Correction, Like Many Others

Key points

• The fall in sharemarkets over the past month is not out of line with past corrections.
• Further weakness is possible and the next few months will likely be volatile, but we continue to see it as a correction and not the start of a bear market. Global inflation is unlikely to get out of hand, interest rates won’t be pushed too high and, although global growth may slow, it will remain reasonable helping to underpin profits and commodity prices. Further, sharemarkets were not, and are not, overvalued.

Sharemarkets have now been falling for a month or so. The key drivers have remained a fear that rising US inflation, at a time when the US economy is already starting to slow, will see the Federal Reserve go too far on interest rates with the result being a sharp downturn in the US economy, which will reverberate globally as US imports slow. Talk of policy tightening in China, along with moves to raise interest rates in many other countries, is only adding to the unease. Although the US is at the centre of this storm, its sharemarket has only had an 8% top-to-bottom fall, consistent with the fact that it has been a relative laggard in recent years. By contrast, emerging markets, after having outperformed over the past few years, have been hit the hardest with India falling 30%, Russia 31% and Brazil 24%. Japan 19%, Asian (ex-Japan) 17.5% and Europe 14%. Australian shares have been a relative “outperformer” during the downswing and have had a 12% fall from their May high to their recent low.

Such falls are unsettling. Markets have certainly fallen faster than I expected. The big question remains whether this is just a correction or the start of a bear market.

Corrections versus bear markets

At times like the present there is often much debate as to whether we have entered a bear market or whether it’s just a correction. There are numerous definitions with some drawing lines in the sand at 10%, 20%, etc. There is really no agreed definition and it’s really just a question of semantics. My preferred approach is that a correction is limited to sharp falls, up to 20% or so, across a few months after which the rising trend in share prices quickly resumes, taking shares back to new highs within say six months of the low. By contrast, a bear market sees falls lasting many months or years and it takes shares more than a year to regain earlier peaks. The next table shows 10% or greater falls in Australian shares since the late 1980s. Following this definition, bear markets are highlighted in bold, corrections are in blue.

Since 1990, the US sharemarket has experienced seven falls of 10% or more. Of these, only the 50% fall between March 2000 and March 2003 would be classified as a bear market, whereas those in 1990, 1994, 1996, 1997, 1998 and 1999 were corrections as the rising trend quickly resumed. There are several points to note about all this.

First, falls of 10% or more are not unusual. Most of these occur within a still rising trend, which is re-established reasonably quickly. Only a small proportion become bear markets. The Australian sharemarket had a correction of 10% or more in every year from 1996 to 2001 and yet made new highs within six months each time and each year saw shares deliver a positive return.

Second, while it is reasonable to worry that recent share falls might be a warning of an approaching economic slump, the track record of sharemarkets in foreshadowing recessions is not good. Of the 10 sharemarket falls in Australia noted above, only that in 1989–1991 ushered in a recession. In the US, only the 1990 and 2000–03 sharemarket falls ushered in recessions.

The correction may still have further to go.

The last day or so has seen sharemarkets put in a decent bounce, despite another poor inflation reading in the US. It would appear that another bad CPI result had already been factored in as markets had become very oversold and sentiment was very negative. However, although the worst may be behind us, it is too early to say whether the correction is over or not. Several considerations suggest that the next few months will see a rough ride for investors and that further declines are possible:

• It will take time for inflation, interest rate and growth fears to fade and for investors to regain confidence. While inflation fears may fade as US growth slows, investors may start to fret more about growth.

• The tail end of a US interest rate tightening cycle is often associated with a financial crisis. This is what happened in 1990 with the US Savings & Loans crisis, 1995 with Orange County and Mexico, 1997 with the Asian crisis and in 2000 with the tech wreck. These aren’t all bad for shares and they usually mark the low but they do add to volatility.

• The risks are higher now than over the past few years because any further increase in US interest rates beyond 5% will take them into restrictive territory and because interest rates are rising all around the world.

