It’s different, but it’s not
Doomsday has been avoided. Not only is the market recovery well underway, it is actually following a rather ‘normal’ recovery pattern.
History shows us that during periods of immense disruption, investment markets tend to rally ahead of economic recovery.
The current recovery cycle has proved to be no exception. Figure 1 shows that the turning point for equities occurred relatively early in the economic downturn and sharemarkets in major economies that haven’t convincingly emerged from recession, such as the US, are up by as much as 62 per cent.
This early mover trend is part of the reason that a very bad year of investment returns are more often than not followed by a period of very good returns.
Figure 2 shows that while the downturn of 2008 was more pronounced than any other, the market correction of 2009 is following a typical recovery pattern that has occurred over the past century.
Risk on, risk off
A more unusual aspect of our current recovery is its ‘risk on, risk off’ nature. During the height of the Global Financial Crisis (GFC) almost all markets fell simultaneously as investors sought to exit any form of risk.
Yet the first phase of the rally – from March to September – was driven by riskier stocks. Depressed markets meant that valuations were very cheap, which boosted returns to the most volatile stocks in every region of the world as shown by figure 3 below.
We are now transitioning to a new phase of the recovery, which is likely to involve a shift from ‘macro to micro’, where it will become increasingly hard for a company’s share price to rise simply because the market is rising. During this next stage of recovery, after-shocks such as the Dubai World debt concerns will continue to ripple through the global financial system, but most will not represent a new systemic risk.
Earnings now need to do the heavy lifting Generally speaking, sharemarkets are trading at reasonable valuations – they are no longer cheap relative to the current expected level of earnings growth.
This means that for sharemarkets to rise further, company earnings need to increase more than currently expected. The good news is that earning revisions are starting to turn positive, which is a typical occurrence during this stage of the recovery cycle.
What does this mean for investors?
The first stage of the market recovery saw global sharemarkets rise spectacularly, almost without a pause. This is typical of the first stage of a market rally, but not the next.
During this next phase, research will become increasingly important. Winners will include companies that deliver solid earningsimprovements, while stocks that disappoint on this front will be punished.
This next stage will encompass difficulties, but offers strong return potential.
Emergency measures will continue to be wound back – the Reserve Bank of Australia’s (RBA) recent rate rise is another example of this occurring – as global economic markets are turning around. Over the longer term sharemarkets tend to track economic growth and company earnings and both of these factors are on the upswing.
