Cyclical bull out of the gate

Since the height of the European public debt crisis in September-October 2011, global sharemarkets are up 32% and Australian shares are up 26%.

With the global outlook looking brighter, inflows into sharemarkets seemingly starting to pick up and shares accelerating to the upside over the past few months, an obvious question is whether we have commenced a new bull market? This note focuses on cyclical bull markets, associated with 3-5 year economic cycles rather than whether we are in a long-term bull market which can run for a decade or two.

Rising highs and rising lows

Trying to define a cyclical bull market in shares is always difficult. My preferred definition is that a cyclical bull market is seen as a pattern of higher highs and higher lows spread over months-years until it’s interrupted by a bear market (which is a 20% fall that takes more than a year to reverse).

While shares rallied nicely coming out of the GFC, this was cut short in 2011 by the Eurozone crisis and worries about a double dip in the US triggering 20% plus falls from early 2011 highs to lows in September-October 2011, resulting in a new bear market.

Since then sharemarkets have been tracing out a rising trend indicative of a new bull market. The 200 day moving average of share prices, which is a good guide to the underlying trend, is clearly rising. What’s more, market volatility seems to be settling down. This can be seen in the chart below. The breadth of the rally – in terms of sectors and stocks participating – over the last year is also consistent with it being a bull market.

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Fundamental drivers

But what about fundamental drivers. Is it sustainable? A typical cyclical bull market goes through three phases.

• Phase 1 is driven by an unwinding of very cheap valuations helped by very easy monetary conditions but with receding downside risks causing some investors to snap up undervalued shares. This is the phase where shares climb a “wall of worry”.
• Phase 2 is driven by strengthening profits.
• Phase 3 sees euphoria with investors not only saying they are bullish but backing it up, pushing cash flows into shares to extreme levels. This is despite shares becoming expensive and central banks starting to raise interest rates to combat rising inflationary pressure.

Right now we are probably nearing the end of Phase 1:

• The rally in shares has reflected valuations becoming less cheap as global risk has receded. But while shares are no longer dirt cheap, they are not expensive either. Price to earnings ratios are up but only to reasonable levels of around 13.4 times in Australia, 13 times in the US and 12.4 times for global shares. In Europe and Asia they are still around 10 to 11 times. The gap between earnings yields and bond yields, a proxy for the excess return shares offer relative to bonds, remains extreme.

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• While we are yet to see the sort of earnings growth upswing associated with a typical second phase of a cyclical bull market, the upswing in global business condition’s PMIs now starting to occur suggests this is likely to become apparent over the next six to 12 months.

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• Australia is lagging in this regard reflecting much tighter monetary conditions in 2011 and the strong $A. However, tentative signs that lower rates are getting traction is apparent in some housing and confidence readings. By the second half, the earnings outlook in Australia is likely to start looking healthier reflecting this.

• And global monetary conditions remain easy, with near zero interest rates and open ended quantitative easing in the US, and Japan joining the fray more recently. Global monetary conditions are likely to remain easy until growth becomes a lot stronger and inflation fears loom. There is no sign of Phase 3 monetary tightening here.

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• Similarly monetary conditions remain easy in Australia with cash rates around record lows, with potentially more cuts in prospect in the short term.

Further to go

These indicators suggest the rally has further to go: shares are still not expensive, forward looking growth indicators are improving pointing to an upturn in the global profit cycle and monetary conditions are likely to remain easy for some time.

What’s more investors may be starting to warm to equities again with inflows returning to equity mutual funds in the US and anecdotes suggesting the same may be starting to occur in Australia. This is likely to accelerate if the US sharemarket breaks out to an all-time high which is less than 4% away and Australian shares break through the 5000 level which is less than 2% away, and which in 2010 and 2011 proved to be a psychological barrier for the market.

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However, any inflows into equities are coming from a very low base. Given the outflows from equities over the last five years or so, it likely has a lot further to go. We are nowhere near the extremes in investor euphoria and equity market inflows normally seen in the final phase of an equity bull market.

How long could it last?

The next table shows the record of cyclical bull markets in Australian shares since 1894. I have applied the definition that a cyclical bull market is a rising trend in shares that ends when shares have a 20% or greater fall that takes more than 12 months to be reversed.

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A typical cyclical bull market in the post WW2 period has seen shares rise 126% (column 4) and last nearly four years (column 5). So far we are up just 26% spread over 16 months.

Concluding comments

Having risen sharply since the last correction in November, shares are overbought technically and vulnerable to a correction. February is often a soft month for shares and several hurdles may constrain markets in the month ahead including negotiations around US “sequester” spending cuts due to kick in on March 1, Italian elections, corruption allegations regarding the Spanish Prime Minister and uncertainty around the earnings reporting season in Australia.

However, the trend in sharemarkets is likely to remain up this year. The positive momentum seen in recent months in sharemarkets is indicative of a bull market, during which corrections are usually short lived and mild. Sharemarket valuations are still attractive. The global growth outlook is steadily improving which should result in better momentum for profits. Global monetary conditions are ultra easy and getting even easier. And shares are likely to benefit from investors switching out of low yielding cash and bonds. Australian shares will also benefit from RBA rate cuts starting to drive a pick up in the key cyclical parts of the economy. So notwithstanding the usual bumps along the way this all suggests that shares are still in the early stage of a cyclical bull market.

Dr Shane Oliver is head of investment strategy and chief economist at AMP Capital. This article was written on February 7, 2013.