Sent: 07-04-2009 10:39:01
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Has the Sharemarket Bottomed?
The strong rebound in equity prices led by the U.S. market in March is forcing us to judge whether we have moved through a market bottom.
Since 9 March, the S&P 500 U.S. equity benchmark has risen by 24.5%. After having previously fallen by 57%, the significance of such a seemingly outstanding gain can easily be overstated. The market remains 46% below its peak value and below where it was even as late as the beginning of February.
Nonetheless, a species bred to believe that market falls, however large, are only ever brief interruptions to an otherwise indefinite uptrend, is taking the past month as a sign of things to come.
There are reasons why such an inference could be valid. On the other hand, there are some reasons the rise may be only temporary relief from the pervasive pessimism of the past four or five months.
Choosing which of these is true is vital for investment decision makers because missing the early stages of a recovery can irreparably harm medium term investment returns. Unfortunately, as with all tough decisions, there are arguments in both directions.
Here are four reasons to believe that we have seen a bottom and four reasons why we might not have done so.
That was a bottom!
1. A recession was unfolding but our political leaders around the world did a remarkably good job encouraging us to fear the worst. In quickly reflecting catastrophic economic outcomes, equity prices might have gone too far. There was scope for a slight upward adjustment. Things were not quite that bad.
2. There is some evidence of a change in momentum. The rate at which conditions are getting worse is slowing. That does not sound especially comforting but markets react to momentum changes. As we discussed in the ATC e-mail of 11 November 2008, markets tend to rise well before a recession is over and once the magnitude of the potential economic deterioration, even if there is more to come, is more completely understood. A lessening rate of decline is an early sign that the overall magnitude of the deteriorating economy is within our understanding.
3. The early missteps by U.S. Treasury Secretaries Paulsen and Geithner may have given way to more efficacious actions to establish a market for toxic loans and, hence, offer an exit strategy for the financial institutions holding them. This alone will not be enough but is a welcome first step in shoring up the preparedness to lend of global financial institutions.
4. There is an unusual coincidence of views among national governments about what needs to be done encouraging some optimism that they will deliver a solution to our current woes. There are no Soviet or Chinese vetoes to blunt concerted action as there might have been in years gone by. One suspects that even bloody minded regimes such as those in Cuba and North Korea agree with the courses being proposed (although, sensibly, no one is soliciting their views).
That only looked like a bottom!
If you wish for something hard enough, your imagination might get the better of you. Hallucinations may follow.
1. Ultimately, earnings have to be high enough to validate a rising market. They might not yet be in this instance. The ATC e-mail on 17 March discussed some of the risks on this front. We have not seen the worst of the macroeconomic conditions and might still be overestimating how quickly earnings can expand.
2. Technically, a market bottom exists when a long-term moving average flattens and then begins to rise. We are getting closer to that happening but we are not there yet. If the U.S. market does not fall from its current level, a technical bottom will have formed over the coming two or three months but that simply shunts aside the question we are trying to ask: do we have a bottom already? Answer: no.
3. There is still ample scope for downside surprises on the macroeconomic front. Employment and business investment will be critical ingredients to any recovery. Whether in Australia or the USA, both could still be falling in a year's time. And, even if that fall is at a slowing rate, the duration of the decline might further erode business and consumer confidence.
4. Secretary Geithner has not shown he can set new prices for the toxic assets at the heart of U.S. and, therefore, our own problems. We all wish him well at the third attempt to cast a solution but a new toxic asset market is vastly easier to describe on paper, however difficult that might be, than create in practice. If the bid-offer spread is too wide to permit trading, we will have a theoretical market but no solution. As long as banks are trying to avoid further capital losses, they will have no incentive to narrow the spread and, in doing so, help create a market. Six or twelve months from now, we might be no further advanced with lending still constricted by the downside risks to the balance sheets of the world's major financial institutions.
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