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Market Review: April 2009 Commentary

New Zealand and Australia are weathering global financial and economic distresses better than most. This month we comment on the recent equity market rallies. Peter Lynn warns “don’t be fooled”.

Wednesday, April 8th 2009, 1:03PM

Bouncing Like A Dead Cat
As Jim Morrison sang, “People are strange” and not only when you’re a stranger, but when you’re an investor as well. How else to explain the gyrations in the sharemarkets of the world over the past month other than quirks of human behaviour?

We all know that markets are driven by fear and greed, but it is the extent of both and their impacts that still surprises. There also seems to be a third factor impacting on prices at the moment, which is some sort of combination of both fear and greed (and ego as well) in that those who have sustained big losses in particular stocks (or, indeed, in the market as a whole) are watching the strong price recoveries from “bottom levels” before bailing out completely – hence, sending the prices nosediving again.

These sorts of actions are keeping the overall market volatility incredibly high. Unfortunately, though, we have simply got used to sharemarket falls or rises of at least 2% in a day. Such movements (especially downwards) just did not occur in 2005 or 2006. However, as we noted in April 2007, they started occurring a few times in February and March 2007 and have increased in frequency as the months have progressed. Historically, our analysis shows that such falls seem to start occurring around 18 months prior to a large crash.

This was the case in the US in 1928 and 1929, it was the case in the US (and NZ) in 1986 and 1987 and indeed it occurred in many countries, particularly the US, in 1999 and 2000 (1999 is often remembered as a very strong year in the US sharemarket, when tech stocks rose alarmingly, but actually a majority of stocks fell in price during that year). In all of these cases, starting around 18 months prior to a large crash, there had been many daily stock price falls of 2% plus. Before that, again in all of these cases, the market would have suffered no more than one or two of these “shocks” in any six-month period.

The incidence of a number of these market shocks would seem to herald some fairly disappointing equity performance ahead. Similarly, their absence seems to imply that the overall trend should be upwards.

So it continues to surprise me when, during the huge rally that occurred in March, many supposedly intelligent commentators on the market expressed such positivity over the future outlook. “The worst of the banking crisis is over” was heard numerous times after the March 9 low (which for the MSCI Index, was the lowest level since 2002).

This March rally started off with Citigroup saying, on March 10, that it was having the best quarter since 2007, which shouldn’t have been a surprise given the very favourable environment that the US government and Federal Reserve had established for banks to trade in.

And so this particular bear market rally drove on, including the strongest two-week rally in the US since 1938 – seriously – until JP Morgan’s CEO Jamie Dimon spoke for the whole banking sector on March 28, when he said that March had been a tougher environment than the first two months. The next two days were pretty weak for the market and one suspects that this rally may now be over.

This is about the sixth of these bear market rallies (or “dead cat bounces”) that we have seen in this crisis so far. The previous one lasted from 21 November 2008 (when the US Government first bailed out carmakers) to 6 January 2009 (when US job loss figures were announced 200,000 higher than forecasts expectations for both November and December). This was the strongest rally since World War II. Remember that optimism that coincided with Obama’s inauguration? It didn’t last long in the markets.

That rally was preceded by four bounces (all of very much the same order of magnitude, 7.5%) from 16/7/08 to 11/8/08, from 15/4/08 to 19/5/08, from 11/3/08 to 7/4/08 and from 27/11/07 to 10/12/07. Notice that all of these rallies are also around the same length – three to five weeks. Also, during all of these cases, there were several comments that “the worst was behind us” (even in the 2007 one) and an amount of optimism that the ensuing period would be the start of the next bull market. We will likely see more of these rallies that could be of the same 20%+ order of magnitude that the last couple of rallies have been. This was certainly the case in Japan in the 1990s.

From 15/12/1989 to 15/10/1998, the Topix Index in Japan fell 66.0%. However, within this almost nine-year bear market, there were many double-digit rallies and even some fantastic ones over 35%. In 1990, just a few months after the large 1989 crash, the Japanese market went on a two-month tear of 18.3%. Towards the end of that year, it rose 23.4% in just over three weeks. Early in 1991, it rose 23.1% in two months. In 1992, it rose 28.8% in a two-and-a-half week period. In 1993, it rose 35.9%.

1994 saw a 26.8% rise over the first half of the year and the last two months of 1995 rose 17.5%. With several more rallies in 1996 and 1997, it just shows you how much it dropped in between the rises to result in such a large overall fall. And each time during these rallies, there was optimism that this was the bull market that would lead Japan out of its mire. And after each rally, a new bottom was soon found.

Back to the current time and there are some good signs around that there can be some strong bear market rallies in the remainder of 2009. The US Fed has now started quantitative easing, which is starting to result in some funds flowing into US households. In addition (and important for this part of the world – see Andrew’s column), the Chinese government is happily subsiding its industrial sector to keep on producing, which doesn’t seem to make any sense when there is weak demand for their products, but keeps the global demand for raw material commodities high. The result is a happier place for equities.

However, any such rallies are unlikely to be sustainable. While there remains uncertainty regarding the global banking industry, volatility is likely to continue. We still have no idea what the banking system’s total losses will be: are the current IMF estimates (USD2.2b) realistic, or are the loss levels well over USD3b? How much more nationalisation of the global banking system is required? How much more will European banks be impacted by the crisis in emerging Europe? How are the Aussie banks managing to get away with very little impact, or is that still to come?

There are a lot of big questions here and these are just on the banking system. There is also the ailing car industry and the airline industry (or, in fact, the hospitality industry) is not having a wonderful time. There are questions over the likely level of global unemployment and, finally, whether all of the fiscal and monetary policies enacted by governments all over the world are going to be effective. Some of these questions will only be resolved in 2010, which will make that a bit of a bellwether year.

So, enjoy the rallies while they last (March was the best month for global equities since April 2003 – and the best month for emerging market equities since 1983!). But don’t be surprised if people in the markets continue to exhibit some pretty strange behaviour. Just don’t be fooled by them.

Peter Lynn, CFA
Head of Strategy

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