January 29, 2010 Downunder Daily

Last Drinks

Either a bear market has started, or we think it will before mid-year. For now, our hunch is that markets will recover their poise, and investors will be able to sell at higher levels than now. Some thoughts: First, a reminder of our framework: we don’t think that developed equities have started an extended bull market. We see the rise from March 2009 as a typical relief rally that follows major bear markets. Those relief rallies can occur regardless of underlying macro conditions, regardless of liquidity conditions and – most importantly – regardless of what happens next. The fundamentals did improve this time – systemic financial crisis ended – but we think risk assets have swung to pricing a better outlook than is likely.

Exhibit 1, from our colleague Teun Draaisma, shows the typical pattern. The average initial relief rally is around 70%. Most developed equity markets saw a rally of that scale. The developed MSCI index gained 77%; emerging markets did significantly better (Exhibit 2).

After the relief rally there is, on average, a 25% pull-back – so, technically, a new bear market. That’s what we expect at some stage this year. Thereafter, the pattern varies. Our view is that a return to the lows is not likely –not out of the question, but a tail risk only – but nor will a new bull market start. We expect an extended period of range-bound markets, as shown in Exhibit 1. Given this framework, we’re on high alert for signs that a 20-25% decline is in the offing.

Teun moved this week: he recommended going underweight European equities on a six month view, although he acknowledged that equities may be a little stronger in the near term. Teun’s shift was because policy makers are shifting away from maximum support for risk assets. This includes the start of conventional tightening in Asia and increased taxes and regulation in the west. Teun’s end-2010 price target implies a 7% drop in European equities from here. (See Sell Into Strength As The Tightening Has Started, 25 January.)

We agree that equities are likely to be lower in six months. However, at the risk of being too cute or greedy, we’d like to see one more sign before selling. We’re waiting for a deceleration in the leading indicators that have been highly correlated with risk assets over the past 18 months.

This reflects our slightly different emphasis to some of our colleagues. We agree that policy tightening will not be good for equities, but we’re not sure that, if that’s the key trigger, it’s
close enough in the west to sell now. It certainly is in Asia, hence Jonathan Garner’s call to be underweight Asia within an EM portfolio. But in developed economies there appear few signs of markets bringing forward their forecasts for tighter monetary policy. In the US, it’s the reverse: the implied yield on Fed funds futures have fallen to contract lows (Exhibit 3).

This rally in rate futures has occurred as the macro data have disappointed, at least in Europe and the US (Exhibit 4). Of the recent key US monthly statistics, only the ISM index surprised
on the upside. In our view, recent (western) equity weakness could be as much about growth concerns as the end of easing.

If that’s the case, then there could one more leg up for stocks. Yes, our big picture view is that the western-world recovery will be disappointingly tepid, but recent softness may be due in part
to an unseasonable cold winter. Exhibit 5 shows the historical correlation between US data surprises and weather conditions. If cold weather has cooled the data, then a return to usual
weather could lead to better data in the near-term. If equities manage to stabilize, then there could be a 10% or so move higher. Ultimately, we think equities have priced in much of this strength, having tracked leading indicators higher through the past year (Exhibit 6). If, as we expect, those leading indicators start to wobble, we’ll have a compelling case to sell.

We don’t want to over-emphasise this. On a six month view we think developed world equities will be lower. However, in a market where we expect less trend and more volatility, we’re aiming to finesse our shift to a bearish view on the market.