We witnessed something of a mini-rally following a couple of marked sell-offs in the early part of 2016, but there's no room for complacency - the odds are that global equity markets will be subject to further correction throughout the remainder of this year. Over the following pages we're presenting a number of perspectives on whether we're really faced by the prospect of a prolonged bear market, together with ideas on how to preserve, manage, or perhaps even to build your investment capital through the down-cycle. We've looked over previous technical bear markets to try and establish if the entrenched views on the performance of counter-cyclical sectors hold any water.
Simon Thompson lends his views on where markets stand at the moment and where they're headed based on historical precedent. James Norrington has assessed how sectors have fared in previous down-cycles and whether patterns have been established which investors can utilise to de-risk their portfolios. James's comments neatly dove-tail with a run-down of managed money options from Kate Beioley of the IC's Personal Finance team. In addition, the IC's trader Nicole Elliott - certainly no advocate of the standard bear market definition - has plotted three key technical support levels for the UK benchmark. And the IC's Companies Editor Ian Smith provides a sobering warning on the subject of negative interest rates - the one issue that differentiates the threat posed by the current incipient bear market (assuming that's what we're seeing) to those that have preceded it.
Time in the market, not market timing
Although investors needn't dread a marked decline in equity values, a prolonged downturn is hardly helpful for retirees who augment their pension arrangements through periodic equity sales. That why financial advisers usually recommend that individuals have access to around three years of spending money so they can cover expenses without selling stocks prior to retracement - and they will retrace. That spending money could come from fixed income or money market funds, but given the outlook on interest rates you might be advised to squirrel away a little more cash than usual.
So if you have sufficient liquidity to cover fallow periods, you can take a largely agnostic view on markets. Indeed, for many of our readers - those whose investment strategy is predicated on buying quality and staying invested - an unfolding bear market will represent nothing more than a detail, an unavoidable low note in the cycle. It's "time in the market, not market timing", as the editor of this august publication never tires of reminding us. And there's certainly been sufficient peer-reviewed research down through the years to support this view. What matters as an investor is what you do - or more specifically, what you don't do - when all others around you are losing their heads. It is nigh on impossible to determine when the peak of a recession occurs. With hindsight everyone is on the money, but that does not help you when making a buy or sell decision.
Backing out of equity positions when markets are in retreat, simply because they're in retreat, could involve you taking losses unnecessarily; you might be panicked by a seeming necessity to curtail paper losses, but it hardly needs stating that the only way to crystallise paper losses is to sell the underlying asset. History reminds us that equity markets have routinely suffered dramatic downturns (see charts on page 30); the average technical bear market lasts for around a year and a half and entails a pullback of 38 per cent. Even after the sell-offs linked to both the 1929 stock market crash and the all too recent financial crisis, equity prices retraced - and within a timeframe acceptable to most investors. There has never been a stock market crash so severe that the market didn't ultimately return to its former high, and move beyond it.
The danger is that we're all inclined to succumb to irrational under-exuberance - the fear that market losses will continue indefinitely. Unfortunately, the average investor's aversion to loss is far stronger than their attraction to gains. Your ability to master your emotional state is arguably more important than your grasp of the market.
Equity markets generally plod along, but they're punctuated by extreme fluctuations that can even rattle experienced money managers, let alone retail investors. So, as a rule of thumb, it always pays to settle on an expected rate of return for your investment portfolio and stick to it - so-called point-to-point investing. It is obvious that the variations on expected returns can vary wildly in either direction at various points of the cycle, but these variations should cancel out as long you can stay invested long enough to endure both positive and negative deviations. Regardless of your stock-picking skills, the longer you can compound returns by staying invested, the less likely you are to end up on the wrong side of the ledger over the long haul.
Counter-party to panic selling
If we accept that a long horizon on investments, coupled with an acceptance of the inevitability of market reversals, is a recipe for preserving capital, surely bear markets present an opportunity to become counterparty to shareholders that liquidate their portfolios out of blind panic. After all, there's nothing like a spot of blood-letting to highlight value plays, to paraphrase Baron Rothschild. Recent history tells us that the best time to buy shares is when their outlook is irredeemably bleak. Conversely, as Warren Buffet would put it: "you pay a very high price in the stock market for a cheery consensus". We at the IC have heard numerous anecdotal accounts of investors who have profited handsomely by employing a contrarian strategy in the aftermath of the dot-com and great recessionary crises.