• Finally, as we have often observed, the May to October period is often difficult for shares.

A correction, not a bear market

We had previously indicated that shares may have a 15% top-to-bottom correction this year. Although the decline has come earlier than we thought, there is no reason to change our view that this would be a correction in a still-rising trend as opposed to the start of a bear market. Bear markets are generally characterised by preceding sharemarket overvaluation and/or threatened inflation problems, which lead to significant monetary tightening, recession and a slump in profits. This time around, sharemarkets were not overvalued and the latter seems unlikely:

1. First, sharemarkets were never overvalued. Right now they are quite cheap. Global shares are now trading on a ratio of share prices to consensus 12-month ahead expected earnings (the forward price/earnings [P/E] multiple of 12.8 times compared to a 10-year average of 18.1 times. Australian shares are now trading on a forward P/E of 13.1 times compared with a 10-year average of 15.2 times and a 1999 high of 18.3 times. After a 19% fall, Australian resources shares are now trading on a forward P/E of about 10 times. The recent slump in metal prices has still left them above the assumptions analysts had built into earnings expectations for stocks such as BHP Billiton and Rio Tinto.

2. Second, our view remains that global inflation will remain benign, notwithstanding periodic scares. The global pricing environment is extremely competitive as cheaper goods from China and other emerging markets continue to put downward pressure on prices and strong productivity gains limit increases in labour costs. There is a danger in reading too much into the recent increase in US inflation. Much of the rise in core (ex-food and energy) inflation reflects accelerating housing rents, which occurred as people have switched from buying a house to renting. Excluding rents, the core inflation rate in the US is just 1.9% year-on-year, which is at the top end of the Federal Reserve Board’s 1–2% range but not a major problem. More broadly, a cooling in US housing and consumer spending will help ease inflationary pressures and the most recent spike in raw material prices showing up in some inflation indicators will soon be reversed as the recent slide in commodity prices flows through. In Europe, underlying inflation is just 1.5% and in Japan it is still less than 0.5%.

3. Flowing from continued benign inflation, interest rates are unlikely to surge. Another US interest rate hike is almost certain, but our assessment remains that US interest rates won’t go much higher because the Fed won’t ignore increasing signs that the US economy is cooling down. Australian rates are essentially “on hold”, with recent data indicating that consumers have been more affected by higher petrol prices and interest rates than tax cuts. Rate hikes are likely to remain slow in Europe and Japan as inflation remains benign. Overall, global interest rates are unlikely to be pushed to excessive levels.

4. As a result, while global growth is likely to moderate, it is unlikely to collapse. In the US, housing and consumer spending will slow but a strong corporate sector will help underpin capital spending ensuring that growth won’t collapse. This should also help to ensure that commodity prices remain high. Overall, this all points to a moderation in profit growth, but not a collapse. This is important because some worry that currently high profit margins will soon collapse, undermining otherwise attractive sharemarket valuations. Past profit collapses were led by a sharp increase in wage costs and much higher interest rates to head off the inflation threat. So far there is no sign of either. In countries where there has been an up-tick in wages growth, it has been modest and more than offset by strong productivity growth.

Basically, we are expecting a mid-cycle slowdown much as occurred in the mid 1980s and mid-1990s where US growth slowed to about 2.5%, allowing bond yields to fall, the Fed to take its foot off the brake and resulting in reasonable gains in sharemarkets. This should provide a reasonable environment for global and Australian growth.

Conclusion

The fall in sharemarkets has certainly come faster than I anticipated. Although there may be further weakness and volatility in the months ahead, this should not be seen as the start of a bear market. The low inflation global economic expansion is likely to remain intact, interest rates won’t be pushed too high, commodity prices are likely to remain high and sharemarkets are not overvalued. The historical record indicates that 10–20% corrections are not unusual. In fact, they are quite healthy in the sense they ensure sharemarkets don’t get too exuberant.