Bursting the recovery bubble

Published March 30, 2011

Don't count on a complete recovery anytime soon, says chief investment strategist at S&P's Equity Research, reports PAUL J LIM

(NEW YORK) DESPITE recent volatility in global markets, domestic stocks have doubled in value in the past two years, the fastest such gain since the Great Depression. And financial shares have fared even better, soaring more than 160 per cent since the long stock rally began in March 2009. But will the broad market in general and financial stocks in particular resume this torrid pace? Perhaps not.

Unsustainable: It's hard to imagine how much longer the broad market can keep up the pace of the last two years, some market strategists say
Consider how stocks have fared over a much longer stretch - since the end of the previous bull market, in March 2000. Last Thursday was the 11th anniversary of the bursting of the technology bubble, a reminder of how long it may take investments at the centre of a major market plunge to return to their past glory.

For example, though most sectors of the Standard & Poor's 500-stock index are now trading above their levels of March 2000, the overall index is still slightly below where it was then. And technology and telecommunications stocks - the market's best performers leading up to the 2000-02 bear market - are still down around 60 per cent, on average, from their peaks 11 years ago; blue-chip growth stocks are off about 35 per cent.

What's the moral of this story? Don't count on a complete recovery anytime soon, said Sam Stovall, chief investment strategist at S&P's Equity Research. 'It could take 15 years for stocks to work off the effects of a major bubble,' he said.

Mr Stovall has studied market recovery periods in the years after World War II. He has found that while it usually takes stocks about 14 months to return to previous highs after a mild bear market, and five years, on average, to bounce back from a severe downturn of 40 per cent or more, it typically takes even longer to recover from a bubble.

He noted, for example, that after oil prices peaked during the energy bubble in 1980, it took 16 years for some categories of oil-related stocks to recover to their pre-bubble highs. And after gold peaked in 1980 at around US$850 an ounce, it took 28 years for the price to return to its pre-bust perch. (Of course, even at US$1,426 an ounce, gold still hasn't recovered to its 1980 levels when adjusted for inflation.)

The reason recoveries take so long 'is that a true bubble occurs only when valuations are taken to extremes, and it usually requires at least two bear markets to bring those valuations back to historic norms,' said James B Stack, editor of the InvesTech Market Analyst newsletter.

To be sure, one could argue that the valuations of financial shares have never skyrocketed the way those of tech shares did in the late 1990s. In fact, at the end of 2007, when the global credit bubble had popped, the price-to- earnings ratio for financial stocks stood at around 17, according to Bloomberg. That's about on par with valuations for the broad market at the time.

Yet that happened because the reported profits of financial companies had soared leading up to the plunge, Mr Stack said, so that earnings - the 'E' in the P/E ratio - generally kept pace with rising prices. 'But in reality,' he said, 'many of those earnings were built on artificial sources of income that were not only going to dry up but reversed course when the asset bubble popped.'

Another reason to believe that financials may soon hit a ceiling, Mr Stack said, is that 'there are still too many people waiting to get out' of those shares. In other words, many investors are still holding onto financial stocks not out of faith, but because those shares are still so far below their October 2007 peaks - about 50 per cent, on average - that they've have been waiting for a bigger rally before selling.

Haven't financials surged over the last two years? Yes. But Jack A Ablin, chief investment officer at Harris Private Bank, notes that since the first three months of this rally - when financial stocks bounced back the most - these shares have actually lagged behind the broad market. Since the start of June 2009, the S&P 500 has gained 42 per cent, versus just 34 per cent for the financial stocks in the index.

Mr Ablin said 'conditions during this stretch couldn't have been any better for the banks', alluding to the government's efforts to keep short-term interest rates near zero, assuring substantial profits when banks relend that money to customers. 'Yet this is all we got to show for it,' he said. 'That would suggest that it could take many years for the fundamentals of this sector to recover.' As for the broad market, it's hard to imagine how much longer it can keep up the pace of the last two years, some market strategists say.

Beyond the threat of rising inflation, as well as various geopolitical risks, valuations are becoming stretched. David R Kotok, chief investment officer at Cumberland Advisors, says a simple way to judge the frothiness of the market is to consider the ratio of total domestic stock market capitalisation to gross domestic product (GDP).

'History says that when stock market capitalisation is about 55 per cent or 60 per cent of GDP, stocks are a great bargain, which was the case during the March 2009 lows,' Mr Kotok said. 'But when stocks are 110 per cent of GDP, it's time to sell.' Today, the stock market is worth about 95 per cent of GDP. 'So,' he said, 'I don't believe the market has a large strategic move upward from here in the short term.' - NYT