The recent decline in the share market is a correction rather than the beginning of a new bear market! Why do we believe this? The share market goes through a repeated cycle:
At any given time, different countries may be at different stages in this cycle. And there may be very different influences on share markets – domestic considerations might be trumped by international concerns. The BRIC countries (Brazil, Russia, India, China – now together over 25% of the world economy) are in phase 3 of this cycle. Australia, because of its exports, and because we never really had a major downturn during the GFC (Global Financial Crisis) is out of phase with our more traditional partners, the US and Europe, and is closer to where China is in this cycle. Traditionally, though, our share market has tended to follow the US.
But there are complications in such a simple analysis. Even though China and India helped us weather the GFC storm, it remains true that the US and Europe are still together nearly 3 times larger than BRIC. And the economic data there are very strong, the strongest we’ve seen for three decades.
In the US, the ISM (Institute of Supply Management) surveys are as high as or higher than they’ve been for over 25 years. (See chart). It’s true that employment growth is slow, but the stats always miss payroll increases from new businesses in the first year of recovery because these new businesses are not yet part of the survey. Later on, they get included and the statistics are retrospectively “panel-beaten” upwards to fit in with new census information. The unemployment survey is a much better guide to what is happening at this stage of the cycle, and the unemployment rate is falling faster than at any time in 25 years.
In Europe, it’s true that fringe Europe (Greece and Ireland are the worst) are still in strife. But core Europe is strong. Germany is booming, and so are other countries producing capital goods as Germany does – Sweden, Denmark, The Netherlands, and Belgium – while even France, Italy and Spain are showing very solid recoveries. Eastern Europe is strong (e.g., Czech industrial production up 17% year-on-year in January) even as Russia itself slows moderately as policy there tightens. These countries are still at stage 2 of the stock market cycle.
Thus commodity prices are likely to continue to rise, and so are resource share prices. In Australia, the RBA’s tightening stance has produced a two-speed economy, with the resource sector very strong and almost everything else weak. The total All Ords index is somewhat misleading – many sectors of the market are sluggish. Yet the resource sector is so strong it will continue to drag the overall index higher. What happens when commodity prices start to fall? This is unlikely to occur for at least a year. Much of the world will still be growing strongly through 2011 and well into 2012. And even in China, now a key world economy, growth will merely slow a little rather than go negative. Recently, in fact, industrial production growth there has been picking up again. Short-term, a key commodity price, the price of crude oil, has been pushed up by revolutions in the Near- and Middle- East, but this is not Iran in 1979. These are not religious revolutions but democratic ones. The new governments will be keen to pump as much oil as possible to pay for new populist expenditures.
The real risk of rising oil prices will come from strengthening global demand meeting inflexible supply, and this will likely progressively occur with the oil price reaching record new highs in 2012. This will combine with good economic growth to cause inflation to rise, and that is when central banks will respond by tightening policy.
The earthquake in Japan and the subsequent nuclear crisis have been seen by some as a bearish (negative) factor for the share market. It is true that weakness in Japan will have some impact on world growth, but the effect will be small because Japan has anyway been growing slowly for 20 years now, and is now no longer the world’s second largest economy. And if world growth is affected, central banks will adjust policy and make sure there is enough liquidity to support growth elsewhere. Indeed, the Bank of Japan’s first action after the earthquake was to provide US$70 billion of liquidity to Japanese money markets, while the G-7 group of countries all conducted a co-ordinated intervention in the foreign exchange markets to drive down the yen. Both measures will help the Japanese economy.
In our judgement, strongly rising interest rates are a year or more away. Even though the unemployment rate is falling in the developed world, the unemployment level and the level of spare capacity in industry is too high for central banks to start raising rates aggressively now. Quantitative easing in the US will end earlier than planned, perhaps, and the European Central Bank will start nudging rates higher, but cash rates outside BRIC will remain exceptionally low for many months yet. The “sweet spot” in the developed world’s share markets will continue for some time, and that will encourage our market higher too.
As well, valuation is on our side. The All Ords dividend yield is higher than at any time since the GFC and the 2003 bear market (see chart). The PE (see chart), another measure of how expensive the market is, is lower (i.e., cheaper) than at any time since the crisis.
Quite a lot of bad news is being discounted by our share market – always a good sign. And for the next year or eighteen months, the news won’t in fact be bad, though outside mining and mining-related stocks it won’t be especially good either. This suggests that
the market is good value.
On balance, the risk of being out of the market (and losing out when shares start rising again after this correction) is greater than being in it. We will continue to remain fully invested. For now.
As always we will be continually reviewing your holdings to take account of market conditions.
