We are now more than two years into the bear market that hit Wall Street when the dot.com collapse occurred in March 2000.
It is already one of the longest bear markets since the Great Depression yet over the past few weeks the bears have tightened rather than loosened their grip. Small investors, particularly in the US, are deserting mutual funds and fund managers are being forced to sell stocks to raise cash. This is adding to the downward pressure. Hedge funds and short sellers, those who try to make money from a falling market, are making things worse and adding to market volatility. Unfortunately an end to all this is not yet in sight.
There are good reasons for the bearish mood but the markets are now being driven by sentiment - in this case fear - more than logic. This makes predictions almost impossible.
So what are the causes of the bear market and what are the implications on the so-called real economy? The causes have been well canvassed.
We have just had the longest period of continuous economic expansion in US history. Share markets, companies, investors and consumers responded accordingly. Surveys of investors over the past few years have indicated that most believed that a 20 per cent a year return from the share market year after year could go on forever. While mathematically this is impossible, it did fuel speculation.
Consumers, particularly those who had shares, believed they were more wealthy and built up substantial levels of personal debt and decided not to save. Companies were caught up in the hype and corporate governance became lax.
This led to a series of bubbles – the share market bubble, the US dollar bubble, the consumer spending bubble and the debt bubble. These all have to explode or at least deflate before things get back on track.
The share market is going down fast and the US dollar is under some pressure. There have been a number of recent scandals surrounding company fraud and overstated profits. We have yet to see what will happen with the debt and consumer spending bubbles. This is the big risk to the real economy where people go to work, make things, provide services and so on.
Some economists see the link between the financial markets and the real economy as being weak or overstated. They say that as long as the US economy continues its recovery then consumer confidence will remain high and business will invest.
Others are much more pessimistic. They see consumer and business confidence closely related to the performance of financial markets through the so-called wealth effect. If individuals feel wealthy because their shares or property have risen in value they will tend to spend and borrow more. If they feel less wealthy then they may cut back spending and stall the economic recovery. If this leads to rising unemployment it could have a snowballing effect.
US President George Bush and Federal Reserve Chairman Alan Greenspan are desperately trying to talk the US economy up. Expect a lot more of this. With interest rates already at record lows, they have few other weapons left to fight an economic downturn.
While the US economy is showing signs of recovery, it is still weak in many areas and a significant drop in consumer spending could see it derailed. And of course, anything that happens in the US will have an effect here. Serious investors – those who are not easily frightened will be looking for opportunities. Kerry Packer for one is reported to be building a war chest to fund bargain basement purchases.
Many have already fled to the property market where residential house prices have soared 17 per cent in the past year and have averaged more than 9 per cent over the past five. The Reserve Bank has recently issued a warning to property investors suggesting that the possibility of capital gains is receding because of low rental returns and an oversupply.
The best buying opportunities will probably come in the share market. But how low can it go? Economists like to think that the market is rational although we all know that for much of the time it is either greed or fear rather than logic that are the driving forces.
So inevitably the market will overshoot. We have to take our lead from the US market. On some measures the US market is still overvalued.
Over the long term the price to earnings ratio of the bigger US companies has averaged around 14. That is, it would take about 14 years to get your money back if profits remained steady and all of them were distributed as dividends. By way of comparison, the Dow Jones index at around 8000 represents a P/E ratio of around 20. At this level shares are still expensive by this measure.
Other valuation models such as the ones that compare equities with bond yields suggest the US market is relatively cheap – hence some brokers are telling their clients to buy. However this latter model is sensitive to the level of interest rates. Should interest rates rise from their record lows then share prices will be seen as high – even at current levels.
In summary then, the market shake-out had to be expected – it was well overdue. But there is still some way to go in terms of purging all the excesses. Eventually the market will find a bottom and there will be good buying opportunities. Then we start all over again.David Tomlinson
David Tomlinson is a freelance finance journalist based on the Northern Rivers of NSW.
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