The FTSE 100 index officially entered bear market territory last week, having recorded a fall of more than 20 per cent since hitting its bull market highs, joining both the export and manufacturing-heavy Japanese Nikkei 225 and German Dax indices in the bear camp. My own hunting ground, UK small-caps, have fared far better by comparison: the FTSE Small Cap index is currently 11 per cent off from last summer’s all-time high, albeit the majority of the decline has come this year. That’s far better than small-cap investors in the US have fared: the Russell 2000 index of small-cap companies is now down 23 per cent from last summer’s highs, so is now officially in a bear market.
That’s not to say we can’t make money during this grizzly phase. A large number of the small-caps I have recommended buying into since the market peaked have subsequently generated bumper returns. This highlights the important point that there is money to be made by buying selectively undervalued situations even when risk aversion is running high. Indeed, I am in the process of compiling my 2016 Bargain shares portfolio and have uncovered a number of cash-rich companies trading on unwarranted discounts to net asset value (NAV), even though the boards of those firms plan to turn those assets into cash for the benefit of shareholders.
No room for complacency
However, I am far from complacent as there is a risk of further lows being hit before the bears can be put back into their cage. True, stock market investors reacted positively to the news last Thursday that the European Central Bank could ramp up its money-printing programmes as early as March. Risk assets, including oil, rallied significantly, too. It’s also fair to point out that even if the 2009-15 bull market is well and truly over – the FTSE Small Caps and FTSE 250 mid-caps are still in correction mode – I would point out then that there are ample opportunities to exploit tradeable rallies even in a down market. The important point being that ‘buy-and-hold’ investment strategies work less well in this environment and the emphasis is now on ‘buy-to-trade’ with a view to crystallising the gains.
For instance, 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. More recently, during the last bear market in 2008, the FTSE 100 had four rallies of at least 19 per cent. Bearing this in mind, I would be surprised if the bounce-back rally we saw last week proves only to be a two-day wonder. History is on my side, too, as research from my colleagues at the Financial Times indicates that in the past three decades the FTSE 100 has posted a modest positive return over the next quarter after first entering bear territory.
This is more than a mere statistic as the steep falls in large-caps reflect the fact that investors can take their money off the table, and put it back on, more easily than in smaller companies. Hedge funds that have been shorting the market will place their bets on larger companies, which in turn exacerbates market volatility. Admittedly, this is of less interest to me as I am focused almost entirely on small-caps, but it’s worth flagging up because one consequence of a rise in market volatility will be sharp rallies, as we witnessed at the end of last week.
Risks to equities
The fact that I feel we could be in for a tradeable bounce-back rally should not mask my unease, as I believe that the confluence of negative factors currently undermining investor confidence have yet to run their course. These are well documented, with a real risk of a hard landing in China’s economy, as investment guru George Soros highlighted at the World Economic Forum in Davos last week, and the ongoing fallout from the plunging oil price undermining economic growth prospects in parts of the world. This comes at a time when the US central bank has embarked on a monetary tightening programme which has not only led to a strengthening in the greenback, but accelerated currency flows from emerging markets, too.
It’s also worth considering the actions of the world’s largest swing oil producer, Saudi Arabia, as it attempts to bankrupt the US shale industry by refusing to reduce supply, with the net effect of driving down prices. It’s succeeding as there is now a ticking $200bn (£141bn) debt bomb of loans outstanding to US shale producers who funded their businesses based on an oil price of $100-plus a barrel. As shale producers fold, those loans are looking far less slick on the balance sheets of the US banks that issued them.
UK companies are not immune to the fallout either, even if the country has returned to trend growth. Indeed, in its quarterly profit warnings survey, accountancy firm EY notes that there were 100 profit warnings from listed companies in the final quarter last year, the highest since the first quarter of 2009. Investors have to be vigilant as the market is unforgiving of companies that miss guidance, especially those still trading on bull market ratings. It also goes without saying that it’s more difficult for a market to make progress when an earnings cycle has turned and risks to economic growth are mounting, which has the knock-on effect of making businesses more cautious.
The flip side is that the dramatic fall in the oil price is tantamount to a substantial tax cut for consumers in western economies at the expense of oil-producing nations such as Saudi Arabia. This is actually supportive of consumer spending and growth prospects in the US, Europe and the UK.
In fact, around 70 per cent of GDP in both the UK and US is derived from consumer spending. However, the focus of investors has not been on the positive growth impact of cheap energy, but on the immediate fallout from the collapse in commodity prices and ongoing economic slowdown in China, as the country tries to rebalance its economy from an export focus towards more domestic-led consumption and investment.
In the circumstances, I would expect the downturn in global equity markets to reach a final conclusion only once the oil and copper prices stabilise. That’s logical as the copper price has proved an accurate indicator of previous equity market bottoms. Bearing this in mind, the copper price has fallen by 58 per cent from its all-time high five years ago, but is still more than 50 per cent above its 2009 bear market low. The oil price is down almost 80 per cent in the past 18 months and is well below its 2009 bear market low, but still above the mid-teens price levels in the early 1990s. Expect daily movements in equity markets to be highly correlated with the commodity complex for some time.
Learn from history
I am also paying close attention to my history books. They have served me well over the years. Even if you believe the bear phase we have witnessed is finally over, and I have my reservations, there is one important statistic worth considering: in the past 108 years there have been 10 occasions when the UK market has fallen by more than 7.5 per cent in the first three months of the year. The FTSE All-Share index is currently down 5.9 per cent. Not only was a bear market running in every one of those 10 instances, but nine of those 10 bear markets did not bottom out for at least another three months after the end of March. So, if the FTSE All-Share index closes at the end of March at 3186 points or less, representing a fall of only 1.7 per cent from its current level, then ignore history at your own peril.
