Published December 3, 2008
A bear market rally framework
Lessons from 1990s Japan may point to a global bear market rally in 2009
By NORMAN VILLAMIN
WITH several high- profile commentators calling a bear market rally in global equities, we find it helpful to understand bear market rallies better in the context of our broader global credit crisis roadmap. The basis of the signposts in the roadmap we are using to navigate the current bear market is the financial crisis experience in Japan post-1989, due to the similarities of an over-leveraged financial system combined with financial and real asset bubbles in a large developed economy. Given Japan's financial crisis have guided us well to date, we believe it can also give some guidance on the nature of bear market rallies we might expect during the global credit crisis.
How did Japan's bear market rallies begin?
The Nikkei 225 saw three rallies greater than 45 per cent between its 1989 lows and ultimate 2003 bottom, each lasting between six and 12 months. Each was also eventually fully retraced.
Two common factors across all three were a combination of fiscal stimulus and valuation. In particular, a series of fiscal stimulus packages (individually valued in excess of 2 per cent of GDP and in aggregate averaging 4-10 per cent of GDP), matched with valuations at or below 1.5 times book value, were sufficient to generate meaningful bear market rallies against the backdrop of Japan's lost decade.
Currently, global equities trade around 1.4 times book value. Since 1975, though, we have seen that recessions have resulted in book value declines of an average of 7 per cent. Thus, even with an adjustment for an average decline in book value during previous recessions, global equities would be trading closer to 1.5 times book value - close to levels from which bear market rallies began in post-1989 Japan.
In addition, the global fiscal stimulus announced/proposed so far is nearing the 2 per cent of GDP threshold for individual stimulus announcements as seen in Japan. China has announced a stimulus package of an estimated 2-3 per cent of GDP. And US president-elect Barrack Obama has proposed a stimulus package over two years of near 4 per cent of GDP (2 per cent per annum).
Clearly, the current fiscal and valuation backdrop shows strong similarities to that seen during the start of the bear market rallies in Japan.
For those seeking a more fundamental explanation of why bear market rallies occurred against this backdrop, when valuations reached cyclical lows (1.5 times book value was the historical low in Japanese equities from 1975-2000), substantial fiscal stimulus appeared to generate supportive, though temporary and below-trend, economic momentum.
Indeed, looking at Japan's leading economic indicators, the bear market rallies from the 1992 and 1998 lows coincided with cyclical troughs in the economy (as reflected by Japan's leading indicators, which fell to -1.5 standard deviations from the historical mean).
How did Japan's bear market rallies end?
Now, with an understanding of how bear market rallies began in post-1989 Japan, it is as important (given all three were fully retraced) to understand how and why they came to an end. Using the same approach as earlier, three factors seem to influence their end:
- Valuation: Japan's bear market rallies tended to peak at valuations near 2.3 times book value
- Cyclical recovery of the real economy: Japan's bear market rallies tended to peak as cyclical recovery emerged as reflected by leading economic indicators (reaching +0.6 standard deviations from the historical mean).
- Waning of fiscal stimulus momentum: Japan's bear markets tended to peak within four to six months of the last announcement of fiscal stimulus.
Exploring these individually, perhaps not coincidentally, the 2.3 times book value level at which the Japanese bear market rallies tended to peak was near the pre-bubble cyclical peaks of the Japanese equity market, or near +1 standard deviation of valuations from 197-85.
Looking at the fiscal stimulus, it is important to point out that this tended to come in a series of packages to support the economy. In the rally from the 1992 lows, Japan passed four stimulus packages totalling almost 10 per cent of GDP. Similarly, from the 1995 lows, Japan passed two stimulus packages totalling 4.4 per cent of GDP, while from the 1998 lows, two stimulus packages totalling 8.1 per cent of GDP were passed. While large in size, the fiscal stimuli were not enough to lift Japanese growth (measured by its leading economic indicator series) to near previous cyclical peaks of +1 standard deviation.
Once the effects of the fiscal stimulus wore off, typically four to six months after announcement, private sector demand remained too weak to support growth in the economy and, trading near cyclically high valuations, it appears the bear market rallies came to an end.
Using the Japan experience as a guide, the market backdrop from the November 2008 lows is beginning to share many of the characteristics of Japan's bear market rallies. Similarly, drawing on insights from Japan, to enhance the durability of any prospective rally, the fiscal stimulus announced and proposed to date needs to be implemented quickly and likely needs to be followed by a further round of global fiscal stimulus in 2009 to more comfortably fall into the 4-10 per cent of GDP stimulus delivered by Japan in short spans of time.
Encouragingly, media reports suggest that Chinese policymakers may be planning another, consumption-focused stimulus package following the initial 4 trillion renminbi (S$890 billion) package recently announced. Similarly, the US stimulus package, as it has been proposed, appears to be a multi-year package, leaving the opportunity for policy makers to accelerate the second leg of the stimulus should it be needed.
While the Japan experience provides us some guidance, the differences between the current crisis and that in Japan, post-1989 are worth highlighting. With the active US policy momentum, we keep close eye on developments in Europe where policy has been less pro-active than in the US or the UK. Similarly, developments in key emerging markets bear watching, as renewed stress in these economies, which are the only ones forecast to grow year-on-year in 2009, would truly leave the world with an absence of a demand driver, even more so than now.
On balance, the global backdrop since the November 2008 lows appears sufficiently different from the backdrop seen from the lows in October 2008. Global equity valuations have now decisively pierced the 1.5 times book value level, while fiscal stimulus is emerging in sufficient size to replicate the first stages of demand momentum (even if temporary) generated in Japan following its crises. In addition, US and European leading economic indicators sit near -1.5 standard deviation readings and the global economy is less than one month from recent fiscal stimulus announcements. Thus, the case for a Japan-style bear market rally appears strong moving into 2009.
The writer is head of research & strategy, investments, Asia-Pacific, Citi Private Bank.
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