The worst is over… for now: Bear market historian

If the experience of the last four great bear markets is any indication, the economy and stock market have likely turned a corner, says author and bear market historian Russell Napier. However, we may still be five years away from reaching the absolute bottom of this market cycle.

In 2005, Napier, a global macroeconomic strategist with CLSA Asia-Pacific Markets, wrote a book entitled Anatomy of the Bear: Lessons From Wall Street’s Four Great Bottoms that chronicled the experiences of the last four great bear markets, which began in 1921, 1932, 1949 and 1982.

Napier’s advice, based on lessons learned from these declines, is currently in high demand. At the CFA Institute’s Annual Conference in Orlando, Fla., Napier argued that history provides some cues as to what caused this bear market and what will signal the end of it.

“When you’re looking at financial history you’re looking at the way that organism was, and the way it is developing and changing,” said Napier, who read more than 70,000 Wall Street Journal articles written during these bear market cycles. “Journalists like to write about the crash. The story and the drama is the destruction. Investors are interested in the creation, the next leg up.”

Napier said historical charts of cyclically adjusted price-to-earnings ratios — which use rolling period earnings versus an historical average — are a good tool for determining when bear markets hit bottom. However, these charts are not good predictors of short-term performance. Looking at more than a hundred years of data, one can identify the bottoms and then identify the market conditions associated with them.

Adding an overlay of consumer price index data to the cyclical P/E chart, Napier pointed out that the road to the bottom is almost always accompanied by deflation.

“All of my bear markets end the same way; they end with deflation,” Napier said. “Equities are not an asset. Equities are a fine sliver of hope between assets and liabilities. The survivability of that fine sliver is significantly questioned during periods of deflation. For a cash flow business, as the price of corporate goods fall, the ability to finance debt declines. If assets fall quicker than liabilities, the very existence of what is referred to as equity gets a big question mark put beside it.”

Napier pointed to last year’s collapse of Lehman Brothers as an example.

“What we saw post-Lehman Brothers is the deflation risk. You see how the cyclically adjusted P/E shifted down,” he said. “It did not shift because it was going to be a recession; there was going to be a recession anyway. It shifted down because equities were viewed as not surviving.”

Napier says deflation brings in more certainty that companies will be able to survive and cover off their liabilities, meaning prices start to stabilize. In all of the four bear markets he studied, abating deflation precedes a sustainable recovery.

A key indicator that a bottom is being formed is the destruction of supply. Usually this process can take some time to work its way out, as it did in the Great Depression. However, Napier said the mode of production in the U.S. and developed world means emerging markets will take the brunt of supply destruction since they now produce most of the world’s goods.

“If you look at the bear markets, it’s a reduction in supply that often stabilizes prices,” he said. “The beautiful thing for America is, most operational gearing is in North Asia — goods are not made here. This is not 1929. We’re not going to be hacking back huge productive industries, because most of those industries are somewhere else.”

Another two key indicators of a bottom are the prices of corporate bonds and copper, both of which tend to rally on a recovery. In both cases, the worst appears behind us right now.

Bust caused by the boomers

Napier says that the ability of the developed world, particularly the U.S., to set monetary policy and the fact that the worst production declines will be felt in the developed world should all lead to a few years of positive returns on equities and a return of inflation.

He said history shows a 4% inflation rate and the consumer price index tends to be the “sweet spot” for equity prices historically — which resulted from steps taken by the U.S. Federal Reserve in the early part of this decade, which offset the downturn started in 2000 and created a 50% jump in equities.

Things, in his opinion, will go from better over the next couple years to a lot worse.

Napier believes the S&P 500 will drop to 400 in 2014, as the U.S. finds itself unable to combat inflation, which will choke off growth. To make matters worse, the largest wealth accumulators — the baby boomers — will be drawing down on the government funds en masse.

“Feb. 12, 2008, is a day that will live in infamy. That’s the day the first boomer started to receive a social security cheque. She has 87 million friends; on top of social security they also get Medicare,” Napier said. “There is no way the debt-to-GDP ratio in the United States will go down in more than a decade because of social security and Medicare expenses to these guys.”

Even with an overly optimistic assumption of GDP growth hitting 3%, Napier said government debt will skyrocket through 2019. This time, the major purchasers of that debt &$151; emerging markets — will need to fund their own account deficits and will recoil from U.S. Treasuries.

“According to data from the U.S. Office of Management and Budget, if you have average real growth of 3% going through until 2019, you’ve still got 20% of the U.S. budget receipts paying interest on the debts,” Napier said. “You put 100 basis points on the average cost of government debt that rises to 24% and another 100 basis points, you’re looking at 30% just to pay the interest rate on the debt. This is a terrible outcome on the treasury.”

Napier added that the growth of the next great bull market will have to come from domestic consumption in emerging markets. Those countries need to refocus their economies so that domestic demand, rather than exports to North America and Europe, fuels production. It is a process that can take a long time.

One thing Napier has learned from the great bears of the past is, the peak to trough of valuations on the stock market can take decades.

“If you bought at a high valuation in 1901, it is 20 years before you reach the low valuations. In 1937, equities were very expensive; they don’t bottom until 1949. In 1966, they’re expensive and they don’t bottom until 1982. It takes a long, long time,” he said.. “The last peak for equities was 2000 and we’re in 2009 and still not at a bottom — 2008 does not go down as the year of the real financial crisis. The reason 2008 shifts the whole of the 21st century is that 40% of the world’s population realized they can’t keep getting richer selling to 14% of the rest of the world’s population.”

(05/19/09)