Bear markets: Lessons from history

Looking back, what can we learn about bear markets from past experiences? 

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There are many who claim an ability to anticipate the next correction, whether through fundamentals, charts, or the fact that their taxi driver has started offering stock tips.

Others take the view that it is almost a decade since the nadir of the financial crisis and global equity markets have trebled. It is simply time to take profits and head to the beach, returning to equities after the "next crisis". 

Before rolling out your towel, it is worth reviewing the lessons from history, looking for reliable portents of doom to see if there is still life in the bull. 

2008: The Global Financial Crisis

This is the crash that is freshest in everyone’s minds. In sterling terms, markets fell by 36 per cent in a year from March 2008-2009.

Portents of doom: High levels of borrowing (to buy houses) and general personal debt, lax banking regulation, rapid growth in the money supply (especially mortgage lending in the UK and US), and ... valuations? Overall, markets were not trading on particularly high price to earnings (P/E) multiples – just 17x. But the market index had a huge weighting to banks, which had enjoyed the boom and which were trading on very high multiples by late 2007.

2000-03: The TMT bubble bursts

Global equities fell 53 per cent in sterling terms over three years from October 2000.

Portents of doom: Valuation – the S&P peaked at a P/E multiple of 34x and numerous large companies had only small cash earnings.

1987: Black Monday

This is the crash that came with a hurricane. Global equities fell 30 per cent in 40 days. The sudden fall was made worse by electronic trading and forced selling by investors who had borrowed money.

Portents of Doom: Valuation – although a P/E multiple of 20x does not sound too high for the Dow, the Japanese market is thought to have been trading on a multiple of 70x. The UK market had been buoyed by a spate of often ill-advised takeovers. Consumers (including taxi drivers) were borrowing to buy shares.

1973-4: After Bretton Woods

The collapse of the Bretton Woods system was compounded by the oil crisis and inflation. Equities fell 45 per cent between January 1973 and December 1974.

Portents of Doom: In a historic context, it is hard to say that equities were expensive, but they had only fairly recently reversed the yield gap – in other words, were trading on a lower yield than gilts. The main portent was the collapse of the Bretton Woods fixed-rate exchange rate mechanism as the US leaked gold to Europe while imports boomed. There was little household or government debt by today’s standards.

1929: The Great Crash

Still a subject of debate and study for economists, the Great Crash saw the Dow fall by 85 per cent in 35 months, starting with a 25 per cent drop in three days.

Portents of Doom: The Dow traded at 32.6x earnings and many of those earnings proved fleeting. Consumers were borrowing to buy shares.

2019?

We learn from this that the most damaging crashes are not always slow and gentle bear-market slides – they can be sudden. We might also conclude that bull markets do not die of old age but, usually, from debt and shocks.

Heading into 2019, debt feels less of an issue than historically. Modern large growth companies are less constrained by capital – their businesses are more reliant on intangible assets like brand recognition than expensive, heavy-duty factories. Many have strong balance sheets.

Previous crashes have been signalled by speculative consumer borrowing but few households have high levels of debt today. Total US debt is higher than it was at the time of the global financial crisis, but most is where you want it to be – in the hands of government ($27tn worth). Future generations must repay the principal somehow, but interest rates are modest so affordability is easy, for now.

It is probably shocks that should concern us most.

Breakdowns in currency arrangements (Bretton Woods) have led to market collapses and there remains the potential for this in the Eurozone. Trade disputes can be painful (Opec crisis); Trump and Xi may have signed a temporary truce but their trade war still poses a threat. Rapidly rising inflation could be damaging, but it remains contained for now.

Valuations

As for equity valuations – they may not trigger a crash but they are useful portents of doom. The S&P currently trades on a multiple of 16x next year’s earnings, with the UK on 12x and Japan 16x. Equities continue to yield significantly more than government bonds. On these valuations, a recession would be unhelpful, but not devastating.

As in the past there are pockets of the market that have experienced irrational exuberance. Despite the recent correction, can Tesla and Amazon justify their valuations? Tesla has a market cap of $61bn and sells $17bn worth of cars annually. GM has a smaller market cap of $51bn but sells $145bn worth of cars a year and offers nearly 4 per cent yield. Amazon is on a P/E of 110 and delivers no yield – compared with Apple, reportedly sitting on $244bn cash, offering about 1.5 per cent yield on a multiple of just 15.

In short, we think it is a bit early (and potentially costly from an investment perspective) to be heading for the beach. You should, however, keep a close eye on valuations in 2019.

Running your winners is a time-honoured tradition of good investment management, but it can result in a handful of stocks taking up a large proportion of your portfolio on inflated prices. In a crash multiples and earnings tumble in tandem, meaning these overpriced companies fall hardest.

It can be emotionally difficult selling a popular stock whose price has outrun its obvious value, especially when it continues its upward trajectory, but global equity managers can usually find alternative, fairer value options somewhere.

When they cannot is when it's time to dig out your sun cream. 

Simon Edelsten is manager of the Artemis Global Select Fund and the Mid Wynd International Investment Trust - find out more by clicking on the links. 

 

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