After two-and-a-half years of falling share prices, markets appear to turn
OCTOBER is traditionally a bad time for stockmarkets: the crashes of 1929 and 1987 both happened in that month. This year could be different. In the four days to October 15th, many of the world's main stockmarkets saw their biggest four-day gains, in percentage terms, in over a decade. America's Dow Jones Industrial Average rose by 13%, Germany's DAX by 17%.
Worries about profits had helped to drive shares to their recent lows. So desperate have investors been for good news that sentiment seems to have been helped by better-than-expected results in the third quarter from Yahoo!, hardly the workhorse of the American economy, and Citigroup, even though tussles with regulators mean an uncertain future for the bank. Those results may have helped the Dow up by 5% on October 15th alone. Then dismaying profit figures from Motorola, Intel and J.P. Morgan Chase dampened spirits once again. Not, however, before investors had begun to wonder if the long bear market might at last be over.
A crucial question, for it is often in the first few months after a bear market ends that the most money is made. America's S&P 500 index took only six months to rise by 40% from its low in late 1974, and three months from its trough in early 1982. London share prices doubled in only two months after the bear market ended in early 1975. Some investors fancy themselves to be on the cusp of similar gains. Abby Joseph Cohen, Goldman Sachs's chief equity strategist, predicts that the S&P 500 will rise, over the next year, by almost 50% from its low.
One popular argument for why the bear market may be over is that, by last week, the S&P 500 had fallen by almost 50% from its peak, a slightly bigger decline than during the bear market of 1973-74—indeed, the biggest since the Depression of the 1930s. The end of 1974 turned out to be an excellent time to buy shares (see chart). Moreover, the argument goes, global economic conditions are now healthier than in the 1970s, when economies were in the grip of stagflation. If share prices recovered strongly then, they can surely do so again now.
Remember, however, that the 1970s saw double-digit inflation. Measured in real terms, share prices have fallen by less from their peak this time. Low inflation implies that prices may have to fall by more in absolute terms to return to fair value. Adjusted for the rise in consumer prices, the rebound in share prices in the 1970s was also a lot less impressive. After an initial bounce in 1975, share prices stagnated. In real terms, the S&P 500 did not regain its level of January 1973 until as late as 1987.
A second argument to support a recovery in share prices is that they are now close to fair value. As always, it depends which measure you pick. The S&P 500 stands at just under 30 times historical reported profits. This is down from over 40 at the peak, but well above the 50-year average of 15. Still, this exaggerates the overvaluation, since profits will presumably recover from today's depressed levels.
To correct for this distortion, Eric Lonergan at Cazenove calculates a cyclically adjusted price/earnings (p/e) ratio, using an estimate of trend profits. At its low point last week, this p/e ratio had fallen to 17, the average during the pre-bubble years of 1990-95. Yet in previous bear markets prices have undershot: in both 1974 and 1982 the p/e ratio dipped below 8. So American shares may yet have further to fall. Using the same measure, Mr Lonergan finds that British shares are cheap, with a p/e of 12; the rest of Europe has a ratio of 14.
Relative to bonds, on the other hand, American shares now look cheap. The dividend yield from shares is historically high, compared with government-bond yields. Yet this is partly because bond yields have tumbled on fears of sluggish growth and deflation. If these fears prove right, future profits will be severely dented. Even without deflation, analysts' average forecast of 18% growth in American corporate profits over the next year seems unrealistic, given that the growth in nominal GDP is unlikely to be more than 4-5%.
What is more, although most economists expect America's recovery to continue, the risk of a double-dip recession certainly cannot be ruled out. Business investment has fallen now for seven quarters in a row, but American consumers continue to spend. For how long? Consumer confidence, as tracked by the University of Michigan, fell sharply in early October, reaching its lowest level in nearly a decade. This partly reflects the plunge in share prices, however; if the stockmarket continues to rally, consumer confidence may return. On the other hand, if consumers cut their spending and the recovery stalls, share prices could easily drop a lot further.
There is a clear risk that the market still has new lows to test
Some investors would like to think that recent volatility is another sign of the end of the bear market. The S&P 500 rose or fell by at least 1% on 15 successive days up to October 11th, the longest such run in more than 60 years. Similar increases in volatility since the second world war, in 1950, 1974 and 1987, were followed by share-price gains of around 20% over the next six months. The snag is that in the 1930s such volatility was more common, and it was always followed by a further slide in share prices.
There is a clear risk that the market still has new lows to test. And even if one believes that share prices are no longer overvalued, the long-run prospects for equities are not dazzling. Over the long haul, share prices depend on profits, which cannot forever grow faster than nominal GDP—as they did through the 1990s. Real equity returns might average only 5% a year over the next decade, compared with annual returns of 25% over the four years to 1996.
Wild parties tend to lead to long hangovers. The 1990s witnessed the biggest bull market of all time, with share prices becoming more overvalued, by many measures, than ever before. By some measures, this is now the most severe bear market. Although share prices have fallen by less than in 1929-32, the total loss of global equity wealth as a percentage of GDP has already been more than it was during the Great Depression—and there may be further losses ahead.
