Bears have upper hand as bull market vanishes

By Neville Bennett

Friday 5th October 2001

Disruption in Manhattan sent huge shockwaves through financial markets. The World Trade Center had housed many crucially important traders and its destruction, along with the closing of Wall Street, raised the spectre of total disruption.

As it happened, when Wall Street opened there was an orderly selldown and the Dow-Jones index fell only 11% in September. Normality has been restored, or has it? And for how long?

Obviously there is great uncertainty and the short-term impact of the barbarous attack is not positive. But the IMF, for example, maintains the world economy is "on track" and "economic growth will accelerate in the US some time later this year or early next year." IMF first deputy managing director Anne Krueger denies she is acting as a cheerleader in adding the attacks "might also mean a sharp upturn later on."

The London FTSE had a tremendous run in the last week of September when it gained more than 10%. The optimism was widely interpreted as arising from investors positioning themselves for the big economic rebound in 2002.

Optimists gain confidence from a surge in US defence spending, the vast tide of liquidity being pumped into the financial sector by the Federal Reserve and a surge in demand for new offices in New York.

The attack occurred when doom was gathering about the economy. There had been a rash of announcements of bad economic news. Japan's GDP fell at an annual rate of 3.2% in the second quarter and the Nikkei fell to a 17-year low. US unemployment increased to an unexpectedly high rate of 4.9% in August. Europe also was at a standstill. OECD economic growth had reached zero, for the first time since 1990.

In short, the world economy was already in recession, or very close to it, on September 10.

It remains difficult to assess the effects of the attack - there simply are no useful precedents. The Gulf War was stimulating but it was different in that Iraq was isolated; no one can predict with certainty what retaliation will follow President George W Bush's riposte.

The reality is that Americans have cut their travel and their entertainment expenditure. GDP will fall driven initially by lower earnings in the air industry, hotel and restaurant. Insurance will become introverted and eventually show red ink on its balance sheets. But will a downturn spread to other sectors?

The large question is the impact on business and consumer confidence. Consumers may become more worried about job security. More importantly, they will feel the "wealth effect" of much diminished investments.

The Economist (Sept 15) estimated $US11 trillion (equivalent to one third of world GDP) had been knocked off world share prices since their highs last year - and most markets have fallen subsequently.

Although there are conflicting signals, the outlook is generally gloomy, as the US economy seems bound for the recession. More importantly, it will drag others down as well. Japan was already plunging deeply and now seems in freefall with falling share prices and weaker sales dragging its desperate banks into a hopeless position.

Much of Asia is in steep economic decline, led by falling electronic orders, plunging Taiwan, Singapore, Hong Kong and Malaysia into recession. Latin America is also slipping and Europe is dormant. Standard & Poor's has reported record debt default and predicts much more. It is extremely unusual for all major economies to be falling simultaneously.

Many investors will take the view this is a good time to buy equities. The funds industry will intensify its litany of mindless accumulation. There is a new advertisement on TV One urging investors to take advantage of volatility.

Actually investors have to calculate whether the worst is already priced into the market. Here the evidence for Wall Street is unconvincing. Dividend yields on equities have been around 1.2% for years, but have recently risen slightly risen as a consequence of falling share prices. This is hardly a "buy" signal as many firms have signaled falling profits.

Nor are price-earnings ratios healthy. The current P/E in the S&P 500 is 30:1; "value" investors would normally analyse this as a bubble and counsel investors to wait until shares almost halve in price until a healthy P/E of 15:1 is established. Thus yields and P/Es suggest a savage bear market lies ahead, one that will extend globally into a synchronised recession.

To be sure, the central banks will cut interest rates and pump up liquidity (one expects the Reserve Bank to be similarly pro-active). But the rally by stock markets at the end of September was merely a manipulation, stemming from short covering and window dressing by portfolio managers, in a determined attempt to make the quarter seem less disastrous.

Wall Street's fall has been spectacular. The Dow Jones and Nasdaq indices are at a three-year low. The already depressed Nasdaq composite lost 30.9% in the quarter. The wretched Nikkei is at its 17-year low - 9000 compared with its 1989 high of 39,000. These huge falls are now the central reality in financial markets.

The disarray in equity mutual funds is obvious. The average fund lost 17% in the third quarter. Their proprietors are trying to de-emphasise their negative returns by stressing their average return over a three- or five-year period. Magellan, the biggest fund, stresses its 2.3% average annual gain over three years. Second in the size stakes is Vanguard, which boasts a 0.2% annual return over three years. It gets worse. The huge Fidelity Growth Fund has lost about half of its value on bets on tech stocks.

Many investors are bailing out and redemptions are at record levels. But fund managers are still buying stock. In the next quarter, these same managers will have to sell stock to raise cash (because their cash levels are below benchmarks) and also sell stock to honour redemptions. Wall Street could see a lot of selling in the next quarter.

Historically, October has been a bad month for stocks. It is extremely unlikely there will be a crash this year as previous crashes have occurred when panics hit bull markets. But markets could slide if funds sell, foreigners retreat and consumers redeem their investments.

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