Following an initial 21 per cent fall, the stock market continues to gyrate frantically.
Following an initial 21 per cent fall, the stock market continues to gyrate frantically.
It has long been recognised that both markets and economic conditions move in regular and somewhat predictable cycles of activity. It is instructional to step back from the hurly-burly of everyday trade to check what is actually happening and where we are in the market cycle.
The All Ordinaries Index peaked last November, when the high point was driven by takeover speculation in BHP and Rio Tinto, but the beginnings of this new bear market phase began last August, precipitated by a failure of the US sub-prime lending market. This bear phase could continue for a further nine to 14 months and the All Ordinaries Index will almost certainly record new lows before this bear market reaches its nadir, with a target of 4,600 on the All Ords looking possible.
Bear markets generally progress in two downward legs, broken by one big bear trap. Briefcase believes we have almost certainly witnessed the first downward move and we are now in an intermediate, bear trap phase, which has sucked in the last of the bulls, before whacking the market into a final downward move, at which point the final bull will have capitulated.
Stock market cycles typically run for four to five years from base to base, but can stretch out to seven years or compress to 3.5 years. Typically, the market rises in three steps and falls in two. Experienced investors look to the multiples that are likely to appear at the top and the bottom of each cycle for exit and entry points. Invariably, bear markets push the share price of good companies with solid balance sheets and healthy cash flows down to the point where they trade on price to earnings (PER) multiples of eight to 12 times historical earnings and offer dividend yields of 5 per cent to 8 per cent.
At the top of most market cycles, many good companies can have an earnings yield of less than 5 per cent (inverse of PER), when notionally it takes 20 years, at the current earnings rate, to ‘earn’ back an amount equal to the share price paid. That is expensive.
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The economic cycle follows the market cycle, typically with a lag of nine to 24 months. Thus, the crash of late 1929, led to a global recession with its nadir in 1932 and the crash of late 1987 preceded global economic weakness in 1990-91.
At the bottom of the market cycle, selected stock prices offer spectacular, once-in-a-generation type value, and this is where we are headed now. Some companies will trade close to, or at a discount to, their asset backing. Investors remain cautious, risk is highly priced and bears rule the market, as the last bulls have been vanquished.
Newspapers are full of gloomy predictions about continuing poor earnings, factory closures, rising unemployment and labour disputes. All of these factors are lagging indicators, reflecting conditions six months prior and not six months hence. At this point, smart money moves into shares of boring, basic industries, looking for value and not momentum. This action lifts the market, but most investors are unsure whether the move is just another bear trap or the beginning of a new bull market. By the time a bull market is declared, the market is up 20 to 30 per cent over a period of six to 12 months, from its cyclical lows. This move is finally met by selling, which pushes the market moderately down as cautious bears quit stocks which may have recovered and traders lock in useful profits.
The second leg of a bull market is usually a longer and more sustained affair, supported by ongoing news of corporate earning growth, falling unemployment and rising commodity prices. This move comes to an end when value investors begin to take money out of the market, reallocating into property or other assets, as worries mount about how long the bull market might run. So again we see the market rising through a wall of worry about its near-term health.
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Through much of 2006 and the first seven months of 2007 we all experienced the final and most exciting leg of a bull market. Corporate earnings growth still drives the market but valuation multiples become stretched and the whole circus is usually fuelled by cheap money or lax lending practices.
Analysts select ‘buy’ recommendations by reference to the relative rating of peer companies, oblivious to the overvalued nature of the whole market.
Good companies, that might normally be expected to trade at PER multiples of 12-14 times their historical earnings are pushed to 20 times and beyond. Recent examples of this can be seen with companies such as United Group, Leighton and WorleyParsons.
The market is now typically subject to bubbles of investment activity swirling around commodities, property or new technology. During the past two years we witnessed money running from oil to nickel and then to iron ore and over to uranium and then back into iron ore again, all underpinned by demand growth from China.
In 1999 and 2000, the bubble was associated with technology, media and telecommunications. Failed companies such as Eisa Ltd, NewTel, OneTel and Thin Technologies were floated and market strength was driven almost exclusively by Telstra and News Corp, along with the banks. The Poseidon boom of 1969 was inspired by nickel exploration, while the bull market of 1987 was led by property and mining entrepreneurs, such as Adelaide Steamship, Bell Group, Elders Resources, Westmex, Quintex and Bond Corporation.
At the top of the market, analysts find difficulty valuing new companies by traditional means. There is often reference to a new business paradigm, which is meant to negate the ‘old ways’ of doing business and determining value. Since so many new companies will not generate earnings for many years, analysts resort to ridiculous valuation methods such as price to turnover or expected turnover, market capitalisation per customer, or they just say ‘feel the vibe’.
The bull market often comes to an end when some exogenous or unpredictable event upsets confidence. Often the market top coincides with a rise in interest rates and indeed, the top of the 2007 bull market was signalled by the sub-prime crisis, which had the effect of raising interest rates and restricting lending.
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During a bear market, all the villains of the bull market are exposed. Companies which have been performing some sort of pea and thimble act, such as MFS or Enron, come to grief. Brokers and financial institutions feel the heat.
In 1991, Westpac nearly went bust and in the current bear phase, we have already seen stresses at stock broker Tricom and no doubt, others will follow in waves. During 2008, we are likely to witness a series of corporate failures. Investors should wait and watch for that golden entrance opportunity after setting target price levels for favoured companies.
So long as you know that the management has a plan and the company generates adequate operating cash flow to run the business and comfortably cover its dividend payments, all should be well. Remember, at the top of the market cycle, valuations are ridiculously high, so at the bottom, selected valuations will be inexplicably low. Watch, wait and take advantage as ‘Mr Market’ provides the opportunities and you will get the chance to set up your portfolio for a 10-year glory run.
• Peter Strachan is the author of subscription-based analyst brief StockAnalysis, further information can be found at Stockanalysis.com.au
