I am not an equity market bear; if anything I am firmly of the view that the world economy is on the path of recovery and repair. Equity markets have, however, run well ahead of themselves and of fundamentals. Technically, equities are heavily overbought. Fundamentally, they are not cheap either. In an earlier article dated 15 June 2009, I suggested that This Equity Market Rally had run out of steam and that a significant correction was probable. 

Equity markets have indeed lost some momentum and some markets have corrected sharply. However, it is too early to tell if this is simply a consolidation before further gains. I do not think so. I believe that we are now firmly in a resumption of the bear market and that 20 – 25% declines are probable in Western markets and 30 – 40% declines are probable in emerging markets.

I am also a firm believer in decoupling of the underlying economies, between emerging and developing markets. So how do I reconcile this with my expectation that emerging markets equities will underperform?

First of all, why do I think that the bear market will resume? The bull market of the last 2 months has been driven by banks, financials, and consumer cyclicals. The dispersion of returns in these sectors has been high. These are sectors with poor earnings visibility and poor predictability of cash flows. In sectors with more predictable cash flows, equity prices have been less, not more, dispersed. In other words, the market has been very news driven, not fundamentals driven; it has been driven by relief rather than conviction; it has been driven by a very thin base and has not been broad based. These are the classic elements of a relief rally, not the underpinnings of a new secular bull market. History has also taught us that markets don’t move in straight lines and that there are basic elements to post traumatic environments. Equity busts have at their roots overvaluation as euphoria overcomes rationality. Weaknesses that were hidden by euphoria eventually manifest resulting in catastrophic loss. Panic ensues. That was last year. Panic turns to despondency and overshooting on the downside. Inventory cycles turn, industrial production surprises to the upside and a relief rally results. These types of rallies can be powerful as short covering reinforces value investing and investors fearing they might lose out. Throughout all this, fundamentals do not feature one bit. By the time they do, the relief rally has outrun fundamentals by a significant margin and its time for a painful correction yet again. I simplify in this example of 2 rallies and 2 crashes but the general principles are there. There can be any number of rallies and corrections but the psychology is pretty much the same.

Technical factors began to show signs of weakness 15 June 2009 across global markets to greater or lesser extent. Only Shanghai markets continued to power ahead. Every one else from DJIA and SPX in the US, the Stoxx and FTSE in Europe, the All Ords, Hang Seng, Sensex, all began to lose steam last week.

On 21 June, the markets began to experience some real weakness. On 23 June 2009, World Bank reduced its 2009 GDP forecast from -1.7% to -2.9% and its 2010 forecast from 2.3% to 2.0%. Developed economies growth was revised from -3.0% to -4.5%. Markets did not like that at all.

Backing up this gloomy view is the fact that there is immense spare capacity in the global economy from developing to developed economies. US capacity utilization for example is below 70%, levels not seen even in the mid 70’s and early 80’s. Unemployment in the US has reached 9.1%, again levels not seen since the mid 70’s and early 80’s. Business confidence has rebounded from its lows but is still very much depressed. GDP is likely to recover in line but again such rebound is likely to be limited. US consumption has rebounded as well but production is still falling. Much of the retail numbers are supported by extraordinary fiscal transfers which are highly unlikely to be repeated, so it is more likely that retail weakens back in line to production than vice versa. US industrial production has fallen by more than has been the case in previous recessions save the Great Depression. For these reasons, it is premature to call a recovery in the US economy and hence US equities for some time yet.

Not all is doom and gloom. There are reasons why the global economy will heal itself. As long as markets are free and protectionism is kept at bay. Emergency measures which might create adverse selection should be quickly reversed. Accommodative monetary and fiscal policy should be maintained until sure signs of recovery are evident. Inflation is unlikely to be a problem for the reasons of spare capacity we discussed. Deflation is unlikely as long as commodity prices can stay near current levels and there is every expectation that they are likely to be well supported. The inflation outlook is likely to be quite healthy, in the old ‘neither too hot nor too cold’ range. The pieces are in place for recovery to take place. However, recovery does not happen in a day. The scale of the damage from the credit crisis was significant. However forward looking equity and debt markets may be, the current rally is simply too much too soon and a correction is well overdue.

Where do we go from here? A simple optical (and linear in log space) analysis of the Dow and the S&P from pre Great Depression times until today would indicate potential downside at about 5600 for the Dow and 650 for the S&P. Are we likely to get there? I think not, but I think that we might get halfway there quite easily. In the assessment of emerging markets like the BRICs it is important to distinguish between beta and volatility. The volatility in emerging markets is such that in a correction, the losses are likely to be higher than in developed markets. The outperformance of emerging markets will likely manifest over a medium to longer term. Intuitively, and quite simplistically, one would be positioned net short at current levels in anticipation of a correction and net long when markets have fallen to more reasonable levels. Intuitively also, a more risk controlled expression would be to maintain fairly balanced books with different growth – value biases in developed and developing markets. A long growth short value position would make sense in emerging markets poised for growth while in developed markets, a long value short growth position would make more sense. Of course micro analyses will reveal richer themes but this is a rational approach to driving the idea generation behind the ultimate portfolio construction.

The rally in global equity markets masks the fact that economic fundamentals remain weak. The bulls say that the recovery is underway, that green shoots of economic recovery are sprouting, that economies have passed their trough; some even go as far as to suggest a V shaped recovery (Goldman Sachs is one of them). The bears point to the unemployment problem, underfunded pension liabilities and healthcare systems together with an ageing population, unsustainably high household debt, growing public debt, risk of inflation, risk of deflation, higher interest rates, distressed real estate prices, murky bank balance sheets and the list is endless. 

