Alas, No Guarantees

I did warn in April equities were once again too expensive and it would benefit those investors who were willing to wait for better entry points, but I did not foresee that six months later I would be looking back on five months of consecutive declines for global equities. But I can justify it, and in more than a few dozen ways.

Needless to say, the overall news flow remains grim and so is the mood of those engaged in what is colloquially known as "investing". No surprise thus the September Survey on Investor Sentiment by FNArena and the Australian Investors' Association showed investors have cashed up their portfolios to an average 26% and with no intention of putting any of it back to work in equities as only a minority still believes the prospects remain positive on a 6-12 months horizon.

Surely this must be the point where history jumps to the rescue and shows we are near an inflection point, with sustainable rallies about to emerge?

Alas, it turns out history is not always as kind as we expect it to be. Thanks to some excellent data-mining by analysts at BTIG, I can now report that history shows the odds do remain in favour of higher equity indices on a 12 month basis, but the overall message is rather mixed. Moreover, there's absolutely no guarantee we won't see a sixth month of further declines, or even a seventh or an eighth. If history shows one thing it is that five consecutive months of declines are rare, but when they do occur something serious is remiss with the world.

This in itself should be enough to contemplate that all this weakness is not just about Greece, or the PIIGS, or even the European Union. An increasing number of experts is worried about a global recession next year. A growing number of economists is now expecting a recession in Europe - soon. The jury is still out on the US, but economic growth won't be flash even if a recession can be avoided ahead of the next Presidential elections on November 6 next year. Asia is slowing too and it's probably fair to say there never has been as much doubt about the sustainability of the Chinese growth miracle as this time around.

A recent survey by Bloomberg indicated a majority of financial experts now anticipates China's growth will slow down significantly in the years ahead. Did I mention banks? French banks are in trouble. We know. This is why the French government has been busy advocating maintaining a gentle approach to the Greek government's financial abyss. We also know that if Greece's problems spread to other countries, there will be more banks in trouble. If Spain and Italy are affected, the entire European banking system will turn insolvent.

The latest joke around the traps on Wall Street is that, according to rumours, Belgium, the country with no federal government, is about to nationalise Dexia, which is a financial institution with assets equal to about 180% of Belgium's GDP. This is what the Global Financial Crisis has come down to: ridiculous situations that would have been laughed about only a few years ago, but today we need to see them happening to save the world's bacon.

The latest joke about Belgium comes with various layers of complexity as the previous rescue operation for Dexia involved France and Luxembourg, and all three countries remain shareholders today. Plus, of course, the tiny detail that Belgium is widely tipped to be the next one to join the PIIGS in needing European support.

Returning to BTIG's historical data analysis, many may be surprised to read that US equities in the 1930s did not experience five consecutive months of declines until 1937 and back then it proved a turning point with gains booked in the following month, as well as the next three, six and twelve months. It was a different story in the 1940s though, but similar to 1937 the Dow Jones Industrial Average was each time higher on a twelve months' horizon.

The story becomes much murkier from the mid-1960s to the early 1980s. Regular readers of my analyses already know I like to refer to this period as the prime point of reference for what equities are going through right now. BTIG analysis confirms declines lasting five months occurred quite regularly during that period and they did not always provide a turning point for the next sustainable rally. Leaving aside all other details, the balance during that period stands at 50/50.

In 1966 five months of weakness were followed up by a strong rally and investors would have picked up more than 20% in gains, even if they'd missed out on the initial turnaround. In 1973 the opposite was true with significant losses twelve months later. In 1974 investors had to wait until much later in the year before the next big rally announced itself. In 1981 the result twelve months later was still negative and if investors had waited one extra month they could have booked a small gain of 3.6%. There were short, sharp rallies in between.

It happened only once in the 1990s and in October of 1990 investors would have found bargains and big returns if they'd bought into US equities.

Surprisingly, and probably showing just how rare five months of uninterrupted falls are for US equities, is the bear market from 2000-2003 did not see one single such event. We did have one experience in 2008 and while optimism briefly returned for a few months, the collapse of Lehman Bros was yet to follow and so did much steeper falls later in the year.

And now it happened again, in 2011.

What's it going to be this time? Up or further down?

There are very good arguments in support of both, but it's always good to keep in mind my crystal ball is not necessarily any less clouded than anyone else's. History shows declines over five months uninterrupted are rare and when they occur global economies really are in a pickle. What happens next is very much reliant upon a return of confidence, and a brighter outlook that is sustained on more than hope alone.

By Rudi Filapek-Vandyck
Editor FNArena