The risk of a correction or new bear market in shares

Since the height of the Eurozone public debt crisis in September/October 2011, global shares are up 58% and Australian shares are up 37%. After such strong gains an obvious issue is whether shares have got ahead of themselves, leaving them vulnerable to a fall. This note looks at the risks.

Cycles, the US and other risks

As my good friend Don Stammer has rightly reminded us over the years there is always a cycle and after two good years in share markets maybe it's worth considering whether we are due for a turn in the cycle back down. Since 2011, shares have been in a cyclical bull market, with a clear pattern of rising highs and lows. See the next chart.

Source: Bloomberg, AMP Capital

However, there are several risks factors at present.

Source: Bloomberg, AMP Capital

Source: Bloomberg, AMP Capital

The rough start to the year in share markets has led to some concern about the so called January barometer that basically says that "as goes January for shares, so goes the year". This has heightened some of the above mentioned concerns.

A correction could occur, but...

Some or all of these factors could contribute to a correction this year and at the very least more volatility in share markets. While 2010 and 2011 saw roughly 15% and 20% top to bottom falls in shares around the middle of each year, in the last two years corrections were quite mild with a roughly 10% fall around May-June in each year, so maybe we are due for a bit more volatility. However, a new cyclical bear market in shares seems unlikely just yet:

First, the track record of the January barometer is mixed. For the US S&P 500 there have been 22 positive Januarys since 1980 of which 19 saw positive years, indicating an 86% hit rate. But the hit rate for negative Januarys (of which there were 12) going on to negative years was only 42%. Similarly for Australia, since 1980 there have been 20 positive Januarys for the All Ords index of which 15 saw positive years, giving a hit rate of 75%. But of the 14 negative Januarys since 1980 only 5 saw negative years resulting in a hit rate of 36%. So based on history if January is positive it augurs well for a positive year, but if January is negative it doesn't really tell us much at all.

Second, the US Presidential Cycle with respect to shares has been a bit messed up in recent times by the GFC and the Eurozone crisis. 2008 and 2011 were both meant to be good years but were far from it. And this year will actually see a let up in the pace of fiscal tightening in the US (and in Europe) which should be a boost for economic growth.

More fundamentally it's too early in the economic/investment cycle to expect a new bear market just yet. A typical cyclical bull market goes through three phases.

Right now we are probably in Phase 2. Rising global growth and a pick-up in Australian growth through the year should drive stronger profits, and optimism regarding the global economic outlook and share markets has clearly returned. But we don't see the signs of vulnerability that become evident in Phase 3 as precursors to a new bear market:

Source: ICI, AMP Capital

Of course there could be a shock from left field - the US, Europe or a policy mistake in China - but that is always the case and arguably the risks on those fronts are diminishing.

Further to go

This suggests that while shares might see a brief 10-15% correction at some point this year, a new bear market is unlikely and as such returns should remain favourable through the year as a whole. 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 more fall that takes more than 12 months to be reversed.

Source: ASX, Bloomberg, AMP Capital

A typical cyclical bull market since 1950 has seen shares rise 126% (column 4) and last four years (column 5). So far we are up 37% over 28 months. So history suggests more to go.

Concluding comments

While this year might be a bit more volatile, the cyclical bull market in shares likely has further to run reflecting the absence of monetary tightening, reasonable valuations and a lack of the sort of investor euphoria that characterises major market tops. When share investing becomes a common topic at barbeques and in taxi rides I will get more concerned!

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital Investors

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