Quite how the global economy repairs itself will not be immediately clear to economists or investors. Excess capacity will need to be eliminated, savings rates will need to adjust, down in emerging markets and up in developed markets, bank balance sheets will need to be repaired, Western consumer balance sheets will also need rehabilitation or at the very least a period of rest, international sovereign current accounts, trade balances, will need to normalize towards more balanced positions, and of course sovereign balance sheets will need to be repaired as well, a process that taxpayers are already eyeing with dread.

One thing is for certain. The credit and debt bubble wasn’t built in a day, and it wasn’t broken in a day; neither will it be fixed in a day. The policies of the various governments and central banks have been variously praised and criticised depending on whether one was hoping they will succeed, the definition of a bull, or hoping they will fail, the definition of a bear. 

There is no perfect policy response. Each approach has its flaws and strengths. The greatest achievement so far of the US led, internationally concerted effort, to save the financial system in the latter half of 2008 is that confidence was restored. If there was no other objective but one, it was to restore confidence and to buy time. Time is a healer, but you need a live patient. This has been achieved. 

While the global financial system and the economy have been saved from catastrophic failure, significant problems remain, significant to the point that there will be long term implications for the real economy. That said, the payments system has not failed, money markets have normalized, and the banking system while seriously impaired continues to function. 

The road ahead is understandably unclear. What we are certain of is that in each industry, opportunities exist and some of them are significant. Existing participants in each industry will be able to see these opportunities; not all of them will be able to take advantage of them. Some will, if they have the wherewithal, if they consolidate, if they have access to capital. These opportunities will at some point be clear to others, and new entrants will take advantage of them. Thus, industries evolve. As these opportunities are exploited, profits are generated, capacity is increased as it is destroyed elsewhere. It is difficult for entrepreneurs in industries not directly involved or adjacent to these industries to detect these evolutions until they have gained some momentum and volume. It is even more difficult for a macro level observer to detect these evolutions until well after they have become entrenched. 

A corollary to this theme is that while macro level, tactical and thematic styles of investing have done relatively better in 2008 and year to date in 2009, the ground is set for more idiosyncratic returns generation. Since late 2007, the fundamental stock picker has had a very difficult operating environment. Markets traded based on relative fear and risk aversion confounding the most rational of company analyses. As volatility settles down, money markets normalize and markets become more continuous, the environment for the fundamental stock picker has improved significantly, and the opportunities in relative value are larger than ever. 

Another corollary is that it is time to revisit the now unfashionable, or forgotten theme of the decoupling of the BRICs from developed markets. There are compelling arguments for and against decoupling. Most of the balance has correlated with the direction and correlation of equity markets. By the time emerging market equities had fallen harder than US and European equities, the decoupling theme had been buried. It may be that the fundamental economies of emerging and developed markets had decoupled but that emerging market listed equities had temporarily decoupled from their fundamentals, dragged by the impact of the exodus of foreign investment capital withdrawn to repair balance sheets elsewhere. Decoupling requires dislocation. The latter half of 2008 has very conveniently supplied this dislocation. It will take some time for fundamentals to take hold and drive markets. Even in the rebound there has been little sign of decoupling. Some point to the strength of the recovery in emerging market equities as sign of the decoupling but this is more likely simply a symptom of higher volatility than actual decoupling. The coming months will tell if markets price in the decoupling that has already begun in their underlying economies. 

Where is the decoupling? Emerging markets continue to have higher long term economic growth rates arising from their less than optimal capital to labour ratios, higher population growth and underpriced (not fully paid for) improvement in their technology sets. Also, in the recovery, much of the economic activity will be supported by Keynesian reflationary policies, thus bought at the expense of weakening the sovereign balance sheet. Where balance sheets remain healthy, growth can be bought. Where balance sheets are already stretched, the propensity to buy such growth is reduced. One of the catalysts to precipitating a decoupling, ironically, is a reversal of globalisation and a disruption to world trade. This occurred last year as trade finance temporarily ground to a halt. Even now, it is only slowly recovering. 

It is impossible to predict how the recovery will unfold. This is not the point of this exercise. It is to realize that as the world economy heals, it will be hard to see and it will only become apparent when it has healed to a greater degree. We can only see the recovery in our own industries and in our own towns and adjacent industries and cities. By the time we see it in industries further afield and by the time it becomes widespread, it will have been going on for some time.

Who bought bank shares without knowing what banks do? Who bought CDO’s without knowing how they work? Who bought RMBS without knowing how they work? Who invested in private equity, real estate, hedge funds, long only equities, commodities, FX, corporate bonds, sovereign bonds, CDS, ABS, structured products, without understanding their markets, their fundamentals, their payoffs under different scenarios, having an exit strategy, having a disaster plan, having the holding power, the stability of funding?

Banks, bankers, investment managers do what they are paid to do. Investors didn’t do what they were rewarded to do, which is to be diligent and vigilant.

When demand for loans, for credit is created by the lender and not the borrower, something fundamental has changed, something fundamental has broken.

Homeowners want homes, they need credit to be able to buy them, they turn to mortgage lenders. They want loans, mortgages. Lenders are diligent in their underwriting standards.

When CDO investors want CDOs, then CDO managers want (to buy) loans and mortgages and asset backed securities, then ABS managers want (to buy) loans and mortgages (for their ABSs), then lenders want to make loans and mortgages to borrowers. Then that fundamental relationship is broken. Underwriting standards become lax. Agency issues arise since risk is passed on instead of retained by the loan originators.

Investors are at the heart of the dislocation, the crisis, the recession. For our ignorance, sloth, negligence, we are paying. We taxpayers and investors, are paying.