After the strong performance of mid- and small-cap equities in March and April, May witnessed a rotation back into large-cap UK equities, according to research by Edison Investment Research. According to Edison, large caps benefited more than small caps both from the flows of institutional money back into equities and from their relatively greater exposure to year-on-year foreign currency translation gains.
Edison proposes that a major factor supporting further upside for equities is the high level of institutional cash. They quote research by investment bank Nomura, which shows that cash holdings are 50 per cent above their level at the bottom of the last bear market in 2002-03, even though shares are 25 per cent cheaper now than they were then. With many institutions having underperformed in the past three months from being underweight in equities, there will be growing pressure for them to return to their strategic equity weightings – which could provide further upward pressure for the markets.
Real or false dawn?
In the almost three months from 9 March to the end of May, the UK equity market rose by 27 per cent. Yet, despite this rally, investors are still down by one-third over the 19-month period since the end of October 2007.
What's more, while investors are hoping that 9 March marked the real market bottom, the recent upturn could still prove to be no more than another bear market rally. A sobering thought is that during the Wall Street Crash the US stock market experienced six bear market rallies, of which three exceeded 27 per cent.
The LBS researchers examined which industrial sectors performed best and worst during the 2007-09 bear market and compared these with the worst ever bear market in the UK, that of 1973-74, after the first oil shock and world recession. They then examined which sectors did best and worst when equities began their recovery in 1975, to see what this could tell us about which sectors were likely to do best when the market recovers from the 2007-09 bear market. Additionally, if March did mark the start of the recovery, have these predictions proved accurate in the period since then?
Chart 1 compares the progress of the 2007-09 bear market (red line) with that of the 1973-74 bear market (blue line), showing the cumulative real total returns to investors based on a starting value of £100 (after reinvesting dividends and adjusting for inflation). Reading dates along the bottom axis, the blue line shows that by the bottom of the 1970s bear market (6 January 1975), the initial £100 had shrunk to just £27.40 in terms of purchasing power – ie, investors had lost 73 per cent of their real wealth.
Despite the sharp recovery in 1975, which saw the market double in real terms, the index value at the end of 1975 was still only £57.80, which means that even after this strong recovery investors had lost 42 per cent of their real wealth since the end of 1972. Reading dates along the top axis, the red line shows the corresponding progress of the 2007-09 bear market. The market low point (thus far) was 9 March 2009, by which time £100 invested at the end of October 2007 had fallen in value to £52.7, meaning investors had lost nearly half of their real wealth.
Chart 1: Two bear markets compared
Sector returns in 2007-09
Researchers found that during the 2007-09 bear market, none of the 40 sectors that comprise the FTSE All-Share index generated a positive return. Chart 2 shows the 10 best-performing sectors as blue bars at the top (non-life insurance was the best performer, returning -10 per cent). The 10 worst-performing sectors are shown in red at the bottom (automobiles & parts was the worst performer, returning -83 per cent).
The findings show that the best performers over this period were the traditional defensive sectors, and all have a beta of below 1 in London Business School's Risk Measurement Service. Beta is a measure of the sensitivity to market moves of a share or sector. A share with a beta of 1 tends to move in line with market moves; one with a beta of 1.2 tends to move by 1.2 per cent for every 1 per cent move of the market index.
It's not difficult to appreciate the defensive nature of the best-performing sectors. Recession or not, people still need to buy food, drink and medicine, and pay for insurance policies. Smokers will continue to smoke. With the benefit of hindsight and knowing that a savage bear market was approaching, investors would get out of equities. However, for those remaining invested, it would have been a good bet to get into these sectors.
Neither do the worst performers come as much of a surprise. On average, these had a beta of 1.2, meaning that for every 1 per cent fall in the market index, these shares fell 1.2 per cent. As the epicentre of the current recession, real estate and banks duly returned two of the worst performances, of -71 per cent and -78 per cent respectively. Consumers have cut back spending on leisure and big-ticket durables – for example, by deferring the purchase of new cars. The slump in the global economy has reduced demand for industrial metals and, therefore, mining. Turbulence in financial markets has deterred investment in life assurance and other financial services products.
