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OPPORTUNITIES IN A BEAR MARKET AND RECESSION

A difficult start to 2008 is generating opportunities
The turbulence in financial markets, which started last summer, has shown few signs of abating. Problems which were initially centred on US sub-prime mortgage markets have spread to the financial sector, equity markets and the real economy.

So far 2008 has been a roller coaster for both fund managers and investors. Equity markets have been extremely volatile. Since reaching a peak of 6732 in June 2007, the FTSE 100 had fallen 19% by March 2008. It then rose 18% by mid May but had dipped below 5450 in early July, again down by over 19% since last year’s peak.

Indeed if, according to many commentators, an equity bear market is defined as a 20% drop in the level of the stock market, we have just seen the ninth such UK bear market in the last 40 years based on the FTSE All Share index. These turbulent conditions are now spreading to the real economy, most notably the tightening in credit conditions. This has resulted in a mortgage famine in the UK causing the number of both commercial and residential property transactions to fall, impacting property values.

Under these circumstances it is easy to dismiss equity and fixed income investment, but on closer inspection there are a number of sectors that have performed well and have in fact made significant gains in 2008 to support the wider market. In addition, the continuing indiscriminate, and in some cases extreme, sell-off in various sectors of the market means that there will be many companies and sectors trading at valuations which should be considered very attractive, especially when judged on a three to five year investment time horizon. As can be seen from the graph above, bear markets are a fairly regular interruption to the general upward market and investors with a long time horizon can benefit from the opportunities they present.

THE ANTICIPATION OF RECESSION OFTEN DEPRESSES STOCK MARKETS

The FTSE All Share Index, reflecting the performance of the overall UK equity market, shows nine bear markets since daily calculations began in 1969. The most recent one can be dated from the peak of the market, 3,478.99 on 15 June 2007, to the most recent low point of 2,777.55 on 17 March 2008 (based on data to 30 June 2008) - a 20.2% fall which may not yet be over.

Of the nine bear markets, there were six quite short ones, lasting a year or less, and three lasting over a year. The most recent bear market lasted over 30 months from September 2000 to March 2003. The economic and financial market characteristics of each of these varied enormously. That said, the current seems to share the characteristics of the short, sharp bear markets of 1987 and 1998 and that of the early 1990s. Turbulence in 1987 and 1998 centred on financial sector triggers, the stock market crash on Black Monday, 19 October 1987, and Russia’s default and the collapse of Long Term Capital Management (LTCM – a hedge fund) in 1998. In the early 1990s the housing market was particularly weak, triggering a bear market of similar magnitude but shorter in duration.

The behaviour of equity markets is often cited as a leading indicator of economies. In particular, weakness in the equity market is thought to signal the likelihood of a recession. This is not necessarily true, the imperfect linkage between the stock market and the economy has long been recognised by economists, with nine bear markets in the last 40 years, but only four recessions (defined as periods in which GDP has fallen by two or more consecutive quarters). Moreover, recent history shows that it’s often the anticipation of a recession that depresses stock markets, not the other way round.

TAKING ADVANTAGE OF THE RELATIONSHIP BETWEEN MARKETS & RECESSIONS

Some economists believe that parts of the global economy are already in a recession, the US being a prime example, but if history tells us anything this may be positive for equity markets.

In three of the last four US recessions, stocks actually gained ground. In the US recession from July 1990 to March 1991, for instance, the S&P 500 rose 4.5%, despite a severe sell-off in the summer of 1990. And in the recession from January to July of 1980, stocks climbed 6%.

Typically, US equities have tended to rebound or maintain momentum as the US economy emerges from a recession. Ned Davis Research in the USA looked at the last 10 recessions and found that stocks rose 24% on average, in the six months after hitting a recession low. Tim Hayes, Chief Investment Strategist at Ned Davis, said that while a recession could continue to pressure the stock market, “it could also lead to a great buying opportunity.”

Similarly in the UK, recessions are not necessarily bad for equity markets. Indeed, the UK equity market has risen in three of the last four recessions. Often, equity market valuations, such as the price to earnings ratio (p/e), rise in periods of weaker economic growth as investors ‘see through’ a temporary period of weaker corporate earnings. However, that is notably not the case at the moment. The price/earnings ratio on the UK equity market is currently close to historic lows, many companies having been down valued but still exhibiting strong earnings and balance sheets.


A BEAR MARKET OFFERS OPPORTUNITY

The Federal Reserve has been more aggressive in its rate cutting, aiming to shorten the duration and reduce the severity of the slowdown in the US. At the same time, the US Government has weighed in with a series of tax cuts to stimulate the economy. Even so, some would say they have been unable to prevent the inevitable. It would seem that the UK may be in a similar position.

Even if the local economy doesn’t slip into recession, the mere anticipation of it can have a profound effect on markets. Many experienced investors position themselves to take advantage of the inevitable ‘rebound’.

Nick Purves of Schroders highlighted this point, “It is very important to separate-out the outlook for the economy – which I agree looks poor – from that of share prices: these are very different things. A huge amount of bad news has already been priced into current share prices in anticipation of an economic slowdown.” The last recession in the UK was back in 1991-92 and in the early months the UK stock market did indeed decline, but whilst the economy continued to contract for almost two years the equity market rallied strongly.

Many of our fund managers believe that there is a time lag between markets discounting future downturns before finally bottoming-out and then, as investors realise events are not as bad as expected, embarking on a new bull market. But this is a window of opportunity for fund managers to buy stocks they like at low prices and then wait for the coming rally.
“You make your best investments when things appear to be at their darkest hour”, was a comment made by George Luckraft of AXA Framlington, summing up the need to remain focused on the long-term.