In our research publications we aim to provide you with insights from a variety of different viewpoints. In this edition of CA Answers, two members of our research team debate whether markets have entered a new bear phase.
Eric Winig: It’s a new bear. Although the post-2009 period has featured several sell-offs that looked scary but ultimately turned into speedbumps (e.g., 2011), the current downturn is different. Global deflationary forces are gaining strength, creating difficult conditions for risk assets.
The first hint of growing deflation was the sharp and sustained collapse in the price of oil, which has not only wreaked havoc on the global energy sector, but is also sending a negative message about global growth. This is corroborated by the sharply slowing—and potentially contracting—Chinese economy, as well as the “stall-speed” US economy, which grew less than two-tenths of a percentage point in the fourth quarter (the widely cited 0.7% growth rate is an annualized figure). Indeed, I find it hard to credit arguments that the US economy is “strong” or even “improving.” Most economic data outside the monthly employment report and the services sector—in other words, measures that look at people actually making or buying something tangible—are pointing in the same direction: down.
Of course, the economy is not the market, but there are distress signals elsewhere as well. Soaring yields for high-yield debt, the third straight quarter of falling earnings for S&P 500 firms, the recent collapse of several of the highflying technology stocks, the plunging Chinese equity market, trouble in other emerging markets, the European Central Bank’s December “disappointment” to markets followed by an about-face when markets fell . . . the list goes on. The most recent worrisome sign was the Bank of Japan’s decision to implement negative rates mere days after insisting it had no such plans.
The situation strikes me as pretty simple: global central banks pegging policy rates at or near zero for six-plus years and engaging in various forms of quantitative easing simply delayed and exacerbated existing problems, and now the bill is coming due. There is nothing new about this—indeed, this is the third example of massive capital misallocation in the past two decades, and we know how the first two ended. No matter how many times they are tried, lower interest rates and “QE” do not create new wealth, but instead reallocate and destroy existing wealth.
The arguments for why equities are not in a bear market, meanwhile, ring increasingly hollow, and remind me of the beginning of the 2000 and 2008 downturns, when collapsing Internet stocks and the imploding housing sector were explained away for any number of reasons (remember when the crisis in subprime mortgages was “contained”?). The most common explanations today are that the rise in high-yield spreads is contained to the energy sector, the US (and European) economy is doing just fine, and Chinese authorities will not allow things to get out of control.
As Charles Gave of GaveKal Research recently put it, “In every bear market that I have seen in my long career [ed. note: this encompasses the 1973–74 market], the explanations given in the early stages of the sell-off for the decline in equity prices later turned out to be completely and utterly wrong.”
Valuations for many risk assets, meanwhile, remain high, and will almost certainly turn out to be understated (i.e., higher than they look) in the event of a financial/economic crisis.
Gave recommends (and I would concur) holding long-term sovereign bonds. While it is of course possible markets will right themselves once again—likely with “official” support—most investors remain overweight risk assets in general, and as such have little protection against a deflationary downturn. Yes, Treasury yields are low, but as Gave quips, “My recommendation is to own assets that go up when the stock market goes down. Unfortunately, I haven’t found that many of them.”
Stephen Saint-Leger: The conditions for a bear market are not in place. US equities, which tend to lead other markets, are simply reflecting the healthy rebalancing that is underway from producers to consumers. If overproduction both in China and amongst oil producers is being pared back and Wall Street has gotten ahead of itself in terms of valuations, then these twin resets are fundamentally positive for the long term.
The latest bull market that began on 9 March 2009 at 677 on the S&P 500 and reached a closing high of 2,131 on 21 May 2015 is not dead but is just resting, having gotten a little out of breath. There have been plenty of hiccups in this bull, such as the scary dive in 2011 my colleague Eric mentions, when the S&P 500 fell nearly 20% from April to October, a threshold often viewed as the technical definition of a bear market. The fall happened quickly, and the market took ten months to regain its previous peak, but few think it was a “true” bear market.
Of course, there is no real definition of a bear market, but, rather like the “duck test,” you know one when you see one. It has something to do with the length of time to reclaim the previous high (several years), as well as amplitude of the drawdown—even more so in an era of machine trading, momentum, and flash crashes. To my mind, a real bear affects investor psychology. It is a market that goes down far enough for long enough that investors begin to doubt the wisdom of sticking to their long-term asset allocation strategy; such a market successfully undermines the will of asset owners to “hold on” through the valley. Both March 2000 – October 2002 and October 2007 – March 2009 were real bears for US equities. It took years for investors to recoup their losses and, with them, their investment beliefs. The arrival of a bear usually coincides with the implosion of an investment mania, rampant bullishness at the top, and economic recessions. Certainly the first two conditions were not fulfilled in 2015, and while recent growth may be a little soft, rumours of an impending recession are premature.
The US economy is not in bad shape overall, even if it is not firing on all cylinders and has disappointed the “back to business as usual” optimists. Growth in 2015 was a respectable 2.4% for a second year in a row. It is true this was dragged lower by weak exports as other parts of the global economy (emerging markets) slowed and the strong US dollar impacted the top line and hence earnings of some large multinationals.
The plunge in oil prices no doubt exacerbated a decrease in business investment. For all of 2015, spending on mining and oil-extracting structures fell by 36%—the most in three decades. Yes, oil has fallen from over $100 to around $30 in short order. But this is because supply went through the roof (+2.6 million barrels/day), outstripping the growth in demand and bloating inventories, not because of an economic crash à la 2008. The International Energy Agency is still projecting demand growth of 1.2 million barrels/day this year (partly in response to low prices and reflected in the renewed boom in SUV sales), and even if Iran is ramping up supply, thereby delaying the rebalancing of the market, the downside is now much more limited.
According the US Department of Commerce, overall business investment contracted at an annual rate of -1.8% in the fourth quarter, dragging down US growth to 0.7% annualised. Fortunately, consumer demand, which represents the lion’s share of the economy, took up the slack (+2.2% annualised), more than offsetting this and the drag from businesses trimming slightly bloated inventories. Consumer confidence is holding up well, supported by a solid jobs market and very low inflation, courtesy of falling gasoline prices. After-tax income of American households adjusted for inflation rose 3.5% in 2015, the most since 2006.
Of course, the plunge in oil prices has caused a massive redistribution of income and wealth between producing and consuming countries, but also within consuming countries. The fall is bad not only for energy companies, but also asset managers (loss of oil-related sovereign wealth fund assets) and banks (energy-related finance), and yes, owners of junk bonds which everyone knew were, well, junk. In short, it is also a transfer from Wall Street to Main Street, which, in what is turning out to be an unusual election year, may be no bad thing.
As for the risks from China, while limited transparency means one cannot rule out further bad “surprises,” the country remains enough of a command economy with ample reserves to avoid a crisis, for now at least. Bear in mind that total Chinese debt to GDP is lower than that of many large developed countries. While China’s much needed restructuring away from overinvestment in construction and manufacturing towards services and consumption is rebalancing the global economy, this is a healthy long-term development and is unlikely to cause a real bear in the short term.
The market may indeed grind lower over several more months, and volatility will probably remain elevated as markets (and central banks) react to data, but barring a political shock somewhere, or the consumer losing her nerve, it is too early to call this a real bear.
Eric Winig and Stephen Saint-Leger are Managing Directors on the Cambridge Associates Global Investment Research team.