3 Feb 2019
Average duration, market bottom valuation of previous slumps close to those of ongoing dip
Cash outperformed equities last year. It is not uncommon for investors to start doubting the wisdom of staying invested in equities after a prolonged market downturn.
As of December last year, the downturn we faced had lasted for 11 months. How long do stock market retreats generally last in Asia?
Let's look at the MSCI Asia Pacific ex-Japan Index starting from 1987 to get some clues. Over the last 30 years or so, there were seven major market declines, including the one last year. From this perspective, negative market returns are not so uncommon - one every 51 months, or one every 4.25 years.
This is in fact how markets work. When the going is good, investors bid up prices. A lot of news will be seen as positive for the markets. Prices will eventually rise to a level that is not backed by fundamentals.
It is usually at this time that unexpected news or development will trigger a fall. Investors with profits will start to take their money off the table, exacerbating the decline. More news will emerge to compound the bearish sentiments.
Just as prices overshoot on the way up, they too tend to overshoot on the way down. However, at some point, the market will realise that stock prices have fallen to too low a level vis-a-vis prices in the actual physical marketplace and the stock market will start to recover. And the cycle goes on.
The table shows the downturns - their severity, duration, valuation at the time of decline, when they hit bottom, and the subsequent recovery. The table is arranged based on the severity of the market drawdown.
There are a few points to note from the table.
One, the higher the market valuations, the more severe the decline.
The three most stomach-churning declines over the last 30 years happened in October 2007 (global financial crisis), July 1997 (Asian financial crisis) and December 1999 (bursting of dot.com bubble).
In the global financial crisis, the market plunged by 62 per cent. For the Asian crisis, it fell by 57 per cent, and for the dot.com bubble burst, by 46 per cent. Of the three, market valuation was the highest in October 2007, just before signs of cracks started to emerge in the sub-prime housing markets in the United States.
At that time, the stock prices of the major index stocks in Asia were trading at 3.5 times the value of their net tangible assets, and three times the value of all their assets, including intangibles like goodwill or brand names.
Just as prices overshoot on the way up, they too tend to overshoot on the way down. However, at some point, the market will realise that stock prices have fallen to too low a level vis-a-vis prices in the actual physical marketplace and the stock market will start to recover. And the cycle goes on.
Say, a company owns a building valued at $100 million, and it has cash, inventory and other assets worth another $50 million. However, it has bank borrowings and other liabilities totalling $50 million. Thus its net assets amount to $100 million.
In October 2007, such a company was valued at $350 million, that is, 3.5 times its net tangible assets or book value. Assume again that this company has $17 million of goodwill, which is an intangible asset, on its books.
This company's total net book value would be $117 million. Since it is valued at $350 million on the stock market, its shares are trading at three times its book value ($350 million/$117 million).
Various studies have shown that stock price compared to a company's book value is a good indicator of value. Stocks that are trading at prices significantly higher than the book value are deemed expensive, and generally yield low returns for investors, and vice versa.
The price-to-book value or PB multiples for the other two market peaks in July 1997 and in December 1999 were 2 times and 2.1 times respectively. In other words, investors were paying $2 for companies with assets valued at $1.
Meanwhile, for the remaining four market peaks - in April 2015, April 2011, May 2002 and January 2018 - the PB multiples then were slightly lower, ranging from 1.6 to 1.8 times. Because they fell from a lower peak, the declines were also less drastic - at an average of about 22 per cent.
The second point to note from the table is that in each of the previous six downturns, the bottom was established when the PB hit one to 1.5 times, with the average being 1.3 times.
The third point is, downturns can last from as short as five months, to as long as 21 months, from December 1999 to September 2001. The long bear market in 1999 till 2001 was slightly unusual in that it endured two major jolts - the bursting of the dot.com bubble and the Sept 11 terrorist attacks in the US. The average duration of the previous six market declines, excluding the one last year, is 13 months.
The fourth point to note is that the higher the market valuation when the crash happened, the longer it takes for the market to revisit the last peak.
For the global and Asian financial crises and the dot.com bubble burst, the market took an average of 72 months or six years to recoup all the losses. For the other three declines from less lofty heights, the recovery time was about 20 months, or just over 11/2 years.
Fifth, market downturns or crash to the bottom on average took less than a third the time the market took to recover to the pre-crash level.
In other words, it took an average 3.5 times as long for the market to regain its previous peak than the time it took to plunge from peak to trough. This again attests to the saying that markets take the lift down, but take the escalator up.
Finally, the last but not the least point to note is: Returns after a market crash, from levels when PB is between 1 and 1.5 times, are sumptuous. The average is 79 per cent. But if we take the downturns that are more similar to what we are going through now, the average returns from the bottom is 28 per cent over the next 11 months.
Can the study of the past downturns suggest to us a road map on what to expect for the current market decline we are experiencing?
Well, if past cycles are anything to go by, we should be nearing the bottom of the current decline. We have experienced 11 months of the markets going south.
The average for the past six downturns was 13 months. The market PB as of end-December last year was 1.4 times. The average market bottom valuation in the previous six downturns was 1.3 times. If indeed we hit bottom soon, then the returns from current levels could be quite attractive.
• The writer is the portfolio manager of a no-management fee fund, Inclusif Value Fund (www.inclusif.com.sg).
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