8 February 2018
Reality Check
Bear market or buying opportunity?
by Frank O’Nomics
No one likes a clever dick. Don’t worry – this is not one of those “I told you so” kind of articles, where a smug Cassandra finally has their day in the sun, when a market does what they said it might. The truth is, one can keep calling the top of the global equity market and eventually the correction will come, but there is a danger of missing out on a great deal of performance over the course of the process. This week saw the largest one day fall in US stocks for over 6 years as the market, prompted by further strong labour market data, finally woke up to the fact that a robust economy is not always good for equities if it means a greater likelihood of inflation and interest rate rises. We highlighted this risk some weeks ago, the excessive valuations that equities were commanding while being vulnerable to central banks “taking away the punchbowl” from the global liquidity party. However, first of all, this is not the same as signaling an extended bear market (this is a correction not a rout), and, secondly, what happens in the US inevitably has repercussions elsewhere but the magnitude does not have to be the same. The UK in particular faces a different set of challenges and a much more modest growth outlook, something which may prove to be a virtue in terms of equity market volatility.
It is important to put the moves into perspective. A 4.6% fall in the Dow in one day has not been seen since August 2011. In terms of points (1,597) it was the largest one day drop ever, wiping $1.25trn off the value of stocks and, on top of the falls seen last week, now means that all of this calendar year’s gains have been erased. However, in percentage terms the S&P has seen 32 bigger one-day falls in the last 30 years and the US market is still up 20% over a 12-month period, so it is only recent investors who are suffering proper losses. The moves in FTSE, while more modest, are perhaps more significant; at one stage on Tuesday £60 billion had been wiped off the value of FTSE, briefly putting levels back to those of late 2016 and, even after a bounce, the UK market is at levels seen in April of last year. Participants in both markets are left wondering whether this is the time to get out. High profile traders such as Paul Tudor Jones talk of a financial bubble being played out along the lines of Japan in 1989 and the US in 1999.
People will always argue that “this time its different” and in this instance they have a point. In the US the economic backdrop of steady, rather than spectacular growth and a very supportive tax regime (effectively a tax cut of $1.5trn) is not disappearing and, while the inflation outlook looks to have turned, the change does not seem sufficient to warrant anything more than the 3-4 rates rises that the market had been expecting. The inflation pressure in part comes from a pick-up in wages, but is also a function of a weak dollar – a factor that has been supporting US exports. Neither of these factors features in the UK. Wage growth still remains relatively benign, forecast to pick up from 2.3% last year to 2.7% this year, and sterling has managed to stabilise in recent months. From an economic growth point of view, the UK looks to be in a very different position, with the forward looking purchasing managers indices showing a weakening in prospects for services, manufacturing and construction. This does not mean that the Bank of England won’t be looking to raise rates, but current expectations are for just 2 quarter point moves this year, and there is no sign of the unwind of quantitative easing planned for the US, leaving domestic monetary policy very accommodative. The problem for UK equities is more likely to be a lack of growth rather than too much of it leading to inflation and excessive rate rises.
There does seem to be some element of markets being again victims of developments in financial engineering. Heavy inflows into US equities in January pushed trading models into extreme overbought territory, so that once the data triggered some initial selling, computer-driven programme trades kicked in to exacerbate the move, turning it into a “flash crash”. Those who suffered most were the many traders who had been making steady money by being short of the Vix, the so-called “Fear Index”, who will have been forced to cover positions by the index surging, at one point, by 124%.
As ever, the real problem lies in uncertainty. The US has to wait some weeks to hear the pronouncements of the new Fed chairman, Jerome Powell, and the UK continues to be concerned by the potential outcomes of Brexit deals. The US is likely to gain some clarity way sooner than the UK and hence it might be easier for the Dow to recover. From a cyclically-adjusted price earnings perspective, the US market remains expensive even after the sell-off, but in both markets the weight of investment money needing a home has not diminished and the alternatives of cash or bonds are still nothing like sufficiently attractive. The bottom line then is that this week’s fall in equity markets probably represents something of a buying opportunity, at least for the medium-term. Analysis by Schroder’s shows that buying after previous one-day falls of the magnitude seen this week has typically delivered returns in excess of 25% over the following 12 months. While this period of increased volatility has probably not yet fully played out, the greater risk still remains being out of a rising market rather than being stuck in one that is falling. Recessions trigger bear markets – not programme trades.
