The US is in the middle of a secular bear phase much like it was in 1929-1942 and 1968-1982.
There seems little doubt now that the US and for that matter most global equity markets have entered into a secular bear phase. The unravelling of the credit bubble has produced severe wealth destruction on an unprecedented scale. In the past 12 months in the US alone, declines in home and equity prices have exceeded nine trillion dollars, equivalent to more than 60 per cent of US GDP. The combined value of US equity and residential real estate relative to GDP is back to the level of 1995. More than a decade of wealth creation has been wiped out in a single year. All the other major global financial markets have a very similar and chilling story of wealth destruction. The future of the financial system itself is up for debate.
If we focus on the US for a moment(being the biggest market with the most data), we find that there have really been only two other episodes which can be identified as secular bear phases.
One was the period 1929-1942 and the other was 1968-1982. As for what are the similarities between these bear cycles, beyond the quantum of wealth destruction, there are many other lessons that one can draw and which may be relevant in trying to dimension today’s market collapse.
First of all is the period of time it takes to come out of a bear phase, one episode lasted 13 years and the other 14 years. If we go by this and assuming that our current bear phase really began in 2000 with the technology bubble burst, it is unlikely that a new sustainable bull phase can begin in the US until 2012-2013. The lost decade (still continuing) in Japan post its1989 equity market peak also further reinforces the fact that there is no quick end to a secular bear phase. You need investor fatigue to set in before this can end.
Secondly, in both of the above periods we had very strong multi-year bear market rallies within the secular bear phase (1932-37 and 1970-73). After these bear rallies failed, the subsequent price destruction was severe. Prices dropped by 65 per cent in real terms between 1937 and 1942 and by 63 per cent in real terms between 1973 and 1982. In both periods the counter trend bear rally began relatively quickly post the peak in the markets (within three years in the case of the 1929 peak and within 18 months in the latter case). Worryingly, in both cases, the longest phase of the bear market actually occurred post the fading out of these multi-year pull back rallies.
Even today we seem to be following a similar pattern with the markets peaking in August 2000, and then we saw a sustained bear rally from 2002 to 2007. We are now in the severe wealth destruction phase (post the collapse of the bear rally) highlighted earlier. The point of greater concern is that if events continue to pan out as per prior history, then the longest phase of the bear cycle is still ahead of us, though the majority of the wealth destruction is done.
Another characteristic common to both the prior secular bear phases is that the level of real earnings was lower at the end of the bear market than it was at the beginning. This means that real corporate earnings actually declined marginally over a 13- or 14-year period. This highlights the potentially huge challenge to corporate sector profitability one can expect over the coming years. If this cycle were to follow the prior two, then real earnings should actually decline over the coming three to five years. The macro strategists have been pounding the table on how micro equity analysts across markets are still way too optimistic on corporate earnings, and the weight of history is on the macro side.
In both the previous bear cycles the PE ratio also ultimately came down to single digits on a trailing basis, before the markets bottomed. While many valuation indicators like the Graham and Dodd PE, Tobin’s Q, interest rate-based valuation tools etc show the equity market to be either cheap or at fair value, we will probably need all these measures to overshoot before the market bottoms. It is very rare that we can bottom out without all equity valuation measures showing significant undervaluation, as opposed to showing markets being only fairly valued.
Another concern is around the whole equity cult. We have all grown up being taught that equities are the best long-term investment and must be held for the long term. In the current decade equity holders have already faced two huge market drops (in 2000 and 2008), heightened volatility and almost no returns in real terms over the past decade. Could we see a whole generation of investors turn away from this asset class? Is the dividend yield/bond yield crossover in US financial markets (the first time since 1958) a leading indicator of a change in attitude towards equity?
All this makes for sombre reading of course, but will it necessarily be so bad?
We can argue that we are looking at only two periods in the US and that is not much in terms of data and history. One can also make the point that both these episodes were elongated because of certain unique characteristics. We had the policy mistakes and lurch towards protectionism in the 1929 period and the serious inflationary concerns of the mid-1970s. Neither of those concerns are valid today, the authorities are hyperactive on the policy front and we are more worried on deflation than inflation. Maybe this bear phase will end faster.
Also one can argue that while this may be valid for the US, emerging markets can probably come out of the bear funk much faster, given their growth and economic fundamentals. As long as the US stops falling, and gradually derates in real terms, this will allow the EMs to differentiate themselves. Much of the forced selling that has decimated the EMs should now slowly tail off.
In India specifically, I think one is seeing the beginnings of a bear rally which can continue for some time. Many of the building blocks for a more sustained bull phase are also now slowly coming into place, be it valuations, sentiment, interest rates and policy action. However, I find it difficult to see how we can break out in a sustained way on the upside till such time as the election uncertainty is put to rest. I think the last 12 months have shown us that eventually governance and reforms do matter. I think a new bull phase in India at the minimum will need investors to feel comfortable on the ability and desire of the new government to move ahead economically.