Sometimes it can be tough to go against the herd, but it's obvious that many investors ploughed back into the market following the rout in global markets earlier this month. US stocks notched their biggest weekly percentage gains in three months, as investors took new positions in lowly rated industrial and resource stocks, although the view at the IC is that global equity markets still have some unwinding to do. Nevertheless, our position remains that long-term investors should approach matters in a bear market in much the same way that you would in a bull market - you buy right through it. You secure new equity positions, or top-up existing ones, in good-quality companies, preferably with well-covered income streams, sit back, relax, and let Leonardo DiCaprio worry about the bears. MR
What's behind the slide?
In the UK, the FTSE 100 officially entered bear market territory last month, having declined by more than 20 per cent from its bull market peak, but both the FTSE 250 and SmallCap indices have avoided that fate, falling by 'only' 17.7 per cent and 14.3 per cent, respectively, from their early June 2015 highs.
Unfortunately, a host of other major indices are firmly in bear market territory. Both Germany's Dax 30 and Japan's Nikkei 225 indices declined by 29 per cent peak-to-trough, the Euro Stoxx 50 lost a third of its value, and in the US the Russell 2000 index of small caps fell by 29 per cent. It's impossible to ignore these savage deratings and, more importantly, the reasons for the heavy selling. In fact, to ascertain whether we have seen the final lows in the stock market rout, or whether there is another down leg to come, it's necessary to understand the cause of the sell-off. There are multiple factors at work here.
China, emerging markets, and the commodity complex
Firstly, last summer's unexpected devaluation of the Chinese renminbi has stoked fears that the country's well-documented economic slowdown could be far worse than the official GDP figures suggest. In fact, a survey of fund managers by Bank of America Merrill Lynch earlier this month indicates that growth expectations for the Chinese economy are at their lowest level since 2008, which heightens the risk of contagion spreading to Europe and the US as China's economy slows.
The renminbi devaluation also raises the risk of a cycle of competitive devaluations emerging if regional central banks act to try to regain their lost competitiveness against China. And the fall-off in demand from the world's second-largest economy has wreaked havoc with the commodity complex, not only undermining the commercial viability of global resource companies, but of whole countries reliant on exporting both energy and commodities to China.
Mirroring these growth fears is a deflating oil price that has slumped to its lowest level since the March 2009 bear market low, having fallen by 70 per cent in the past 18 months. Government finances of major oil producers Russia and Brazil have been ravaged too, as have their currencies. They are not alone as even the largest swing producer in the world, Saudi Arabia, has been forced to tap bond markets to finance its budget deficit, something that was unimaginable a few years ago.
To compound matters, the spike in risk aversion has come just as the US central bank embarked on a tightening of monetary policy, a move predicated on an improvement in the country's employment rate to levels last seen before the 2008 global financial crisis, and an economy returning to trend growth. This has sent the US dollar surging and has exacerbated the capital outflows from emerging markets that had previously benefited from the recycling of low-cost US dollars flows during the Federal Reserve's previous quantitative easing programmes. Investors in emerging markets equities have taken an almighty bath in recent years, accentuating the negative wealth effect in equity markets.
There are other major factors at work that are construing to undermine the confidence of investors too.
Bond market warnings
The fact that credit spreads between government and corporate bonds have widened markedly is sending a clear signal that investors are seriously worried about recessionary risk. Analysts at credit rating agency Moody's point out that their speculative-grade gauges are flashing red for junk debt, noting that increasing downgrades and defaults on these low-grade bonds, and widening credit spreads, has increased risk aversion and is making it far more difficult for lower-rated companies to access funding.
The sell-off is not just occurring in the battered energy sector where credit default swaps have rocketed, reflecting the collapse in the oil price that's depleted cash flows and the ability of indebted companies to service their borrowings, and so pushing up the cost of insuring against credit default. Almost all of the high-yield sectors tracked by Barclays have fallen in value in the US, with bonds rated triple C declining by almost 15 per cent in the past 13 weeks alone. Pan-European bonds with the same credit rating have fallen by 9 per cent in value over the same period. Losses are eye-watering for lower-grade bonds, and for the investors holding them. With lending standards becoming more stringent, and investor risk aversion running high, default rates are set to spike further.
Moreover, there is a ticking $200bn (£138bn) time-bomb of loans outstanding to US shale producers which is going to lead to substantial impairment losses to the financial institutions that issued the loans. Forward production hedges, put in place when oil was north of $100 a barrel and providing much needed cash flow to service those loans, are now unwinding. I would expect defaults to rise markedly as a result. We have already had a taste of things to come with US investment bank Citigroup recording a 32 per cent rise in non-performing corporate loans in the fourth quarter last year, mainly related to its North American energy book. It was not alone: Wells Fargo took an $831m hit and JPMorgan Chase said that it would be forced to add up to $750m to reserves this year if the oil price stayed around $30 a barrel.
