Bear necessities – how to spot the bottom of the market

By Tom Stevenson, 24 July 2008

This week Tom Stevenson examines previous bear markets and looks for clues that may signal the end of the current downturn. There were 14,500 references to “bear market” in my press cuttings service over the past 12 months. That compared with just over 8,000 in the prior year¹. Even before the world’s major indices notched up the 20% peak to trough fall that has become shorthand for a bear market, the grizzly had long since chased the bull out of town.

But bears come in many different shapes and sizes. Knowing which kind you are dealing with is no simple matter. Like recessions, bear markets are only defined with the benefit of hindsight. And the rear view mirror is of little help to investors.

Understanding the wily bear is key to investment success. Bear markets are damaging to your wealth while they are underway but crucially they also create the circumstances in which investors can make serious profits. If you can keep your head while all around you are losing theirs and buy at the bottom, the gains can be staggering.

You have to have your wits about you, however, to capture those gains, because the opportunity can be gone almost as soon as it arrives. Research by Fidelity shows that some of the best gains are seen in the three months immediately after the market turns around ².

Since 1970 there have been five bear markets in Europe, as defined as a 20% fall from the previous high in the MSCI Europe index ³. The declines since last October make six in a number of European markets.

As the table below shows, these ranged from the 1987 crash (scary at the time but hardly a bear market as generally understood) to the long grinding declines in the early 1970s and after the bursting of the dot.com bubble.

As the spread of peak to trough declines shows, breaching the 20% mark was no guide to what lay ahead in any of these cases. Two of the five bear markets ended immediately they had fallen by this amount while two others continued for another 12 and 18 months respectively, losing more than another 20% before finally hitting bottom.

But how useful a definition of a bear market is a simple 20% nominal fall? Taking inflation into account puts a very different complexion on things. On this basis even the S&P 500, which hit an absolute peak last October, has never regained the peak it set in March 2000. The FTSE 100 is well down on this measure and it could be argued that UK shares have been trapped in a bear market for eight years, in which the rise between March 2003 and October 2007 was no more than an aggressive bear market rally.

The importance of earnings

Certainly, if you define the bull and bear not by absolute price levels but relative to earnings then shares have indeed been on the slide since the 2000 peak. The chart below shows the decline in the average market price-earnings ratio since 2000 in the UK. In America the fall has been even more pronounced.

I would argue that this is the best definition of a bear market because it measures the willingness of investors to expose themselves to the risk of the stock market. Over the past eight years they have become prepared to pay a lower and lower price for every pound of corporate earnings.

Learning from the past

History shows that an eight year slide on one of these more subtle definitions of a bear market is far from unusual. An excellent book by Russell Napier, Anatomy of the Bear ⁴, analyses four huge market slides during the 20th century, finding common characteristics in each.

The most important of his findings is that on average the journey from extreme overvaluation (the top of the bull market) to extreme undervaluation (which marks the bottom of the bear market) takes around nine years – 14 if you exclude the very rapid decline after the 1929 Wall Street crash.

Other important conclusions that may surprise some investors include the fact that bear markets can run during periods of economic expansion but they usually end during a recession. They also tend to bottom out after a period of price disturbance (either inflation or deflation) and the bottom tends to be reached when commodity prices are stable.

Contrary to the widespread belief that markets always rise ahead of an economic recovery, the big market bottoms in the 20th century coincided with economic rehabilitation and the best guide to recovering prices was an upturn in car sales. The “capitulation” which traders often look for as a sign that markets have finally bottomed out is something of a myth, Napier concludes. More usual is that share prices start to pick up again at the point when investors, and certainly the population at large and the media, have no interest at all in the markets.

Other factors to keep an eye out for, Napier suggests, are an increasing supply of good economic news being ignored by the market; commentators suggesting that a worsening fiscal position will prevent economic recovery (they will be wrong); evidence that the market is declining on low trading volumes and rising on high volumes; a large number of private investors shorting the market.

Where are we now?

There is good and bad news here. The bad news is that very few of these classic market bottom signs are in place. The good news is that after eight years of declining relative share prices we are well into this bear market by historical standards.

The most important thing to realise is that, to misquote Sir John Templeton, it really is different this time. We can look all we like at the history books but in none of the big market cycles in Napier’s book was the world going through the massive economic shift that we are now. The integration of China, India and all the other emerging nations into the global economic system changes everything and that makes it impossible to predict how this bear market will end or when.

Which leaves only one rather dull conclusion: keep a decent spread of investments, geographically and by asset class; and keep saving. The rest will take care of itself.

Past performance is not a guide to what might happen in the future. Please note the value of investments can go down as well as up so you may get less than you invested. Investments in small and emerging markets can be more volatile than other developed markets and changes in currency exchange rates may affect the value of an investment. The ideas and conclusions in Tom Stevenson’s weekly column are his own and do not necessarily reflect the views of Fidelity’s portfolio managers. They are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.