Bear or Superbear? The new Draaisma-land

Beyond the call of duty!

Apart from analyzing valuations, interest rates, and growth, the author has also read all the daily Wall Street Journals in the four months surrounding the identified bear market bottoms…

This is Teun Draaisma, Morgan Stanley’s European strategist, reflecting in his latest note to MS clients on his own lessons from reading Anatomy of the Bear, published in 2005 by Russell Napier.

Napier analysed US equities over the last 100 years, observing along the way that every now and then markets go to levels of gross overvaluation - overvaluation events that are invariably followed by a bear market that ends at levels of gross undervaluation.

Four great bear market bottoms are identified - the four best moments in the last 100 years to buy and hold equities for at least ten years: 1921, 1932, 1948 and 1982. The year 1974 almost also made the grade, but didn’t make it into the final selection because the subsequent returns over the next 10-15 years were low in real terms.

Anyway, Mr Draaisma, now famous for his Sell, Sell, Sell last June and his Buy, Buy, Buy last September, enjoyed the book. He has now used the lessons learned as a framework for the “superbear” scenario within his current market thinking — namely that this ‘bear market rally’ is coming to a juddering halt and that steep price falls will follow as real economic slowdown overcomes the underlying economy.

Here are Mr Draaisma’s eight lessons from the great bear markets of the past 100 years:

1. Valuations get very very low indeed. The cyclically-adjusted PE, aka the Shiller PE, represented by the latest price divided by the average earnings of the last 10 years, reaches 10 or even less at bear market bottoms, while Tobin’s Q, the price divided by the replacement value of assets (or price over net worth defined as assets minus liabilities), gets as low as 30% or less. These valuations are the biggest problem with today’s market, as the Shiller PE is more than twice that. Today’s message: Shiller PE is above 20 still, while true bear markets tend to end at less than 10 times (see Exhibits 12 and 13). Equities are not cheap enough and need to decline by at least 50 percent.

2. Equities become cheap slowly. The average duration of bear markets has been 14 years, with the much more rapid 1929-32 episode, when equities went down 89%, the exception. Today’s message: we are in year 8 of a 14 year bear market.

3. Sentiment is not hugely negative at the bottom of the bear market. The popular myth that there are no bulls left at the bottom of the bear market is wrong. Many market commentators are correctly bullish right at the bottom of the bear market. Popular myth has it that talk of ‘equities are dead’ and ‘there is no future for equities’ should be widespread and are classic signals of the end of the bear market. This is far from the truth, it turns out. In related fashion, there is no climactic last and final sell-off on high volumes. Quite the contrary, the final slump is on lower and lower volumes. Subsequent higher volumes at higher levels confirm the bear market is over, with hindsight. Today’s message: do not take any ‘contrarian comfort’ from the fact that many people are quite bearish on the macro outlook, contrary to conventional wisdom, that is not a classical sign of a bear market trough.

4. Patience! Equities do trough during economic recessions, but they do not anticipate economic recovery by 6-9 months. The lead time is much shorter, and often equity and economic recoveries are coincident, and sometimes economies bottom before equities do so. Patience is key. Today’s message: indeed, this is consistent with our finding that one should be patient in bear markets as there is not much discounting of the upturn going on at the end of the bear market, after numerous failed rallies and false hopes (see Exhibits 9 and 10).

5. Times have changed, but most rules have not. Although times have changed dramatically over the last century, and economies have been functioning differently, while investors have arguably become more sophisticated, there are many common signs and characteristics at the bottom of bear markets.

6. Don’t fight the Fed. When the Fed cuts rates and equities are cheap, you should buy. There have been some major exceptions, such as in Nov-1929 (as in Jan-2001 and March-1980), when Fed easing was a false signal to start buying equities. Today’s message: if equities are cheap one should not fight the Fed, but arguably equities are not cheap enough yet (see lesson 1).

7. There are some consistent early signs of economic improvement. The three best are the copper price bottoming out, auto sales improving (or at least getting less bad), and inventories being very low. Today’s message: the copper price has not even fallen yet, so we are far away from the bear market trough.

8. Fixed income markets have given some good warnings signals. Government and corporate bonds rally on average 10 and 4 months, respectively, before equities reach their final trough. Today’s message: similar to the copper price in lesson #7, government bonds have not even sold off yet. Corporate bonds have, of course, and troughed in the middle of March, which in isolation means that equities are close to a trough too. However, in conjunction with the other lessons, we think this does not stack up at all, as valuations are simply too elevated.