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Grounds for Optimism

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Grounds For Optimism (FT Column)

This is the original version of my latest FT column, and is I suppose the nearest I have been to a unqualified market call for some time (I always bear in mind Galbraith's famous comment that economists forecast "not because they are know, but because they are asked"). My friend Jim Rogers, I see, talks in the latest issue of Barron's about this probably being "a bottom, but not necessarily the bottom", which is about where I come out too. Too risky, in any event, to be completely out of equities at this point.

The view expressed by this column at the start of 2007 was that it would be a good year for professional investors to study how bull markets end and to start preparing for that outcome. That turned out to be not a bad call, even though in the event it was not until the last quarter of the year that the market averages finally peaked and the financial crisis, in all its fury, started to spill over into the real economy.

The challenge for investors now is clearly to try and understand what lessons can be learnt from the way that bear markets bottom out and to prepare for that eventuality instead. After a traumatic first two months of the year, the markets have since caught a new mood of optimism ? and there are, increasingly, some solid reasons to believe that this time they may be right to display that optimism.

Most bear markets, intriguingly, seem to display a number of common features. For example, they start out declining at a relatively slow pace and then accelerate. A typical pattern is for two thirds of the overall decline to be concentrated into the final third of the bear market?s duration.
While there have been bear markets that last more than 18 months, it is usually unwise ? and increasingly risky ? to act on the assumption that they will last much longer than that.

The reason is that the risks of missing out on what is often a rapid recovery in the first stages of a new bull market soon begins to outweigh the risk of further falls in the ageing bear market that preceded it. The scramble by underinvested professional investors to get back into stocks is one of the engines that typically then drives the equity markets back up to a higher level.

If you believe in these two simple metrics, the current bear market is acting true to form. The S&P 500 index, for example, peaked precisely 18 months ago, at 1565. Eleven and a half months later, in late August 2008, it had fallen to around 1200, a decline of just over 20%. From then until its recent low, at 676, it has fallen a further 44%. The Dow Jones index peaked a month later than the S&P index, but has followed a broadly similar pattern since, as has the MSCI World index.

From peak to trough, the US money manager Ken Fisher points out, it is unusual for the monthly rate of decline in the market averages during a bear market to exceed 2.5% to 3%. At the time of the lows in early March, the S&P 500 index had fallen at a rate of more than 3.5% since its peak in the autumn of 2007. This seems to imply that the risk of the market falling through its March lows any time soon is now relatively slim. It is certainly consistent
with the view that equity markets were horribly oversold at the end of February.

Of course historical precedents are made to be broken, and there are big differences in the regulatory, political and corporate environment compared to that which prevailed during the great bear markets of the past. Nevertheless the historical experience cannot be ignored. Russell Napier?s in-depth study of the four most extreme bear market bottoms in 20th century history (1921, 1932, 1949 and 1982) throws up further interesting pointers to what might be happening today.

His thesis is that the engine which drives bear markets to extreme lows is the fear of deflation. Once that threat recedes, or at least is no longer perceived to be real, it creates the conditions in which equity markets can recover. They typically won?t do so until (or unless) corporate bonds and commodity prices also improve. In the modern era, it is logical also to expect that the receding threat of deflation will be reflected in the price of index-linked Government bonds and
other measures of inflationary expectations.

In recent weeks all three of these market indicators have started to move in the right direction. While that does not prove that the bear market has ended, it is certainly not inconsistent with such an outcome. It provides the clearest of warning signs to the professional community that being out of the market is indeed becoming a significant risk for those willing to assume equity risk.

It is worth emphasising that the bear markets under discussion are medium rather than long term cycles. Mr Napier, for example, does not believe that we have seen an end to the long term bear market in equities that began in 2000. He does not expect the current generation?s equivalent of the four great market bottoms of the 20th century to hit for another five years or so, when the great bull market in bonds that began in 1981 finally runs its course and the dollar is abandoned as the world?s reserve currency.

If you thought what has happened so far is bad, in other words, there may well be worse to come. Today?s equity market valuations are still not as low as they typically fall to at the bottom of history?s worst bear market experiences. The issue however is whether there is money to be safely made from equities over the next 18-24 months and on that point, even without a crystal ball, and notwithstanding the huge uncertainties surrounding the real economy, the omens look much more positive than before.

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