OCTOBER is traditionally a bad time for stockmarkets: the crashes of 1929 and 1987 both happened in that month. This year could be different. In the four days to October 15th, many of the world's main stockmarkets saw their biggest four-day gains, in percentage terms, in over a decade. America's Dow Jones Industrial Average rose by 13%, Germany's DAX by 17%.
Worries about profits had helped to drive shares to their recent lows. So desperate have investors been for good news that sentiment seems to have been helped by better-than-expected results in the third quarter from Yahoo!, hardly the workhorse of the American economy, and Citigroup, even though tussles with regulators mean an uncertain future for the bank. Those results may have helped the Dow up by 5% on October 15th alone. Then dismaying profit figures from Motorola, Intel and J.P. Morgan Chase dampened spirits once again. Not, however, before investors had begun to wonder if the long bear market might at last be over.
A crucial question, for it is often in the first few months after a bear market ends that the most money is made. America's S&P 500 index took only six months to rise by 40% from its low in late 1974, and three months from its trough in early 1982. London share prices doubled in only two months after the bear market ended in early 1975. Some investors fancy themselves to be on the cusp of similar gains. Abby Joseph Cohen, Goldman Sachs's chief equity strategist, predicts that the S&P 500 will rise, over the next year, by almost 50% from its low.
One popular argument for why the bear market may be over is that, by last week, the S&P 500 had fallen by almost 50% from its peak, a slightly bigger decline than during the bear market of 1973-74—indeed, the biggest since the Depression of the 1930s. The end of 1974 turned out to be an excellent time to buy shares (see chart). Moreover, the argument goes, global economic conditions are now healthier than in the 1970s, when economies were in the grip of stagflation. If share prices recovered strongly then, they can surely do so again now.
Remember, however, that the 1970s saw double-digit inflation. Measured in real terms, share prices have fallen by less from their peak this time. Low inflation implies that prices may have to fall by more in absolute terms to return to fair value. Adjusted for the rise in consumer prices, the rebound in share prices in the 1970s was also a lot less impressive. After an initial bounce in 1975, share prices stagnated. In real terms, the S&P 500 did not regain its level of January 1973 until as late as 1987.
A second argument to support a recovery in share prices is that they are now close to fair value. As always, it depends which measure you pick. The S&P 500 stands at just under 30 times historical reported profits. This is down from over 40 at the peak, but well above the 50-year average of 15. Still, this exaggerates the overvaluation, since profits will presumably recover from today's depressed levels.
To correct for this distortion, Eric Lonergan at Cazenove calculates a cyclically adjusted price/earnings (p/e) ratio, using an estimate of trend profits. At its low point last week, this p/e ratio had fallen to 17, the average during the pre-bubble years of 1990-95. Yet in previous bear markets prices have undershot: in both 1974 and 1982 the p/e ratio dipped below 8. So American shares may yet have further to fall. Using the same measure, Mr Lonergan finds that British shares are cheap, with a p/e of 12; the rest of Europe has a ratio of 14.
Relative to bonds, on the other hand, American shares now look cheap. The dividend yield from shares is historically high, compared with government-bond yields. Yet this is partly because bond yields have tumbled on fears of sluggish growth and deflation. If these fears prove right, future profits will be severely dented. Even without deflation, analysts' average forecast of 18% growth in American corporate profits over the next year seems unrealistic, given that the growth in nominal GDP is unlikely to be more than 4-5%.
What is more, although most economists expect America's recovery to continue, the risk of a double-dip recession certainly cannot be ruled out. Business investment has fallen now for seven quarters in a row, but American consumers continue to spend. For how long? Consumer confidence, as tracked by the University of Michigan, fell sharply in early October, reaching its lowest level in nearly a decade. This partly reflects the plunge in share prices, however; if the stockmarket continues to rally, consumer confidence may return. On the other hand, if consumers cut their spending and the recovery stalls, share prices could easily drop a lot further.
There is a clear risk that the market still has new lows to test
Some investors would like to think that recent volatility is another sign of the end of the bear market. The S&P 500 rose or fell by at least 1% on 15 successive days up to October 11th, the longest such run in more than 60 years. Similar increases in volatility since the second world war, in 1950, 1974 and 1987, were followed by share-price gains of around 20% over the next six months. The snag is that in the 1930s such volatility was more common, and it was always followed by a further slide in share prices.
There is a clear risk that the market still has new lows to test. And even if one believes that share prices are no longer overvalued, the long-run prospects for equities are not dazzling. Over the long haul, share prices depend on profits, which cannot forever grow faster than nominal GDP—as they did through the 1990s. Real equity returns might average only 5% a year over the next decade, compared with annual returns of 25% over the four years to 1996.
Wild parties tend to lead to long hangovers. The 1990s witnessed the biggest bull market of all time, with share prices becoming more overvalued, by many measures, than ever before. By some measures, this is now the most severe bear market. Although share prices have fallen by less than in 1929-32, the total loss of global equity wealth as a percentage of GDP has already been more than it was during the Great Depression—and there may be further losses ahead.
