Placing September's Rally Into A Meaningful Perspective

By David Schwartz 12:12 8- Oct -2007

Current economic reports do a poor job of predicting when a bear market will begin. But history occasionally provides us with a useful perspective about what lurks just ahead.  

The stock market rebounded in September after three consecutive monthly losses. Most investors, City pros and private investors alike, are befuddled by recent market fluctuations.

So what lies ahead? Is the bull market that began in 2003 still in place or are recent swings the start of a major stock market reversal?

The simple truth is no one can say with certainty. In fact, experts can not even agree on what constitutes a bear market.

Bear markets were once defined as long price slides firmly linked to broad economic ills. Shares could zig and zag along the way but rallies always ran out of steam below previous rally peaks. Subsequent sell-offs then dragged prices down even lower.

This bear market definition no longer works, assuming it ever did. Shares peaked in July 1987 and bottomed out four months later. Even though billions were lost and investors were traumatised, there was no bear market according to the classic definition for two important reasons. The correction ended after just four months and November's low was above the low point of the previous correction that ended one year earlier.

An even faster correction occurred in the summer of 1998. Shares crashed 25 per cent in just three months.

Given these recent trends, investors would be better served by abandoning emotive words like bull and bear market. A better approach is to think about the likelihood of a big drop of 20 per cent or more in the near future, regardless of what the experts label it.

A quick scan through UK stock market records of the last few decades finds information that will frustrate most investors, no matter if they rely upon economic fundamentals to spot downturns or rely upon the views of trusted experts. Here is some impartial evidence.

Don't rely upon current economic news

Think back to 1981 when US inflation was rising at a double-digit rate. Despite this out-of-control inflationary spiral, shares on both sides of the Atlantic rose strongly until August. Fed chief Paul Volker, Alan Greenspan's predecessor, then suddenly reacted by raising interest rates and threatened further increases until inflation moderated.

UK investors were caught by surprise and shares fell 21 per cent in just five weeks.

The next big stock market drop occurred in 1987 when the FTSE-100 lost more than one-third of its value. As we now know, investors suddenly took fright from a potent combination of over-valued shares, global trade imbalances, inflation, and currency imbalances. Here too, these problems did not suddenly emerge. They had been developing for many months.

The real surprise is that investors suddenly chose to react in July 1987.

Fast forward to the third quarter of 1998 when UK investors were slammed by a 25 per cent drop. We again learned, after the fact, that a combination of Russia's bond default, a major hedge fund collapse and Asian capital outflows had serious consequences. The hedge fund collapse caught most investors by surprise but the other problems were well known, considerably in advance of the stock market peak in July 1987.

The objective evidence is quite clear. Investors frequently do not grasp the significance of worrying economic trends in a timely manner. Many of the economic issues that contributed to recent downturn had been festering for many months before the downturn began. Investors simply chosen to ignore them.

Experts offer little help

History signals that experts do not fare much better. There were five big drops in the last three decades that pulled the average share price down by more than 20 per cent. Four of the five (1981, 1987, 1998 and 2000) began without any warning from the mainstream commentators.

So if we can not rely on fresh economic data or trust experts to spot the next painful downturn, who can we trust? Happily, history occasionally provides a useful perspective One clue about what might lie ahead is linked to the fact that the UK stock market declined in June, July and August – three months in a row.

Many investors hope September's bounce-back rally signals that good times lie ahead. History provides a different perspective.

Since the Second World War, there were eight other years when the UK stock market declined in June, July and August. It is not common knowledge but a 20 per cent or greater dip was underway in seven of those years.

The single exception occurred in 1992. In retrospect, it was probably the exception that proves the rule. Recall that the UK economy was in a state of near-collapse in mid-year after we entered the Exchange Rate Mechanism (ERM) with an over-valued currency.

The stock market fell by 18 per cent in three months after peaking in May, 1992, just two percentage points shy of the traditional bear market definition. Further falls were in the cards but we were (mercifully) ejected from the ERM in mid-September which triggered a powerful rally.

There are no guarantees in the world of investing. Even so, if the past is any guide, the price weakness of recent months is likely to run a bit longer despite September's welcomed rally.