Is it a bear market rally or the start of a bull market? Who better to answer than Russell Napier, Global Macro Strategist, at CLSA Asia-Pacific Markets. Russell simplified the understanding of the bear market and its various stages in his book ‘Anatomy of the Bear’. The book analyses the great bear markets in the US during 1921, 1932, 1949 and 1982 and was reviewed by Marc Faber as an “outstanding must read” for any follower of the financial markets. His ability to isolate factors that identify bear markets and their bottoms has enabled many to avoid bubbles and enter markets at an early stage of recovery. Jitendra Kumar Gupta spoke to Russell on the recent rally in the global equity markets and the outlook from here on. Excerpts:
What do you read into the recent recovery in global markets?
The markets had fallen very quickly after the Lehman Brothers case. And after that credit crisis took over followed by deflation with the falling prices of goods. Now, that has changed. The government reaction globally is so huge people are saying we would not have massive deflation we will have a small deflation, perhaps inflation. The risk premium is shrinking due to more government action and therefore equity is going up.
For Indian investors, I will be more convinced if companies are selling their goods at higher prices next year. Equities are, at this stage, an inflation play and India is having extremely low inflation and heading for deflation. But, if there is any sign of that turning, that is the good time to buy Indian equity. Obviously, if American equities go up, that will underpin the Indian equity as well.
How comparable is this bear market vis-à-vis previous ones and where are we now?
One thing that is really different so far is the low valuations. If you look at the previous four occasions and the valuations ratio, which is the Q ratio (valuations relative to replacement value of assets) and the cyclically adjusted price earnings (CAPE) (rolling 10-year average numbers), the markets have not gone anywhere near to those lows that we saw in 1921, 1949 and 1982. That is the key difference. Having said that, I think the markets will go up strongly. All lows need to have very long periods of time, you often get very significant rally, which can last for years in a great bear market.
But, are the signals the same?
Yes, this bear market probably ends in 2014. So, in the medium term, we will get some rallies. The crucial call is that equity will go up when the markets start to move away from deflation towards the inflation. The change is coming and you should be buying equity. There are three premises for that, the price of copper, price of treasury inflation-protected securities and the price of corporate bonds, all these things have been improving for few months in America. So, this rally could last for the next couple of years. The last rally lasted between 2003 and 2007. Having said that, I do not think the bear market is over, but after a couple of years from now there will be a huge bear market in the US treasury, and that bear market (treasury) would be even more frightening than what we have just lived through. And then, equity will go to very low valuations than we had in 1921, 1932, 1949 and 1982. So, the number there, if it comes to 400 on S&P or say 50 per cent lower from today, that is where we will eventually get to.
What about the Indian markets?
I look at Asia at the broader level but I am more optimistic about America. I believe Europe has got more problems to come. India is not that much exposed (in terms of exports) as others. I am not negative on the Indian stock markets, rather I am positive. But, what will surprise is just how quickly and strongly America recovers and this will not be as quicker anywhere else.
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How do you read the current earnings cycle in relation with the market bottom?
I have looked at every earnings cycle in the US since 1881. What generally happens is that, economy bottoms by three-to-six months after the stock market bottom and about three months after that the earnings bottom. So, if you think earnings will bottom in fourth quarter, based on the historical perspective, one can buy equities today.
In India, is the improvement in some core sector numbers an early sign of recovery in equity?
Yes, because markets were factoring for much worse. I do not see any problem in buying Indian equities at the current price. But, I just think there may be some more nasty surprises to come in India. But, my basic position is that, you should not buy any investment unless you have three years time horizon—anything less than that is like a gamble.
How have the defensive sectors (FMCG and utilities) performed during and after in the earlier bear markets?
Usually defensive sectors have underperformed during the bounce back. I cannot think of a single example when these sectors outperforming in the bounce back. Although there is nothing wrong in owning the underperforming sector. If American equity markets rise by 30 per cent in next 12 months and defensives give you a return of 20 per cent, what is wrong in that. After all you are taking a low risk, but only that you will not beat the index.
It also depends on the individual risk profile. To me that is going to be commodity and financials. My own sense is that commodities will outperform and so far they are outperforming. Obviously, financials are very distressed and a lot of luck is involved, especially in the America financial sector. But in India one can choose either (commodity or financials) because the banking system is sound compared to the West.
Are commodity prices stabilising?
Yes, since now there is reduction/adjustments in supply that is a good sign. Globally, a lot of supplies have been taken away from the system. On the demand side, China is going into incredible infrastructure spend that should be good enough to stabilise the prices. In the long run, the Chinese and Indian demand for commodities will underpin the higher commodity prices.
What is your view on the deterioration in the economic fundamentals and fiscal deficit?
Historically, this has always been a false reason to sell equities just because the fiscal deficit will grow bigger. If you go back to 1982, which is a good example, people were saying the fiscal deficit will get worse and it went much worse in 1983, 1984 and 1985 than anybody could have forecasted. Despite that, stocks markets went up strongly. In 1949, which is the third bear market bottom, fiscal debt to GDP in America was much higher than today, obviously because of the Second World War. Three to five years from now we are going to see some significant issues about the US federal debt and its size, but this is not the time to worry about.
When do you think the next bear market coming?
I would say some time by the end of 2011. By that time, we are going to see treasury going up. So clearly, until inflation in America gets close to 4 per cent (may be 3.5 per cent), then equity should stop going up.
