A correction, or the beginnings of a bear market?

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Written by:
02/10/2015
Sharp downturns and continuing volatility in major stock markets in recent weeks have been dubbed “a major market correction” by Goldman Sachs. But when does a correction end and a bear market begin?

A correction is technically defined as a market fall of 10 per cent or more, a bear market a fall of 20 per cent or more.

The S&P 500 has experienced 20 such corrections since 1945 (meaning on average corrections occur every three and a half years), and 12 bear markets (meaning bears occur roughly every years on average).

This suggests corrections develop into bears around 60 per cent of the time so could the current correction be such an occasion?

Polarised opinion?

Colin Morton, manager of the Franklin UK Equity Income fund, believes it’s “anyone’s guess” as to whether the current correction will become a bear market, although he notes there is growing uncertainty in the market.

“China’s slowdown has impacted oil and mining companies, Volkswagen’s scandal has raised bigger questions about the wider automobile industry, and the Fed hasn’t allayed many concerns with the opaque situation around interest rates,” he says.

Craig Melling, investment manager at Redmayne-Bentley, meanwhile believes the bull market is nearing its end.

“Volatility is here to stay and investors may have to get used to smaller annualised returns,” he says.

It is not unusual, however, for markets to experience corrections during extended periods of strong performance. Patrick Gordon, head of research at stockbroker Killik & Co, believes the current correction should be viewed in the context of “a bull market that commenced over six years ago”.

Rory McPherson, co-manager of the Russell Multi Asset Income fund, points out emerging markets and commodities are already in bear phases. However while pullbacks in the US and European stock markets have been significant, he doubts a fully-fledged bear is on the horizon. The conditions associated with a bear market are not in evidence he says.

“In the run up to a bear, we typically see runaway growth combined with high valuations (as in 1999 – US equities traded on 27 times earnings, US growth was over 5 per cent), excessive leverage and over-stretched credit markets (as in 2007/8), inverted yield curves (as in 2000 and 2006), high inflation – and aggressive Fed rate hikes in response,” he explains.

“Today, inflation is generally below target, growth is modest and stable, valuations are full but not eyewateringly high, there’s much less leverage, and steady wage growth.”

While John Stopford, portfolio manager of the Investec Diversified Income fund, does not think a bear is coming he notes it may be too soon to sound the all clear.

“Market corrections typically last weeks or months rather than days, and a number of risk measures remain elevated,” he states.

Peter Elston, chief investment officer at Seneca Investment Managers, points to different metrics that suggest a bear market is not on the cards.

“The output gap for advanced economies, according to the IMF, hit long-term highs of around 2 per cent in both 2000 and 2007 – today, the IMF output gap is -2%, hardly indicative of economic overheating,” he says.

“This would be an unusual place for a pronounced bear market to start.”

Unbearable?

Despite some broad agreement that a bear market is not on its way, there is also recognition that certain factors could cause one.

While a recession in the US would crash markets, but McPherson says this scenario is unlikely given the consistent strength of the US labour market. Likewise, an aggressive Federal Reserve interest rate hike would likely produce a bear. Again, McPherson believes this improbable with the Fed making it clear that it will err on the side of caution, and increases will be small and gradual.

Nevertheless, China’s recent problems represent a more tangible threat.

“China’s a risk given the opacity of its data – a hard landing here could be a big financial event in markets. If this was coupled with aggressively rising rates, we’d probably be in trouble,” McPherson states.

“On its own, China’s slowdown isn’t the worst thing in the world. We don’t see a major collapse happening there, but it is a risk.”

Stopford believes weak emerging market conditions overstate the risk of Chinese collapse.

“Investors are in danger of extrapolating what appears to be a severe adjustment into an accelerating collapse in demand,” he says.

“Our base case is a slowdown in Chinese GDP growth rather than collapse. The downward acceleration in commodity prices and emerging market exchange rates suggests a harder landing in China is being priced in.”

Grin and bear it?

For many, the present environment represents a potential buying opportunity. Gordon notes analysts have downgraded their forecasts in a number of sectors, which may increase the chance of “positive earnings surprises”.

“It may well be company outlook statements that provide more meaningful information for investors and dictate the market’s response to the earnings announcements,” he says.

Morton welcomed August’s 15 per cent fall in the FTSE 100, on the basis there are better opportunities in the market at 6,000, than 7,000.

“The best time to get more involved in the equity market is when others are cautious and unconvinced,” he says.

“Selected equities remain good value, with attractive returns. This as an opportunity to improve quality in a portfolio by taking advantage of undervalued companies.”

McPherson favours markets where business cycles are improving, liquidity and credit growth are on the up and central banks are supportive.

“The easy returns in the market have been had, but investment conditions remain fertile in places. The US market is expensive – I’d say it was fully valued – but in QE markets (Europe, Japan) there’s potential for double digit earnings growth,” he says.

“One needs to be thoughtful about which markets you’re exposed to. There is some value to be had in emerging markets, but business cycles are ugly. It’s still too early to get involved there again.”

Stopford sees value in a number of different asset classes.

“Equities may not be cheap in absolute terms, but offer a decent risk premium over government bonds – corporate bonds and sovereign credit offer more average relative value, but have become noticeably cheaper of late,” he says.

“Emerging local currency debt and emerging currencies are increasingly undervalued, even allowing for a very weak fundamental backdrop. Cautious and selective additions to exposure in all of these areas looks sensible.”

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