At its recent low, the US KBW banks index, covering the biggest US commercial banks, had lost almost a fifth of its value since the start of this year and was being priced on 90 per cent of book value. Investor confidence in the European banking system has been rattled, too, with the FTSE-Eurofirst 300 banks index falling by over a quarter at its February low at which point it was trading at only 62 per cent of book value. Credit default swaps for corporate bonds of German giant Deutsche Bank hit a level that was even worse than during the 2008 global financial crisis.
The conclusion must be that not only are banks' profits set to come under pressure, but so too are their balance sheets. This has substance when you consider the movement in yield curves this year.
Yielding to stress in the banking sector
One consequence of the spike in risk aversion is a flattening of the yield curve as market participants bet that the US Federal Reserve will hold back from tightening policy given the dramatic change in financial conditions following the slide in equity prices, spike in credit costs for riskier borrowers, and the appreciation of the US dollar. The US Federal Reserve acknowledged as much last week.
In fact, the one percentage point yield differential between US 10-year Treasuries and two-year bonds is the smallest gap since the global financial crisis in 2008, and the US yield curve is as flat as it has been at any time since 2007. Banks in the UK and Europe are also being squeezed, with 10-year gilts hitting a record low of 1.26 per cent last week, and 10-year German Bunds currently yielding just 26 basis points. The shift at the top end of the yield curve suggests that investors are far more concerned about deflation and the possibility of a sharp economic slowdown, or even recession, rather than harbouring any concerns on the inflation front.
An end-result of these shifts is that the net profit margin earned by banks from borrowing at rock-bottom short-term rates, and then lending longer term, is being squeezed dramatically just as losses on non-performing loans look set to rise. To acerbate matters, Japan has just joined Denmark, Sweden and Switzerland by adopting negative interest rates, so eroding the net interest income of banks.
US recessionary risk spikes
In my view, the greatest risk to equity markets is an economic slowdown in the US. It's worth noting that US industrial production has fallen year on year no fewer than 10 out of 12 times on a month-over-month basis. It may be a little known fact, but using data going back to 1919, this has only ever happened when the economy is in recession, according to John Hussman of US fund management group Hussman Funds. Also, the risk of recession increases dramatically when stock market action deteriorates and economic data is weakening. In fact, the conditional probability of recession prior to the S&P 500 falling below its 12-month moving average was only 5 to 10 per cent, according to economist William Hester at Hussman. It's now between 60 and 75 per cent.
Moreover, the sharp fall in asset prices, both in bond markets and equities, could easily lead to a negative feedback loop whereby consumers (accounting for 70 per cent of GDP in the UK and US), and businesses, become far more cautious and rein in spending as we witnessed in 2008. In effect, the downward spiral becomes self-fulfilling as cheaper energy prices are saved, not spent; the threat (even if only perceived) of unemployment undermines economic growth; and availability of credit for consumption purposes becomes far less available.
Needless to say, a US economic slowdown would drive down profits of banks further and cause even greater stress in the banking system. That said, we are not there yet and may never get there. Some other economists suggest that there is only a one-in-five chance of the US economy entering recession this year. They could be wrong and I sincerely hope the central bankers are alert to the risk.
Time for central bankers to act
And that's why we need reassurance from the US central bank at next month's FOMC meeting that it will not tighten monetary policy in light of the escalating economic risks, especially as amid the market turmoil US inflation expectations have collapsed below the level in the eurozone, hardly the backdrop for another rise in the Fed funds rate.
The ECB has to play its part too and, in particular, address the anaemic inflation and economic backdrop in the region at next month's meeting. The eurozone economy expanded by just 0.3 per cent in the final quarter of 2015, and an inflation rate of 0.4 per cent is miles off the ECB's target rate of 2 per cent. The central bank is already purchasing E60bn of assets a month through its quantitative easing programme, launched in January 2015, and could easily ratchet this up. It's time for Super Mario (Draghi) to deliver.
Finally, it's worth keeping a close eye on the oil market as a firmer oil price reduces the financial stress in the energy sector, the potential for impairments on bank balance sheets, and has a positive wealth effect. It's no coincidence that the rally in equity from their lows earlier this month has coincided with a stronger oil price, too.
