If you’re unconvinced by the current market rallies but don’t quite know why, the following John Authers interview with Russell Napier, bear market historian and author of ‘Anatomy of the Bear’ is definitely worth some of your time.
As Authers explains at the beginning of the clip, Napier’s book focuses primarily on identifying bear-market bottoms.
According to Napier, history proves two of the best measures to do so are the Q ratio — a measure of a company’s market value divided by the replacement value of the firm’s assets — and the cyclically adjusted PE ratio, where you take the price of a stock and compare it to an average of its earning in the previous 10 years. Another indicator to look out for too is a stabilisation in commodity prices.
And indeed, the measures do come to identify the four great bear-market bottoms of the 21st century. For example, here’s the PE chart:
Also worth considering is what drives valuations precipitously lower in the first place. As Napier explains to Authers this happens to be the same thing every time - deflation, or the perceived risk of deflation. As he states:
Remember equity is not an asset, it’s a balance of assets and liabilities. So if your assets start falling faster than your liabilities the crucial thing is that [equity] can go to zero. In an inflationary situation, [equity] is very unlikley to go to zero, and in an deflationary situation it’s very likely to go to zero.
And this is why commodity prices, as an inflation hedge, become an important indicator of bear-market bottoms; they indicate when deflation risk has passed, and when price stability — or in other words some degree of inflation — is returning.
It is only at that point, when the element of survivability has returned to the market (no more zeroes), that you can begin to focus once again on future earnings. Or as Napier expresses it:
At that stage you can begin to focus on future earnings but unless you can get to the next business cycle, unless your equity can survive to the next business cycle, even those valuations are irrelevant. So commodities signal that deflation risk is passing. Your equity is likely to survive and you can focus on the future again and valuations go up.
And the crucial thing to point out in today’s context is that can happen long before you have an economic recovery or an earnings recovery. We’re not talking today about looking at next year’s earnings and forecasting equity on that. We’re talking about survivability. Are they going to survive?
As of November 2008 it really looked like they may not survive and today it’s much more clear they’re going to survive so you can begin to look further and further into the future and the value is obviously more evident in equities.
That concludes the first part of Napier’s interview with John Authers. What he has to say in the second part however - to be released on Friday on FT.com - is perhaps even more interesting.
Luckily FT Alphaville has had a sneak preview.
To sum up the main points Napier says he does not believe this year’s March lows marked the actual bear-market bottom, the risk of deflation has now passed, however, the worsening market for treasuries and inflation will eventually set off another cataclysmic run lower to as much as 400 on the S&P 500.
As he explains (our emphasis):
I think the market can bounce for a couple of years but that [March lows] was not the great bear market bottom. Let me briefly explain. We were looking into the face of deflation in November/December/January and February and it’s passed now.
The key three indicators that we’ve passed the risk of deflation are rising price of Treasury inflation protected securities, the rising price of commodities and the rising price of corporate bonds. This is not to say that this bounce is the end of the bear market.
Napier believes, meanwhile, the key driver to the next phase lower will be the key measure of 6 per cent on US Treasury yields. As he states:
The true catalyst to bring this market down to 400 on the S&P which is where it is on its low ‘q ratio’, is a terrible market in treasuries. And I think a terrible bear market in treasuries is beginning but the critical number is a yield on treasuries of somewhere around 6 per cent. Financial history suggests that a rising treasury yield does not disrupt the bull market in equities until we get close to 6 per cent, and then this country, the United States, is in very significant trouble and that’s when we get the final cataclysmic bear market.
But until we reach the elusive 6 per cent:
From 666 we could easily double, because I agree I think it’s going to be a long time before treasury yield gets to 6 per cent. For me a long time is about 2 years. But in 2 years time I can see it getting there.
The Federal Reserve is going to have severe problems pulling back liquidity when things get going. They’ve got a lot of excess assets now and not all of those assets are that liquid that they can bring them back, and any sort of fiscal pullback to try and slow down inflation has always been virtually impossible.
So I see inflation problems in a couple of years and I see problems with the Chinese not being as big a buyer of US treasuries simply because they will be having a great domestic consumption boom which means they’ll not run surpluses and buy these surpluses. And the crucial one people sometimes forget is the retirement of the babyboomers, the medicare costs in particular and the social security costs of this is going to be issuing a lot of treasuries into the future.
All of which leads Napier to conclude the worst investment in the world today is US Treasuries:
For the next couple of years people will see it as normalisation, if yields on Treasuries go to 4 or 4.5 per cent. People will say this is a normalisation of the treasury yield as we pass the deflation risk . There’ll be a great breath and sigh of relief that we’re going back into another business cycle, and when it looks like we may never get there equity prices will go up. But the final sting I believe is in the tail. The last treasury bear market lasted from 1946 -1981 and there’s no reason to suggest that this one will be any shorter.
Ouch.
