Rising prices do not signal a bull market
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Deputy Editor
Tim Bennett May 29, 2009
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After a couple of months of rapid stockmarket gains, more and more pundits are saying that this is the start of a new bull market. But the rally looks vulnerable to us – here's why.
The power of feedback loops
One of the main reasons people are piling into the market is simply because they see prices rising. This shows the power of the 'feedback loop' – rising prices draw in investors, which in turn pushes prices higher. The stockmarket has benefited from several such loops in recent years.
Share buy-backs, for example, where firms use cash or borrowed money to buy back their own shares, create the illusion of shareholder value by boosting earnings per share (EPS) (because there are fewer shares to go around), even though underlying earnings haven't changed.
Smithers & Co estimates that corporate buying of shares, or 'de-equitisation', hit a peak of $1trn in 2007 – in fact, firms were buying more of their own shares than anyone else. At that point, the FTSE 100 was around 50% higher than today. So positive loops are pretty powerful.
Another seemingly virtuous circle was created by company pension funds. When these were in surplus (ie, the assets held, mainly stocks, exceeded the estimated value of all future liabilities to the scheme's pensioners), firms could cut contributions. This boosted cash flow and profits short-term, lifting share prices. Rising prices raised the value of pension funds further, giving more scope for contribution cuts, and so on.
Loops like these explain why bull markets can run way past the point where 'fundamentals' – say, historic price-to-earnings multiples for shares – suggest they should have turned. Governments keep the ball rolling via generous tax breaks and low regulation – the extra tax revenue from rising asset prices becomes addictive.
Why this rally is vulnerable
When the party stops, feedback loops can go into reverse, and they're as powerful on the way down as on the way up. That's what's happening now. In equity markets, as profits fade and write-offs mount, earnings are falling. Cash-strapped firms are now raising rather than returning capital. This re-equitisation deflates EPS, in turn pushing prices lower.
Meanwhile, pension funds – or rather deficits – have become a millstone as asset prices fall. Suddenly, firms have to support their schemes (BT recently slashed its dividend to do so), which means yet more hits to cash flow and profits, again driving share prices lower.
But these are just sub-loops within a more ominous one, says Sean O'Grady in The Independent. He cites the recent 1.9% drop in first quarter UK GDP – the biggest since 1979. One third can be explained as a temporary "inventory effect", as firms run down stockpiles. But the rest of the fall was due to "fundamental factors", such as the steepest drops in household spending seen since 1980. That will lead to rising unemployment (already at its highest since 1997) as firms cut costs, hurting confidence, hitting spending and leading to more job cuts.
This is the grand-daddy of vicious feedback loops and the one keeping central banks and governments awake at night. Throw in falling corporate investment, down 5.5% in Q1, and as Buttonwood says, "there will have to be a lot more than a couple of months of rising share prices before one can say a bull market is underway".
What would Ben Graham do?
How can you avoid being suckered in by short-term twists and turns in the stockmarket? Seeing as the Dow Jones is up 30% since its low in March, "it is natural for you to feel happy or relieved", says Jason Zweig in The Wall Street Journal.
But legendary US value investor Ben Graham would be worried. Jittery optimism and a "desperate need to believe that the worst is over" are danger signs. Rather than take his cue from what other investors are doing, Graham focused on buying stocks when cheap, according to a range of measures including price-to-book (which looks at how expensive a share is compared to its underlying assets).
His view was that eventually the market would spot this undervaluation and push up the price. From that perspective, now is not a good time to buy.
As James Montier of Société Générale notes, there are few value shares left: the Shiller p/e, which compares share prices to a ten-year average earnings figure, has risen from 13.1 to 15.5 for the S&P 500, the fastest rise in nearly 25 years. In ten weeks shares have gone "from the edge of the bargain bin to the full-price rack".
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