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Three markets that could predict the future

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The recent rebound in stock markets has investors across the City wondering if this is the real thing ? or if it's just a short-lived bear market rally destined to fizzle out any day now.

Identifying the bottom of any market isn't easy. But if anyone should be in with a chance, it's Russell Napier. In 2005, the CLSA analyst published Anatomy of the Bear in which he studied the market conditions surrounding the ultimate bottoms of four previous US bear markets ? it's well worth a read.

I was at a conference recently at which Napier gave his views. He reckons there are three specific markets you should watch when trying to identify when conditions are ripe for stock market recovery. They are: the corporate bonds market; commodities, particularly copper; and inflation-linked bonds.

Corporate bonds tend to bottom just before shares

The corporate bond market is a particularly gifted forecaster of market recovery. Bond market investors tend to be more rational than their equity market counterparties. The equity market is prone to all sorts of wild stories, tips, ramps and rumours, whereas the bond market is a comparatively placid place where cool mathematics tends to reign (well, at least it was until the subprime crisis tipped it into the abyss.)

Why more rational? Probably because corporate bond investors have much more to lose. If their credit analysis is correct and they buy a corporate bond, then they stand to make a small return above cash rates as an annual coupon payment. If they buy the bonds below par and hold to maturity, they stand to make a relatively modest capital gain.

But if their credit analysis is incorrect and the issuer defaults, they run the risk of losing everything. They have a comparatively modest upside; but a catastrophic downside. So maybe that's why bond investors, as a whole, tend to spend more time thinking about company fundamentals than their stock market peers.

In any event, the corporate bond market has an uncanny history of marking turning points in other markets.

In 1974 for example, the corporate bond market bottomed just two months before the stock market. In the early 1980s, it was a similar story, although the corporate bond bottom came around 10 months before the stock market stopped falling. There was a similar pattern during the recession of the early 1990s.

The evidence is the same for older bear markets. US corporate bonds bottomed in June 1921. The stock market bottomed in August 1921. And it was the same in 1932. The bond market reached its low in May and the stock market duly troughed in July.

The predictive powers of Dr Copper

The commodities markets show the same trend. Deflation (or perhaps more properly the fear of deflation) kills equities and commodities, but as and when the market starts to scent a turnaround in the prospects for inflation, commodities are quick to recover. Copper, known as 'Doctor Copper' for its correlation to the broader economy (people say it has a PhD in economics), is a leading indicator.

The third and final piece of the jigsaw is inflation-linked bonds, which in the US market are called TIPS (US Treasury Inflation Protected Securities). During the deflationary phase, conventional (i.e. fixed-coupon) bonds rally, as a fall in the general level of prices and interest rates makes those fixed coupons worth more. At the same time, inflation-linked bond prices collapse. But as and when the bond market starts to sniff the return of inflation, the process goes into reverse. Arguably, we are close to that point now.

So we can debate whether quantitative easing or colossal fiscal and monetary stimulus will trigger inflation or will be powerless to prevent deflation, but at the end of the day, simple price action (from corporate bonds, commodities, and inflation-linked bonds) will give the definitive answer.

There are early indications, though perhaps no more than straws in the wind, that we are close to this sort of key turning point. It is certainly my view that in a fiat (i.e. government-backed) currency world, there is a natural bias to inflation in the system, and no one can accuse the authorities globally of inaction now in the form of stimulus.

But we're not out of the woods yet

To cut to the chase in terms of market direction, Napier believes the conditions are in place for the bear market rally we're seeing now to continue. But this is a tactical (i.e. relatively short term) view, rather than a strategic (secular) view.

Taking the longer view, his outlook is less sanguine. He expects that the ultimate low in US markets, for example, will be at around 400 on the S&P 500 Index. That is more than 50% below where the market is currently trading ? albeit he doesn't expect us to get there until around 2014 or so. That would take the market down to the sort of 'revulsion' low valuation (the point where everyone is sick of losing money in stocks basically) that has marked the bottom of previous historic bear cycles.

If he's right, you have plenty of time to trade and reallocate your portfolio to take advantage of a bear market bounce in the meantime. But this also reinforces the fact that you need exposure to investments other than just equities as part of a balanced portfolio.

So what should you buy? Well, I've recently raised the proportion of my own portfolio devoted to investing in stocks. But I've been balancing that out with various classes of bonds, as well as a few funds run by some of the smartest investors around.

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