Chart 2: UK downturn 2007-09
Sector returns in 1973-74
Chart 3 shows the relative performance of sectors during the 1973-74 bear market, the worst ever to hit the UK. It is important to note that sector definitions and compositions were different in the 1970s: manufacturing was much more prominent, while services, banks, mining and pharmaceuticals were all much less so. Some sectors such as telecoms, utilities, airlines and steel hadn't yet been privatised and remained in public ownership.
Despite the differences in composition, Chart 3 still clearly shows that traditional defensives were among the best performers in 1973-74, and that there are many similarities to the best-performing sectors in 2007-09, most notably food manufacturing, wines and spirits, tobacco and pharmaceuticals.
The worst performers in 1973-74 also have much in common with the recent bear market. Hire purchase (consumer finance) was particularly badly hit and returned -88 per cent. Consumers again cut back spending on leisure and durables, postponing purchases of new cars, electronic goods and televisions. While mortgage market difficulties didn't ignite the 1970s recession, property-related sectors such as contracting, construction and building materials all ranked among the worst performers.
Chart 3: UK downturn 1973-74
Sector returns in the 1975 recovery
Chart 4 shows how sectors performed in the sharp, post-bear market upturn of 1975. In general, defensive sectors such as tobacco, wines and spirits and brewers and distillers – which had performed least badly during the bear market – were left behind in the recovery. In contrast, more cyclical, high beta sectors such as motors, leisure, contracting and construction raced ahead. In fact, there was a very strong negative correlation of -0.75 between sector returns over 1973-74 and subsequently in 1975.
The LBS researchers would expect to see the same tendency repeat itself in any bear market recovery, including the most recent downturn. The more difficult task, they emphasise, is to predict the turning point.
The researchers admit that their analysis of the 1973-74 bear market benefits from perfect hindsight of the market bottom, armed with which investors could profit from positioning themselves in high beta sectors and shares. However, if investors believe the market has bottomed and adopt this positioning, they risk heavy losses if their judgement subsequently proves inaccurate, as they will have moved into precisely the wrong sectors and shares. The researchers caution that during the 2007-09 bear market, many of the world's most respected and celebrated investors mistakenly called the bottom far too early.
Chart 4: Upturn 1975
Sector returns since 9 March 'bottom'
While investors hope that 9 March did mark the bottom of the 2007-09 bear market, the rally in UK equities since that date might still turn out to be just a bear market rally, and markets could head south again with a vengeance. In fact, a recent survey by Barclays Capital revealed that six out of 10 respondents believed that the rise in equities since 9 March was a bear market rally.
Despite these doubts over the authenticity and sustainability of the current rally, Chart 5 shows that the performance of sectors during the upturn has been exactly as the researchers would have expected in a recovery.
Chart 5 shows that not one of the 40 sectors has recorded a negative return over the period from 9 March to 31 May. High beta sectors have tended to perform best, with especially strong returns from automobiles & parts, banks, industrial metals, mining, life insurance, real estate and financial services – precisely those sectors that were hardest hit on the way down. In contrast, the market laggards over this period have been the defensive, low beta sectors such as tobacco, utilities, pharmaceuticals, healthcare and household goods.
Chart 5: Upturn 2009
Yearbook findings
The Credit Suisse Global Investment Returns Yearbook 2009 (Dimson, Marsh and Staunton) documents the six worst episodes for equity investors since 1900. These were the two world wars and the four great peacetime bear markets: the Wall Street Crash and Great Depression of 1929, the oil shock and global recession of 1973-74, the bursting of the internet bubble in 2000-02 and the credit and banking crisis that began in late 2007.
A key finding of the Yearbook is that the peacetime bear markets were more severe than the two world wars. The worst global bear market was the Wall Street Crash from 1929 to 1931, when the market in US equities fell by 79 per cent in real terms from a peak in September 1929 to its trough in June 1932. In contrast, during the Wall Street Crash, UK equities fell by just 38 per cent in real total return terms.
