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The words ‘bear market’ and ‘recession’ have been floating around in financial media rather a lot over the past few months.
The prospect of a looming bear market scares countless investors witless and leaves them paralysed with fear, or causes them to abandon what were once high-quality, long-term investments in a desperate attempt to avoid the pain of further losses.
What most investors perhaps don’t realise is that the old adage “sell in May and go away” has never been truer than it was last year, as this was in fact when the current bear market started.
A bear market is defined as a market condition in which share prices are falling, and widespread pessimism causes negative sentiment to be self-sustaining.
As a rule of thumb, once a broad-based index – such as the MSCI All Countries World Index – has lost 20% from its highs over a period longer than two months, the market in general is considered to have entered a bear market.
The MSCI All Countries World index – the broadest possible measure of the state of world equity markets – has been on the decline since May 2015, and on 11 February this year officially entered into a bear market when it closed 20.2% down from its 21 May 2015 high.
The MSCI World Index (Daily Chart)
The MSCI World Index (Weekly Chart)
Sure enough, the index bounced higher the very next day, but nonetheless the bear market signal was triggered.
How did we get here?
Now, if you throw a rock into any random bush, about five analysts will jump out and each will offer you five vastly differing opinions on what happens next.
That’s a lot of uncertainty. So before we start throwing rocks around in an attempt to find the next most accurate lucky guesser, we should look at what has happened to get us to where we are now.
First of all, and probably the most obvious, is the sharp decline in oil prices.
This is something that one would normally believe to be good for the world economy as everything from electricity to transport and food prices should benefit from significantly cheaper energy.
To a large extent this has been the case as we see large developed economies struggle to attain any meaningful measure of inflation.
At the same time though, it causes other problems. The main risks here are the impact that thousands of potential job losses directly and indirectly connected to the oil industry could have on the world economy at large, and the knock-on effects that oil company bankruptcies could have on the financial sector.
Both are relatively difficult to measure and therefore not only exacerbate the fear around declining oil prices, but also spread to other asset classes such as equities and particularly banking shares.
The possibility also exists that the 70% decline in oil prices could destabilise or even topple governments. This would be, for lack of a better word, catastrophic.
China and the Fed
There is also the effect of a less accommodative monetary policy being adopted by the US Federal Reserve.
For seven years markets have been propped up by record low interest rates and quantitative easing (QE), which has come to a messy end.
First there was the tapering of QE which took some of the momentum out of equity markets, then QE came to a halt and finally the Fed moved to hike interest rates in December last year.
The ample stimulus that drove equity markets higher is no longer present and it seems that without ‘free money’ there is little impetus left to sustain a continued move higher.
The US is also struggling with low growth and low inflation, which bodes ill for equity markets.
Then there is also the reality that China is slowing down. The Chinese economy is slowing and gradually evolving into a consumer-driven economy.
Almost 50% of China’s population now lives in urban areas, which means that the demand for housing and infrastructure will likely never be as frantic as it once was.
The Chinese economy needs to transform itself into a service-driven economy, much like the US, and unfortunately this means that demand for resources may take many years to recover to the levels we enjoyed post the 2008 financial crisis.
This paints a grim outlook for companies and countries that are heavily dependent on the mining, production and export of these natural resources.
The world’s financial markets appear to be in trouble and, even more worryingly, seem to have been in trouble for the past eight months without anyone really noticing.
We’re all sitting up and paying attention now. But is it too late?
So what now?
Two possibilities exist for what happens next. The bearish case is a little more focused on the US market and looks rather dire.
According to a theory compiled by studying the writings of Charles Dow, the founder of The Wall Street Journal and co-founder of Dow-Jones & Company, we are in for some really difficult times.
The basic premise of this theory is that when the S&P 500 and the Russell 2000 Small- and Mid-Cap indices make new significant lows at approximately the same time, it signals the start of a bear market.
When looking at the two charts, we can see that the confirmation signal of a new bear market only came a few weeks ago, which would indicate that we have a lot more downside in equity markets to navigate and survive.
SPX Weekly
Russell 2000 Weekly
First it was the Russell 2000 Small- and Mid-Cap Index that broke down to form new significant lows.
A few weeks later the S&P 500 followed and also made new significant lows. Thus according to Dow Theory, the bear market has just begun.
Do the bulls have a point?
However, there is an alternative scenario which, as you probably have guessed, is bullish. It hinges on a few factors which, like so many things in financial markets, may or may not come to pass.
A US policy turnaround, or, a move by the Fed to reintroduce QE and even possibly set interest rates to negative – like so many other countries have done – combined with a sudden surge in Chinese demand for resources could be enough to save the day.
This seems very unlikely, but nonetheless it is possible. To lend credence to this possibility we need look no further than the MSCI All Countries World Index.
The last time that the MSCI All Countries World Index contracted during the period between April and August 2011, it fell some 21.3%.
Back then the fear of a double-dip recession was rife and central banks around the world banded together to take joint action in order to avoid calamity.
Further support for the bullish case comes in the form of technical analysis.
We can see that the MSCI All Countries World Index has come down to test the previous highs of April 2011.
The possibility exists that this might be a turning point for world markets.
Strangely enough, technical charts will often indicate a high probability of a price movement, which is subsequently confirmed by a fundamental event and it turns out that the MSCI chart managed to correctly predict what was to unfold.
Some believe this to be voodoo magic, others think it pure coincidence, but nonetheless we cannot deny that it holds some measure of probabilistic truth.
So what impact will all these various events and possibilities have on our local market?
Well, it is difficult to tell as we have a host of our own independent problems that may tip us into recession regardless of what transpires in the larger outside world.
Investors in South African markets need to remember that over the long-term equity markets have always recovered and thrived.
Those who lived through 2008 – and so many crashes and recessions before then – will attest that if you had remained invested in high-quality companies during these periods of market and emotional turmoil, you would have come out the other end with more money than you had going in.
Those who managed to keep some cash on hand and take advantage of the amazing opportunities that irrational fear-driven markets provided did exponentially better by capitalising on the fear of others and not allowing the market to scare them into abandoning great investments in an attempt to avoid losses.
In a nutshell, investors should see such turbulent times as opportunities to buy great companies at great prices.
Right now the future looks murky, but one day in a few years from now we will look back and think “man, I bought some great shares during the bear market of 2015/16”.
*Petri Redelinghuys is a trader, equity and equity derivative portfolio manager in Johannesburg with experience in niche asset management firms and brokerages.
This article originally appeared in the 25 February 2016 edition of finweek. Buy and download the magazine here.
