bear market, share prices

Five reasons why stocks have further to fall

01.02.2008

by Tim Bennett

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With global equity markets recording double-digit losses since the highs of last summer and sectors such as banking and property marked down by as much as 50%, some commentators say now is a good time to get back into shares. But we think there are at least five reasons to believe this bear market is far from over.

1. Risk is not yet back in fashion

For a sustained share-price recovery, rather than a short-term bounce, the majority of investors have to be willing to risk buying them, rather than sticking their money into a savings account. That doesn’t look set to happen any time soon – Absolute Strategy Research’s (ASR) “spook” index of global risk appetite reveals that investors are highly risk averse just now, a far cry from their carefree pre-credit crunch days.

The group monitors eight main risk indicators, including the CBOE volatility index, or “Vix” (known as Wall Street’s fear gauge); emerging market equity prices; the Swiss franc exchange rate (a “flight to safety” indicator); and the three-month Eurodollar. While ASR sees scope for a short-term share-price bounce, driven partly by investors exiting short-selling positions, their latest spook readings suggest “it will be short lived”.

2. Stocks are not yet cheap enough

While stock valuations measured using the p/e ratio have been dropping since August, “we are still far from..the ten-times multiple across sectors, which historically has signalled previous turns in major bear markets”, says Rob Arnott of Research Affiliates in the FT. Take the S&P 500 – the historic p/e is around 17 times, overvalued by Arnott’s yardstick. But as John Authors adds, it looks even more expensive if you adjust for the earnings cycle, by comparing prices to average earnings over the past ten years. That puts the figure at more like 26. The fact that the market is also hyper-sensitive to earnings upsets, as recent sharp falls in Apple’s share price show, indicates that we are some way from “capitulation”, or the point when prices are so low that they reflect all possible bad news. 3. The end of 2007 spelled trouble

For chartists, the bear market signals came thick and fast at the end of last year. Back in November we pointed out that Dow Theory predicted a fully-fledged bear market for 2008. Bill Meridian of Cycles Research, meanwhile, points to the failure of normally bullish indicators – for example, late October and December are traditionally strong, and so is New Year’s Eve. This wasn’t the case in 2007.

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4. We’re at a “Minsky moment”

Economist Hyman Minsky is famed for observing that a long period of stability is inherently unstable. Confronted with an apparent long-term reduction in risk (the period from 2003 to 2007 being a good example), investors tend to increase their risk by “gearing up” using borrowing. This, as Jeremy Grantham notes, is “contagious and reinforcing” to the degree that risk is ignored and debt levels soar, taking asset prices to the point where capital gains are needed simply to pay interest on the debt used to buy the asset. Then something goes wrong – last year’s credit crunch, for example – and investors cut back on leverage, dragging prices down in the process. “The logic is simple and powerful,” says Grantham. Following “the most important US financial crisis since World War II”, asset prices have much further to fall even after the direct effects of the credit crisis have passed.

5. Bear markets last a long time

Far from being the start of a painful but short-lived credit crunch, the events of last August are symptomatic of a much larger problem, says Ed Easterling, the head of Crestmont research. The fact is that the major global economies have actually been in a structural downturn since the dotcom bust in 2000. He believes that this marked the start of the fifth secular bear cycle since 1901. However, this time equities may have much further to fall to mirror previous bear cycles, during which p/e ratios more than halved. That’s because the dotcom-driven p/e ratio of 42 at the beginning of this bear market in 2000 is a misleading starting point, given that previous bear cycle opening p/e ratios averaged just 22.

Easterling’s research suggests that today’s multiples need to sink “by at least another 30%-40% into the mid-teens” before we see the end of this bear cycle. He believes that the oddity of the past decade is not the recent surge in volatility, but rather the flood of cheap money unleashed via aggressive interest-rate cuts (the “Greenspan put”) in 2003 to prop up asset prices. This fooled many into thinking that a new bull market had begun.

The analysis of this century’s previous bear markets in Richard Russell’s book, Anatomy of the Bear, backs this up. As Russell puts it, “equities become cheap slowly” – it typically takes around 14 years. What’s more, ignoring 1929-1932, the bottom of a bear market has never occurred sooner than three to eight months after the Fed stopped cutting interest rates, economic news started to improve and share prices had already collapsed by 20% or more on low trading volumes. The fact that none of this has yet happened suggests that the worst still lies ahead.

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