Where does this leave the stock market?
Admittedly, stock markets have rallied strongly off February's lows from very oversold technical readings, and I will be keeping an eye on market internals and economic indicators to ascertain whether this rally has the potential to develop into something more substantial. I will also be keeping a close eye on the US stock market and the critical 1,810 support level on the S&P 500, representing both the low on Wednesday, 20 January and on Thursday, 11 February. It simply has to hold, otherwise brace yourself for another down-leg to equities on both sides of the Atlantic.
There are valuable pointers from our history books, too. That's because 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 1930s, 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 bear market bottom.
However, the seven bear markets that followed the seven longer bull markets have been far more savage. Given that the 2009 to 2015 bull market was a long runner, during which time share prices more than doubled, this heightens the risk that this month's lows didn't mark the end of the market slide. ST
Which sectors bear the brunt?
When the UK All-Share index entered technical bear market territory, on 9 February 2016, the roll-call of worst performing sectors, since the April 2015 peak, did not spring any surprises. Oil and gas producers have inevitably come under pressure, although in the circumstances the mega caps have held up better than one might have thought, due partly to reduced anxieties over their ability to fund their dividends through 2016. Oil services took comparatively more of a battering but the most heavily sold stocks have been the miners. Banks are also under pressure and the common theme is that companies with a high exposure to macro trends, such as China's slowdown (and the knock-on effect for other emerging markets and broad commodity prices) and the drastic adjustment in the oil price, have seen their share prices suffer most.
The UK stock market is renowned for its level of concentration and the difficulties being faced simultaneously by the biggest sectors, according to market capitalisation, has resulted in the current bear market. In spite of global macro issues, however, Britain's economy is still doing well. Companies that have profited from strong domestic consumption and the house price boom actually enjoyed positive share price momentum, even as the market was dragged down by its largest constituents. How long this can continue, in the face of global headwinds, is debatable but the UK economy's feel-good factor is evidenced in the stock market by the performance of sectors such as beverages, food producers, household goods, leisure goods and non-life insurance.
How does this compare with the same phase in the last downturn? Between the peak of the stock market in June 2007 and the start of the bear market in March 2008, the worst-performing sectors were the banks, real estate investment services, tech hardware, general retailers and leisure goods. All of which was, again, unsurprising as the effects of the 'credit crunch' were being priced in for companies dependent on the UK's debt-fuelled consumption. In stark contrast with the present (in 2008 China's growth was continuing unabated and there was talk of a commodities 'super-cycle'), the best sectors in 2007-08 were oil services, mining and chemicals as well as defensive industries such as electricity and tobacco.
Once a bear market has begun, are there any patterns that identify the best defensive sectors?
Considering the last two major bear markets, in 2001-05 and 2008-12, the sectors hardest hit before troughs were those most affected by the crises that precipitated market falls. In the early 2000s, tech stocks were savaged. In 2008-9, banks and life insurance suffered. Despite their relatively good performance in the run-up to the technical start of the bear market, mining stocks also took severe losses as the market plunged to its depths in 2009.
In terms of defensive sectors, in 2008-9 non-life insurance, pharmaceuticals and food & drug retail did well. Interestingly, those sectors most badly hit in the previous bear market, software and computer services and tech hardware and equipment, also did well. Perhaps these sectors, so unloved after the tech bubble burst, had been punished enough and financial stocks were now drawing most ire from investors.
Momentum a crucial factor
Based on studies of more bear markets over the past half century, text books tend to make generalisations about which sectors perform best at different stages of the stock market and business cycles. Transportation and financial stocks supposedly do better in the run-up to a fresh bull market; tech and capital goods in the mid-bull phase; energy and mining companies, at the peak. In bear markets, consumer non-cyclicals and healthcare are touted as strong performers in the early stage, as the real economy lags the stock market, in terms of its growth and recessionary phases. As bear markets progress, so utilities and other defensive sectors such as tobacco outperform the wider market.
In the past two bear markets this pattern has loosely been followed but, as mentioned, a key and overriding feature has been continued negative momentum for the sectors from where the initial crises, that sparked sell-offs, originated. For 2016, the lesson would be that, even if oil and gas and mining stocks start to look decent value, it would be prudent to wait for the first shoots of share price recovery, rather than looking to make a contrarian play and call their bottom. JN
What a bear market looks like
Not all bear markets are created equal. The following eight charts illustrate all the bear markets experienced by the FTSE All-Share index since the start of the 1970s excluding a one-day technical bear market in 1981. The graphs chart the index's journey from its peak into bear market territory (a 20 per cent-plus decline from the peak level) and then back to the previous high (in many cases the index went on to claim far greater highs in the years that followed). AH
The spectre of negative rates
Who woke up the bears? A lot of the blame has been placed on the US Federal Reserve, which embarked late last year on its much-trailed strategy to increase interest rates. Market watchers see parallels between the volatile markets that we have seen over the past year and those of the 1930s.
