A bear market rally or the start of the next bull market?

Saturday 5th July 2003

It was an extraordinarily strong quarter with the US (S&P 500) up 15%, New Zealand (NZSX50) up 14% and Germany (DAX) up 33%. However, most major overseas sharemarkets are still down from their levels 12 months ago (the worst being the DAX which is still down 27%) but at least they are now well off their lows. The New Zealand sharemarket continues to be one of the best performing bourses globally, being up more than 10% over the past year.

So is this just another bear sharemarket rally or the start of a new bull market? After all, there have already been three other 20% or greater rallies since the bear market commenced in early 2000.

It is positive that this latest rally has been the most significant in terms of size and longevity.

If it is the end of the bear market then it will go down in history as the fourth worst in US history with a peak to trough (January 2000 - October 2002) fall of 38% on the Dow Jones Index.

To make it back to January 2000 levels from its lows the Dow will have to rise 61%, the maths being that any rise has to be greater than the preceding fall.

A majority of economists are now forecasting the current substantial monetary, fiscal and currency stimulus will start to positively impact on US economic activity in the second half of this year with an annual growth rate of 4% now being forecast by many.

However, much of this already appears to be factored into markets with the consensus forecast being for double-digit corporate earnings growth in the second half of 2003 and for the 2004 year.

The result of the recent rally is that markets are less "cheap"" and in some cases still relatively expensive. According to GTFM's global equity manager, Capital International, the US market's P/E (price/earnings ratio) is above 20 again, although well shy of its 10-year peak of 35. While lower interest rates can justify higher P/Es, a P/E over 20 does need the double-digit earnings growth mentioned above to eventuate if it is to be sustained.

While the feed through to global sharemarkets from a US economic recovery is still uncertain, any sustained return to 4%-plus GDP growth would probably result in higher interest rates.

It may be the sell-off in bond markets in recent weeks is recognition of the potential negative impact on interest rates from growth resuming in the US. Even if it is, our view is that New Zealand rates are less vulnerable, given the yield spread over US Treasuries remains high and could decrease if our country risk premium falls.

A significant by-product of a global rise in interest rates is that the current strength in house prices around the world may come to an end and even reverse somewhat. This comes from the vulnerability of residential property investors to a combination of higher mortgage rates (and the resultant impact on required debt servicing) and less attractive rental yields (relative to competing asset classes), which impacts on house prices.

A recent study by the IMF highlighted the potential significance of any housing market reversal and stated that when compared to equity price declines:

"Housing price busts were less frequent but lasted nearly twice as long and were associated with output losses that were twice as large, reflecting greater effects on consumption and banking systems, which are typically heavily exposed to real estate."

While New Zealand commentators have suggested that the New Zealand residential property market is not yet "over heated", the same cannot be said for the US, UK and Australia. Any significant fall in these markets on the back of higher interest rates and/or lower confidence in these residential property markets could have significant negative impacts on overall consumer confidence, consumption and (therefore) GDP growth.

Thus the US Federal Reserve continues to face a real balancing act of ensuring deflation does not occur while not allowing inflation expectations (and therefore interest rates) to rise too dramatically in 12-18 months time.

On a brighter note there was finally some good news out of Japan with the latest business survey (the Tankan) confirming an improving trend in business confidence. It seems many exporters are experiencing improving conditions while domestically things are marginally better. This fed through to the Japanese sharemarket, which was up 8% for the June month and 14% for the June quarter. Conversely Japanese bond yields did rise through the June month as well, with the 10-year bond up from 0.5% to almost 0.8%.

The better export picture for Japan is partly currency related as shown by the weaker Yen against the Kiwi dollar. The Kiwi is up 2% for the month against the Yen and has risen over 20% for the past twelve months. In fact, the Kiwi is at a five year high against the Yen, with these levels last seen in August 98. So while exporters are hurting New Zealand consumers of Japanese cars, whiteware and brownware will be quite happy.

Of course this is not great for our balance of payments (BOP) and there are starting to be worrying signs that a BOP deficit for New Zealand of over 5% is possible over the next 12-18 months. It is at these levels that a currency can come under pressure.

Coming back to the bull versus bear market question raised at the start of my piece, it is very pleasing to have a bounce in shares globally over the past quarter. However, we are certainly "not out of the woods" yet. Our belief is that while the lows of bear market in equities will not be re-tested, neither are we in the throes of a bull market. Rather we expect equities to range-trade or sell off slightly in the short term with good stock selection being even more critical than usual.

Anthony Quirk is the managing director of Guardian Trust Funds Management

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