The magnitude and duration of the recent equity bull market has a number of commentators worried: it is now almost seven years since the trough in the FTSE 100 and, with only short-lived exceptions, markets have been rising ever since.
More recently, markets have been buoyed by rising global growth indicators and expectations of fiscal reform under Donald Trump. However, there are concerns that this might reverse if it does not prove possible to deliver those reforms. Equally, there are plenty of political and economic risks looming, and stock market valuations do not look cheap.
Even if the circumstances seem obvious in hindsight, it is seldom possible to see a bear market looming. The trigger may be different in each case. Alan McIntosh, chief investment strategist at Quilter Cheviot says: “In the 1970s, there was a global recession, with high inflation. The circumstances are very different to the dotcom bubble, which was largely a case of over-valuation. In 2007/08, the trigger was a collapse in the banking sector.”
The Causes Of A Bear Market
Nevertheless, there are some common characteristics that create the conditions for a bear market. In its analysis on US bear markets since 1929, JP Morgan offered four possible causes for a bear market: recession, commodity spike, tightening by the Federal Reserve and extreme valuations. It defined a bear market as a fall of 20% or more from the previous market high. Its analysis showed 10 major bear markets since 1929, with an average market decline of 45% and duration of 25 months.
In recent bear markets, some combination of these factors has usually been at work. People don’t care about high valuations when everything is going well. Equally they are less troubled about a recession if share prices are low. Brad Holland, senior investment manager at Nutmeg says bear markets usually begin after a period where investors suspend their disbelief: “Markets lose sight of the risks. In the credit crisis, high risk income flows were priced as low risk income flows. Investors forgot the basic rule of thumb – a higher risk requires a higher return.”
In cases of over-valuation, there needs to be a catalyst for investors to recognise that over-valuation. This might be a political crisis, or a currency devaluation, or – in the case of the 2007-8 crisis – something that exposes the real value of the asset. Holland adds: “Once investors began to look at bank balance sheets, and question the link between the balance sheet and the income statement, and by extension, the viability of the investment, they started to question the way in which financial assets were valued.”
Are Share Prices Over-Valued Today?
The question is whether any of these conditions are in place today. In equity markets, valuations do not look particularly stretched. McIntosh says: “Investors can always choose a statistic to make their case. Markets have had a strong run, but this was from very depressed levels.”
Holland agrees: “The arguments you hear for a coming bear market often focus on how long the cycle has endured. Certainly, it is getting quite ‘old’, but we see this as poor reasoning. The simple truth is that the cycle has been prolonged because it was so weak and there are plenty of areas in the world that haven’t taken part in it.”
McIntosh believes the next bear market will come from an economic shock, rather than because markets are too expensive. He believes this would have to be more than, for example, a victory for Marine Le Pen in France. After all, this has been well-flagged as a possibility. A global trade war could be a trigger, for example, or an unexpected geopolitical event. Others points to a significant spike in inflation as a key risk. Sharp rises in interest rates have historically been a prompt for markets to unravel.
Most investors tend to see bull and bear markets as a stock market phenomenon. However, Holland argues, the area at greatest risk of a bear market is currently the bond market. It may already be in a bear market. He says: “Negative bond yields were a suspension of disbelief. Most investors recognised that the markets were over-valued, but it wasn’t until the Bank of Japan and European Central Bank starting talking about winding down quantitative easing that investors started to shift their position. We have had a bear market in government bonds since that point.”
However, a prolonged bear market in bonds remains an outside possibility because higher yields would inflate government debt, which would be an unacceptable situation for most governments and they would almost certainly take measures to prevent further rises. Also, bonds still have price insensitive buyers in the form of central banks and some insurance and pension funds.
McIntosh concludes that ‘nothing is flashing red’ in equity markets and while bonds look unattractive, a prolonged bear market seems unlikely. Certainly, while it is difficult to see significant rises in equity markets from here, there is little to suggest a bear market either. Bear markets often come when no-one is looking for them.
