to assume unrealistic growth expectations that underpin current valuations. Needless to say, I believe a rude awakening is on the cards for investors buying into this rally once the reality of the economic slowdown hits home in the second and third quarters.

Trading Strategies

It's no secret that I have been pretty bearish since the start of the year. Indeed, given my negative outlook for equity markets, I advised taking out portfolio insurance through a short listed contract for difference (CFD) on the FTSE 250 index to protect the value of our investments (Bad Tidings, 7 January 2008). I also suggested how a short-long trading strategy using a SG Securities Global Bear Market Accelerator Note, SN01, had potential to generate bumper gains with minimal downside risk (The Bear Necessities, 14 January 2008). So given my belief that the current market rally will peak in the next month before the next leg of the bear market unfolds, I would suggest keeping both hedging positions open.

In fact, I am now salivating at the prospect of being able to short the FTSE 100 again at around 6100-6250. My advice would be to average into an aggressive unhedged short trade around this level using a Societe Generale covered put warrant, SM29, (http://uk.warrants.com) which has a strike price of 6600, expires on 19 December 2008, parity of 1000:1 and gearing of 4.1 times to the underlying index. If the index trades at 6200, the warrants would be priced around 75p, or 750 points per contract, so we would need the index to expire at 5850 in December to recoup our warrant premium. However, if my interpretation of the evidence is correct, and the blue chips fall a minimum 25 per cent peak-to-trough to 5000 before this bear market ends, the warrants will more than double in price.

Further Reading

To see how Simon Thompson uses leveraged products, such as covered put warrants and CFDs, in practice (Trading Techniques For A Bear Market, 7 March 2008).

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