A STOCKBROKER recently commented that he thought the Australian sharemarket had hit the bottom of the cycle and was ready to gradually move higher. Could it be that, after four years and eight months, the ghastly bear market in which the All Ordinaries Index is down 38.5 per cent from its all-time high is over?
Is the bear about to wander off into the woods? One way to answer this question is to look at how sharemarkets behave at the end of a major decline?
The All Ordinaries Index has rallied a healthy 4.6 per cent in 46 days since the market bottomed on June 4. While this is a nice response to the disasters of May, it is not the typical end to a bear market. A look back through history reveals that equities nearly always enter a swan dive in the final months of a bear market. Since 1900 the Dow Jones Industrial Average has fallen 20 per cent or more on 16 occasions in the final year of a downtrend in shares.
On all of these occasions the market's decline accelerated into the ultimate bottom before bouncing sharply to form a V-shape. The bounce is usually about 10 per cent in the first few months.
The only real exception to this is when the market cuts a V-shape bottom only to collapse again soon afterwards to form another V-shape. This is commonly referred to as a double bottom and has occurred on seven of the 16 occasions the market sank 20 per cent at the end of a downtrend.
A classic example of this was at the end of the tech wreck. This double bottom took about six months to play out, but formed the basis for a multi-year rally.
The Australian sharemarket has concluded bear markets in a similar fashion. The market will fall for a period, try to rally and then in the end, exhausted investors dump stocks before a major rally ensues. Even the most mild bear market, such as the one during 2002, saw the All Ordinaries stumble almost 13 per cent in just over two months at the beginning of 2003. Within three months the market had recovered a robust 14 per cent.
In fact, there has never been a gentle end to a bear market or a timid start to a new bull market.
Unfortunately, the rebound in the Australian market from the 10.5 per cent decline in the month to June 4 does not qualify for a V-shaped recovery. In fact it looks more like an L-shape. This suggests there might be more bad times ahead.
So much for the technical view.
Fundamentally, it is far more difficult to identify the typical set-up for the beginning of a new bull market. The major secular bear markets in the US over the past 100 years have ended on extremely dire notes. The Depression-inspired bear market from 1929 to 1942 effectively came to a close during the heady days of World War II. At the time there was no certainty who would triumph in the battle, but still the market took a view and it proved correct about three years later.
The curtain fell on the protracted bear market of the 1970s when Federal Reserve chairman Paul Volcker took the bit between his teeth and jacked up interest rates to kill the bogey of inflation.
Initially the sharemarket took cover, but within two years US equities started one of the greatest bull market runs in history.
In Australia, the recovery usually revolves around cycle low interest rates that manage to stimulate economic activity in key sectors such as housing, retail and transport. We are currently enjoying an easing in monetary policy that may last until the end of 2012.
There are major economic hurdles facing the globe. All of these are well documented, with the critical ones being the debt loads in Europe and the US. The US market has chosen to ignore these problems over the past three years, preferring to run a socialist agenda, with the Federal Reserve subsidising investors by printing money.
As we sit here in July, the market has high expectations that chairman Ben Bernanke will oblige again some time before September. This, combined with solid US earnings, has the market on another rally. However, more money pumping does little to address the issue of getting the national balance sheet in order.
Bernanke would be well advised to observe the harsh stance Volcker took back in the early 1980s.
A refusal to support the market with money printing might just cause that last-gasp selloff that strong-arms governments to take a tough stand against the problems facing the world. In other words, the marketplace will force the issue.
A refusal by the Federal Reserve to step up to the plate would be doubly powerful given the "fiscal cliff" the US faces in 2013.
A plan to attack the debt problem in the new four-year presidential term could initially scare markets it could also inspire by providing a road map out of the mess. As history shows, markets have great resistance when things look dire.
Former fund manager Matthew Kidman is a director of WAM Capital.
matthewjkidman@gmail.com
Frequently Asked Questions about this Article…
Has the Australian sharemarket hit the bottom and started a recovery?
Some stockbrokers think the market has bottomed, but history suggests caution. The All Ordinaries Index was down about 38.5% from its all‑time high and has rallied 4.6% in the 46 days since a low on June 4. The article notes that such early rebounds are common but don’t necessarily mark the end of a bear market — further falls often accelerate before a lasting recovery.
What does historical market behaviour tell everyday investors about bear market recoveries?
History shows bear markets rarely end gently. Since 1900 the Dow hit 20% or more declines in the final year of a downtrend 16 times, and on all those occasions declines accelerated into a bottom followed by a sharp V‑shaped bounce (typically around 10% in the first few months). Australian markets have shown similar patterns.
What is a V‑shaped recovery versus an L‑shaped recovery, and which is the market showing now?
A V‑shaped recovery is a sharp fall followed quickly by a strong rebound; an L‑shape is a drop followed by a prolonged, shallow recovery. The article says the recent rebound after the 10.5% decline into June 4 does not qualify as a V‑shape and looks more like an L‑shape, implying the possibility of more tough times ahead.
What is a double bottom and has that happened in past bear markets?
A double bottom is when the market forms a V‑shaped recovery only to fall again and form a second V. According to the article, this occurred in seven of the 16 historical occasions when the market sank 20% in the final year of a downtrend. A classic example was after the tech wreck, where a double bottom unfolded over about six months and preceded a multi‑year rally.
How do interest rates and monetary policy influence Australian market recoveries?
In Australia, recoveries often revolve around cycle‑low interest rates that stimulate activity in housing, retail and transport. The article notes there was an easing in monetary policy that could last until the end of 2012, and such easing can help kick‑start a broader market recovery.
How do US Federal Reserve actions affect global markets and investor expectations?
The article highlights that Fed policy matters a lot: recent years saw the Fed 'printing money' to support markets, and investors expected chair Ben Bernanke to act again before September. While such stimulus can spur rallies, the article warns it doesn’t solve underlying national balance‑sheet problems and that a refusal to provide more support could trigger a sharp sell‑off that forces tougher fiscal decisions.
What major economic risks should everyday investors be aware of right now?
Key risks cited include large government debt loads in Europe and the US, and the US 'fiscal cliff' looming in 2013. These structural issues can lengthen market weakness or cause renewed sell‑offs, even if short‑term monetary stimulus sparks temporary rallies.
What should everyday investors realistically expect during the end of a bear market?
Expect volatility and an uneven path to recovery. The article points out bear markets often feature a last‑stage acceleration downwards, intermittent bounces, possible double bottoms, and then a sharper rally. In short, recoveries are rarely smooth — patience and awareness of downside risk are important.
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