The latter was a period of recovery from the Great Depression. US stock markets were rising strongly and policymakers became concerned about the amount of froth in the financial system given a period of ultra-accommodative monetary policy. Concerns grew about asset bubbles and rising inflation. Sound familiar?
In response, the Federal Reserve increased the reserve ratios required of its member banks, while the US Treasury sterilised gold inflows in an attempt to reduce its excess reserves. The combined effect of these measures appears to have been to arrest the growth in the money base. There has been much discussion since about whether these measures led to the 1937-1938 recession.
Looking at the path of US industrial production over the years since those decisions to tighten monetary policy, Jonathan Wilmot, head of macro research at Credit Suisse Asset Management, sees some correlation with today's markets. Consider industrial production, a useful barometer of economic health. The correlation in its fall since the financial crises of the late 1920s and late 2000s marches almost in lockstep for the first couple of years. Thereafter, the US's experience under president Franklin D Roosevelt saw a stilted recovery in production (see graph 'US industrial production on page 31'), before it falls off a cliff after the tighter monetary policy comes into effect.
It is clearly too early to conclude that markets will follow the same journey this time around, although commentators have been quick to judge that the Fed's decision to get ahead of the game in late 2015 overestimated the solidity of the financial system. Indeed, Mr Wilmot argues that after major financial crises investor confidence and 'animal spirits' in business sentiment can remain fragile for a decade or more.
"Ultimately the policy mistake in 1937 was to underestimate that fragility, and to tighten well before inflation was a real issue," he says. This argument maintains that the risks are weighted towards tightening too soon, or too fast, rather than the opposite.
Mr Wilmot adds: "Does that mean we think the US stock market will fall 50 per cent and the economy plunge back into recession? I somehow doubt it - but it does means we can have a bear market without a recession until the Fed clearly signals that pre-empting inflation isn't really on its agenda anymore."
Perhaps the grand policy error of 1937 was one of miscommunication rather than poor choices, given academic debate over whether the increased reserve requirements really had the contracting impact on the banks that has been portrayed. In a 2006 paper, the Federal Reserve Bank of New York's Gauti B Eggertsson and Benjamin Pugsley argued that it was in fact authorities' "vague and confusing signals", particularly regarding their inflation goals, which were to blame. "[This] created pessimistic expectations of future growth and price inflation that fed into both an expected and an actual deflation," they conclude.
Rates and prices
The historical evidence suggests both bonds and equities underperform in a rising rate environment, as demonstrated in this year's Credit Suisse Global Investment Returns Yearbook. That is because rate rises reduce spending, which in turn reduce corporate revenues and therefore profits, as well as increasing companies' cost of credit.
Clearly in December 2015, it felt like the dangers of tightening too late outweighed the shock of starting early. This is a common conundrum for central bankers, concerned with restraining demand by tightening policy only for that demand to evaporate in a fresh crisis and for their hands to be stayed. It happened in Europe in 2010, before the euro crisis knocked the bottom out of the market.
Some argue that the Fed was unlucky rather than wrong in 2015, with the commodity slump continuing to confound market optimists. But its course could now be changing just as quickly as it did back in the 1930s. Then, monetary taps were loosened again as quickly as 1938, and reports suggest today's Fed is reconsidering its plans for four interest rate rises this year. The prospect of negative rates, following in the footsteps of Japan and more recently Sweden, is probably far off, although Fed chair Janet Yellen did face questions on their legality from US legislators in February.
Negative rates would have clear risks, as anyone that has looked at the bank stocks this year can attest. "The risk is that [they] reduce banks' earnings power and might make them more reluctant to lend, offsetting any benefit from stronger credit demand or a weaker currency," says Mr Wilmot.
Whether or not the Fed's 2015 'lift-off' will preface a slowdown similar to 1937 remains to be seen. But it is clear that investors have lost some of their belief in central bankers' power over the global economy, including the potency of quantitative easing strategies, and are deeply uncertain about interest rates that are lower, and even negative, for longer. IS
