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Saturday, October 27, 2007

Enter the mature bull - and higher volatility

Teh Hooi Ling
Sat, Oct 27, 2007
The Business Times

STOCK investors need pretty strong nerves to stay invested in the market of late. It is not uncommon to see the Straits Times Index (STI) open up 50 points but end the day at -50. And a 100-point plunge in one day may be followed by a similar jump the next.

This is a sign that investors are jittery. On the one hand, equities around the world have done spectacularly well in the last four-and-a-half years. During that time, the STI has more than tripled. That's a lot of profits to lock up. On the other hand, there are just as many compelling reasons to hold on to, as there are to quit, equities now.

The economic force that the emergence of China and India unleashes into the world, as hundreds of millions of new consumers flood the marketplace in the next few years or decades, is unimaginable. Meanwhile, the wealth accumulated thus far in these two countries is scouring the world for viable investments. That liquidity flow will continue to support asset prices globally.

On the flipside, the economy in the United States - still the world's biggest market today - is slowing down. The impact of the sub-prime mortgage crisis on consumer spending is still a big question mark. If US consumers tighten their purse-strings as they see their home prices fall, then many of the exporters around the world will be hit by declining profits. Demand from Asia may not yet be enough to make up for the shortfall. But increasingly, the market wisdom is that problems in the US are not severe enough to cause a recession there, and hence the impact on the global economy may not be as great as initially feared.

Still, the increased volatility is symptomatic of a maturing bull market.

Four-phase cycle

In a report this month, Citigroup Global Markets' equity research said that the global equity bull market that began in March 2003 is maturing, but not finished yet. We are now into the third phase of a four-phase market cycle, according to Citi.

The first phase is when the economy is emerging from a recession. It follows the bottom of the credit bear market. Spreads fall sharply as companies repair their balance sheets, often through deeply discounted share issues. This, along with continued pressure on profits, keeps equity prices falling. Phase two begins as profitability turns and equity prices start to rally. Credit spreads fall even further as corporate cashflows rise strongly. This is an immature equity bull market. In the current cycle, this phase began in March 2003.

The third phase is when the credit bull market comes to an end. Spreads start to rise as investor appetite for leverage wanes. The equity market decouples from credit and continues to rise. "We think that the market is entering this phase now. This is the mature equity bull market," says Citi.

And after that, the market enters the bear phase, when equity and credit prices are falling together. This is usually associated with falling profits and worsening balance sheets. Insolvencies plague the credit market, and profit warnings plague the equity market. At this stage of the market, a defensive strategy is most appropriate - cash and government bonds are the best-performing asset classes.

Citi tries to identify the four phases in the last 20 years' market cycles. It found that the different phases are not equal in length. For credit market, phase one tends to be fast and furious. It lasted 18 months in 1991-92 and just five months in 2002-03. But the returns are significant - spreads collapsed by 29 basis points (bp) per month in 1991-92 and 50 bp per month in 2001-03.

Phase two tends to be longer. It lasted five years in the mid-1990s and just over four years in the early 2000s. Spreads fell by a more leisurely 3 bp a month in 1992-93 and 10bp a month in 2001-03.

The credit bear market begins in phase three. Spreads rose by around 300 bp in 1988 and 1997-00. This time round, they have already risen by 120 bp since spreads bottomed on June 12, 2007.

Spreads keep rising in phase four as defaults increase and corporate profits fall. This tends to be the most painful period for credit investors, notes Citi. It lasted 30 months back in 2000-02.

While the credit investor makes money in phases one and two, an equity investor makes money in phases two and three. In phase three in 1988-90, global equities rose by 38 percent despite a 317 bp increase in credit spreads. And in phase three in 1997-2000, equities rose by 57 per cent despite a 282 bp increase in credit spreads.

While equities perform well in phases two and three, phase two - the immature bull - lasts longer and is less volatile.

For example, the US Vix measure of implied volatility has averaged 15 in phase two and 22 in phase three. This is a key difference between a mature bull and an immature bull. "The returns may be as good, but the quality of those returns is worse," says Citi. "Sharpe ratios and risk-adjusted returns deteriorate." As for now, the Vix is 16 - having peaked at 30 in July. "But we would expect the overall trend to be rising as the mature bull market develops."

This suggests that while it is still right to be overweigh equities in phase three, the overweight should not be as great as during phase two. And a leveraged strategy is less appropriate as volatility rises.

Among the sectors, Citi's analysis showed that travel and leisure, retail, media and industrial goods and services performed well in phase three of the last two cycles. Banks underperformed during this phase as credit spreads rose.

Meanwhile, the mature bull phases are also when major bubbles develop. In 1990, Japan rose to a 60 times trailing earnings multiple and accounted for 50 per cent of total global market cap. It now accounts for only 10 per cent. In 2000, technology, media and telecoms (TMT) also rose to 60 times PE and accounted for 40 per cent of global market cap. It now makes up 20 per cent of global market cap.

"These bubbles usually build on a theme that has already been performing strongly through phase two. Into phase three, easier monetary policy and rising capital inflows from other asset classes provide the fuel to drive prices to spectacular and ultimately unsustainable levels. This then bursts and proves a major downward force on global equities in the bear phase four," says Citi.

Next equity bubble

The next equity bubble could be building in emerging market or commodity plays. "These are stocks or markets which are perceived to be most positively exposed to a robust global economy, irrespective of the US slowdown."

However, the Asia ex-Japan index, at 19 times PE, although a premium to the MSCI World's PE of 16 times, is still a long way off the 50-plus times multiple more typical of the peak in these mature bull market bubbles.

"The key point is that if the bubble for this cycle is to be created in the global growth trade, and the Asia Pacific/emerging markets indices in particular, then they could have a lot further to go.

"Investors who try to fight the current re-rating of these markets could suffer the same fate as those who tried to fight Japan in the 1980s and TMT in the 1990s. Probably the right call, but the timing could hit you," says Citi.

According to Citi, signs of the end of the mature bull run include rate hikes and extended equity valuations. Both don't apply now.

So while the recent dislocation in financial markets suggests the end of the credit bull market, it is not the end of the equity bull market. We are entering the mature bull phase, which will still provide decent returns for equity investors. However, it is becoming increasingly unstable. This is the phase where a major speculative bubble typically develops in the global equity market. Perhaps this time round, it is in emerging markets and commodity plays. However investors should remember that these bubbles can go a lot further than anybody expects - it can prove fatal to bet against them too early, cautions Citi.

The writer is a CFA charterholder. She can be reached at