Leading market historian: ‘Shares could halve from here’

Financial historian Russell Napier gives his take on how to spot the bottom of a bear market

Not all bear markets are created equal. Some matter and some do not.
The technical definition of a bear market, a 20pc decline in the share index, can be of little importance if it does no long-term damage to the real purchasing power of investors.

The bear markets that destroy purchasing power, even for long-term investors, are those that begin when shares are very overvalued. That is where we start today and thus investors need to be aware that long-term damage to their purchasing power is now probable.

Investors agree on little about the future and even the past is up for much debate. So while not everyone accepts that the ?cyclically adjusted price to earnings? (Cape) ratio has been a good measure of stock market valuations, and hence future returns, many experienced investors set great store by this particular measure of value.

We have data for the Cape ratio for American shares from 1881 to the present and this shows that shares have attracted higher valuations than today only three times: in 1901, 1928-29 and 1995-2008.

It would be very difficult to see stock markets elsewhere in the world, including Britain?s, not being very negatively affected by such a major decline in American shares.

While some argue that 1995-2008 represents a new normal for valuations, it is much more likely that the elevated valuations resulted from a prolonged period when the US economy produced strong corporate earnings growth while also producing low inflation and thus low interest rates.

As interest rates are key in assessing the present value of future earnings, low interest rates are good for share prices and high interest rates are bad. While the benign combination of low interest rates and robust corporate earnings could continue, the immediate outlook is that we will experience deflation, falling corporate cash flows and potentially a major credit crunch.

With interest rates already at rock bottom, the impact on current elevated stock market valuations would be very dramatic indeed in this situation. This would produce a major decline in the long-term purchasing power of savings invested in the stock market.

In my book Anatomy of The Bear: Lessons From Wall Street?s Four Great Bottoms, I looked at the great bear markets in shares and also what brought those great bear markets to an end. My analysis shows that stock market valuations can fall rapidly when the nasty surprise for investors comes in the form of deflation and slowly when it comes in the form of inflation.

As the price of shares discounts the future, it is the surprises that matter when valuations are high and fundamentally there can be only two surprises: when corporate earnings growth is lower than expected or when interest rates, the rate at which future corporate earnings are discounted, are higher than expected.

Of course one can be wrong on both, with particularly negative implications for stock market valuations. All rapid declines in valuations are associated with the prospect of deflation, either directly or because investors foresee a collapse in the banking system which will lead us to deflation. With inflation currently close to zero, after nearly seven years of extreme monetary policy, investors need to protect themselves from a rapid decline in share prices caused by deflation.

So what evidence is there of the deflation that might act rapidly to reduce stock market valuations from expensive to cheap? Well, inflation is falling. In America it peaked at 3.9pc in September 2011 and has now declined to 0.7pc. The recent declines in the oil price suggest that inflation will decline further.
As commercial banks continue to struggle to lend money, the actions of the central banks have not led to the scale of growth in the money supply associated with previous robust economic expansions. If Milton Friedman was right and inflation is ?always and everywhere a monetary phenomenon?, the lack of growth in the money supply suggests that deflation is increasingly likely.

So inflation is low and falling, global growth is low and falling and key central banks are failing to boost the supply of money that is the most likely precursor to future inflation.

A low average rate of inflation hides a wide range of changes in individual prices. While some prices are rising rapidly, others, most notably those of crude oil and other commodities, are falling rapidly. For the companies and countries that rely on selling such products, the decline in revenues associated with the fall in selling prices can threaten their ability to meet their liabilities.
This fall in inflation comes despite the dramatic ?printing? of money by key central banks that began in 2009. This money printing has failed to generate inflation because it has primarily resulted in an increase in commercial bank reserves.

In other words, bankruptcy beckons for key companies and countries, with major negative consequences for the global credit system. Already Azerbaijan, Surinam, Angola and Nigeria are in talks with the IMF or the World Bank about possible emergency finance.

The market price of the bonds issued by many energy or commodity producing companies has collapsed, indicating that the market expects these countries to default on their debts. Should this impair the ability of the global credit system to finance growth, the powers of deflation would grow further.

Could all this really affect growth and inflation in the developed world? It could through its negative impact on the banking system, particularly in Europe, whose banks are very exposed to emerging markets such as Brazil (Spain), eastern Europe (Austria), Angola (Portugal) and Turkey (Italy).

The negative impact on the price of corporate bonds is already creating liquidity problems for bond funds ? two such funds in America were forced to suspend redemptions before Christmas.

While we associate a credit crisis with a banking crisis, the next one could begin with further distress in the corporate bond market as funds dump their investments in a desperate attempt to meet redemptions from investors. Any such developments would clearly have negative effects on growth and inflation in the developed world.

At current valuations, stock markets offer little promise of recovery. However, should we see the development of deflation and the likely associated recession and credit crunch, share prices could halve if they return to the levels seen in the four great bear markets.

That is a risk/reward balance that favours selling shares and waiting to buy when valuations are much more reasonable.

Not all bear markets are created equal but this one looks like a big grizzly.