There is another important trend worth considering. Since the 1930s, there have been 10 bull markets in the UK when the stock market doubled or more, including the last 75-month bull run ending in May 2015, during which the FTSE All-Share index rose by 118 per cent from its prior bear market low. It may not be a well-known fact, but in every one of the bear markets that followed these nine previous bull markets the UK stock market fell by at least 25 per cent. Of course, the FTSE All-Share index missed entering a bear market by a whisker last week, but the clear implication is that if we see another sell-off that takes it into bear market territory then it’s highly unlikely to stop there.
Also, there is a relationship between the length and depth of a bear market and the preceding bull market. Namely, the longer the bull market, the deeper the subsequent retracement in share prices. Indeed, since The Great Depression, two-thirds of the bull markets in the UK have lasted less than 30 months. In nearly all the subsequent bear markets following these short bull markets, the UK stock market fell less than 25 per cent from its peak to the bear market bottom. However, the seven bear markets that followed the seven longer bull markets have been far more savage. Each of these bear markets recorded falls of at least 25 to 30 per cent, with most posting even bigger declines, including 50 per cent losses in the past two bear markets.
In other words, the fact that the 2009 to 2015 bull market was one of the longest on record and posted a gain above 100 per cent, could easily register a bear market decline (more than 7.5 per cent) in the first quarter this year, heightens the risk that last week’s lows didn’t signal the final trough. For the record, the average bear market in the UK in the past 190 years has recorded a decline of 35 per cent and has lasted almost three years, albeit there has been a tendency since the 1950s for UK bear markets to be shorter in length. However, the last 12 bear markets since 1957 have been no less severe, recording an average peak-to-trough fall of 33 per cent and lasting on average 13 months.
The conclusion being that the sell-off we have witnessed since last May’s highs would appear neither deep enough nor long enough in duration, given the length and strength of the previous bull market. That gives reasons for caution.
Strategy
Having made hay for the past six years, and also in the eight months since my favoured small-cap sector peaked out, I still feel that selective buying of special situations can generate a positive outcome assuming a ‘margin of safety’ is built in to the valuation to start with. I will endeavour to continue to pick stocks on this basis, and also exploit trading buy plays to take advantage of the spike in market volatility.
I also feel that a sensible course of action at this stage is to consider closely your own investment exposure and whether or not you are overly exposed to another down leg in the market, bearing in mind the relative performance of your individual shares in the sell-off we have witnessed this year.
Finally, I have published articles on 33 small-cap companies from my watchlist so far this year, all of which are available on my IC home page. I plan further updates on a number of companies that have released trading updates recently when I have completed work on my 2016 Bargain Shares portfolio.
MORE FROM SIMON THOMPSON...
I have written articles on the following companies since the start of last week:
■ Grainger: Buy at 243.5p, target 280p; Dart: Take profits at 580p; Crystal Amber: Hold at 159p; Redde: Take profits at 203p; Burford Capital: Run profits at 196.5p; Renew: Run profits at 404p; Plethora Solutions: Speculative buy at 4.5p ('Stock check', 5 Jan 2016)
■ Elegant Hotels: Buy at 118p, target price 130p to 135p ('Check in for a profitable stay', 6 Jan 2016)
■ Safestyle: Run profits at 272p ahead of pre-close statement on 25 Jan 2016 ('Clear cut gains', 6 Jan 2016)
■ Epwin: Run profits at 143p, new target 170p ('Epwin on the acquisition trail', 6 Jan 2016)
■ GLI Finance: Recovery buy at 37.5p ('GLI shelves fundraise and its chief executive', 6 Jan 2016)
■ LXB Retail Properties: Buy at 97.5p, new six-month target 120p; Urban&Civic: Buy at 286.5p, target 325p; Conygar: Buy at 172p, target 200p ('Hot property, 7 Jan 2015)
■ Somero Enterprises: Buy at 139p, target 185p; 1pm: Buy at 70p, target 82p; First Property: Run profits at 53p; Avation: Buy at 145p, target 200p ('Small-cap value plays', 11 Jan 2016)
■ 32Red: Run profits at 147p; Netplay TV: Buy at 7p ('Chipping in', 12 Jan 2016)
■ Cambria Automobiles: Buy at 87p, new target 95p; Vertu Motors: Buy at 76p, target range 85p to 90p ('Motoring ahead', 12 Jan 2016)
■ Global Energy Development: Hold at 24p ('Cash rich, but unloved', 12 Jan 2016)
■ KBC Advanced Technologies: Bank profits and sell in the market at 183p ('Tech watch, 13 January 2015)
■ Sanderson: Buy at 75p, target range 85p to 90p ('Tech watch, 13 January 2015)
■ Trakm8: Buy at 300p, new target 400p ('Tech watch, 13 January 2015)
■ Amino Technologies: Buy at 120p, new target range 155p to 160p ('Amino has the ammunition', 14 January 2015)
■ easyHotels: Buy at 89p, initial target 100p ('easyHotels ramps up expansion', 14 January 2015)
■ Stanley Gibbons: Hold at 58p ('Stanley Gibbons fundraise', 14 January 2015)
■ Miton Group: Buy at 28p, target 35p; Moss Bros: Buy at 97p, target 120p to 130p; Bioquell: Buy at 140p, minimum target 170p; UTV Media: Trading buy at 184p ('An awesome foursome', 18 January 2015)
■ Simon Thompson's book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.95 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stockpicking
