As equity investors ponder whether the recent (Aug 2009) pullback in equities is just a brief pause for breath in an extended rally, fixed-income markets are signalling a less optimistic view of the economy and the consumer.
Until late Aug 2009, equities had diverged from the bearish performance of corporate credit and steady decline in Treasury yields. Then, equities were hit by selling, a move which extended the weakness in credit and boosted government bonds further.
This split in thinking has long been a feature of trading across asset classes, with equities usually reflecting a more optimistic view of the economy and the consumer. But over the Aug 2009, the debate over the sustainability and strength of a recovery in economic activity has intensified.
Equities in Japan, Europe and the UK have also pulled back after a strong rebound from their lows in March 2009. While data from Japan, France and Germany show that their economies have pulled out of a recession, doubts remain about how quickly activity will normalise. There are a number of headwinds in the economy and they are not really going away very quickly or easily.
Economists expect the US will expand in the third quarter 2009, as low inventories are built back up, but recent US data (Aug 2009) has highlighted weak consumption and tighter credit standards. The latest Federal Reserve loan officers survey for the three months ending July 2009, revealed further tightening in lending conditions.
Against a backdrop of high and rising unemployment and declining real incomes, it would be a leap of faith to suggest that this situation is going to change any time soon.
That has fuelled a Treasury rally, with the yield on the 10-year Treasury note back below 3.50 per cent, down from near 3.90 per cent at the end of the first week of August 2009. Once you stabilise, the recession ends, but the reality is that US face very weak growth as consumer balance sheets take time to adjust. There have been solid inflows into Treasuries since yields recently (Aug 2009) peaked.
Institutional investors such as Pimco have recently sought to lower their risk to some areas of the credit market, such as high yield, which has rallied more than 30 per cent this year (Till Aug 2009). High yield has been the winner of the year and it's time to turn cautious.
The second half of the year (2009) is going to see choppy waters for credit and that is a function of the economic reality being pretty weak with credit being range bound.
For many companies, however, cost-cutting translates into slashing jobs or wages, and the bleak employment picture, in turn, weighs heavily on consumer spending and confidence.
Consumers in different income groups have their own reasons to keep a lid on spending, be it high unemployment in the low-income segment, the overlevered balance sheets of the middle class, and lost wealth and fears of tax hikes among high earners.
US Equities have yet to fully reflect the consequences of declining nominal sales and incomes, which in part was evident in the economic data from the latter part of last week (Aug 2009).
The bank warns: "In particular, with an absence of corporate cheerleading for the next couple of months (Sept 2009 & Beyond), the economic news will likely need to improve somewhat for equities to make much headway during the tricky months of September and October 2009.”
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In the past five months (March 2009 – July 2009), the world’s stock markets have gained more than 50 per cent. The big question now (Aug 2009) is: where next? This rally is not unprecedented but history offers few comparisons. Those that exist are all imperfect and contradict each other. But rallies in the last century stand out:
1930. In the wake of the Great Crash, the S&P 500 staged a rally a lot like this one. From its low on November 12 1929, it rallied 47.2 per cent in five months. This fooled many. Anyone who bought at the top of the rally, on April 10 1930, would have lost 83 per cent over the next two years. If there is a rally for the bears to cite in their cause, this is it.
1932. Marking the very bottom of the 1930s’ bear market and arguably the most impressive rally in stock market history, the S&P did twice as well as in this current rally (March 2009 – July 2009), in half the time. It rose by 111 per cent in the 10 weeks from July 8.
This time (March 2009 – July 2009), the lows were never revisited. But the outlook was not good. After that violent upswing, just before the election of Franklin D. Roosevelt, the bear market dragged on for decades, with gains only for opportunists. The S&P fell 25 per cent once more by the end of 1932 and it would fall below its level of September 1932 in 1934 and again in 1938. This was not a great time to buy and hold.
1975. After the savage 1973-74 bear market, stocks enjoyed a 53.8 per cent rally from October 12 1974 to July 15 1975. In one five-month span, it gained 47.1 per cent.
In hindsight, it looks like a cousin of the 1932 rally, as the rally gave way to a bear market that ground on for the rest of the decade. Stocks were no higher three years later. Profits were only for opportunists.
1982. With Paul Volcker at the Federal Reserve still attacking inflation, and Margaret Thatcher and Ronald Reagan applying unpopular economic medicine, the 15-year bear market suddenly ended.
In the five months after August 12 1982, the S&P gained 43 per cent, starting a secular bull market that lasted until the tech bubble burst 18 years later. August 1982 was possibly the best time ever to buy stocks; early 1983 was still a good time.
This is the rally that bulls call to their aid. Those alarmed by the potential for fresh crises in emerging markets can even point out that this rally survived the first great Mexican devaluation crisis, which hit in the early weeks of the equity rally.
What did these rallies have in common?
Pessimism had grown overwhelmingly, with fear far outbalancing greed when they started. Except for 1930, they came near the end of severe recessions. They have both points in common with the current (March 2009 – July 2009) rally.
But there are differences. The rallies of 1932, 1975 and 1982 came when stocks were unambiguously cheap, and were still cheap after the initial 50 per cent rally. The cyclically adjusted price/earnings ratio, a multiple of average earnings over 10 years, was at extreme lows.
But in 1930, stocks never dropped to long-term fair value before rallying and were blatantly expensive by the time the rally ended. This time, prices fell a bit below their long-term average for a few months but the rally has already brought them back to look expensive.
In the critical sense of valuation, then, this rally (March 2009 – July 2009) looks nothing like 1932, 1975 or 1982. It looks a little more like 1930.
The environment of inflation and interest rates differed widely. In 1930, western economies were lapsing into deflation; in 1932, the world was mired in deflation; in 1975, it was stuck in inflation; and in 1982, inflation was high but coming under control.
The current (March 2009 – July 2009) picture does not fit with any of these – consumer price inflation in the west has been tame for decades. Last year (2008)’s crisis created the risk of severe deflation but the prompt decision by governments to throw money at the problem is a huge point of difference from 1930. Those who believe the deflationary scenario can logically forecast a repeat of the 1930 collapse in share prices. But this is a pessimistic point of view.
Parallels with 1982 do not work any better. The 1980s’ huge gains from steadily lowering rates and innovation in the financial sector are not available this time around (2009). The very opposite is more likely.
The 1932 rally came in truly extreme conditions.
But the 1975 rally may be a decent match; it came during a restocking boom after companies had slashed inventories (very much what the market is betting on now (Aug 2009)), at a point when oil prices were volatile and exerting a big influence on the economy.
The world now (Aug 2009) is still different in many important respects from 1975 but this may just be the best comparison. That would suggest the most likely outcome now (Aug 2009) is a protracted dose of directionless trading. For those more optimistic or pessimistic, you have your examples to hang on to.
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