Why the bears are brandishing their history books

Why the bears are brandishing their history books
By John Authers
Published: January 28 2006 02:00 | Last updated: January 28 2006 02:00. Copyright by the Financial Times

Are we in a bear or a bull market? There are always differences of opinion over the future course of stocks. It is unusual to argue over whether the stock market is locked into a down cycle or is moving forward.

But the bizarre start to the year allows for both interpretations. The market leapt in the first week on the back of optimism that the Federal Reserve would stop tightening monetary policy sooner than many people had expected, and the Dow Jones Industrial Average passed 11,000 for the first time in 4½ years. As 11,000 had functioned as an uncrossable barrier for the Dow during rallies last year, the hope was that the market was ready to move on with the next phase of its bull cycle.

Instead, last week saw dramatic sell-offs in response to corporate earnings announcements. Less than two weeks after the Dow passed 11,000, we were back below 10,700 and in the negative for the year.

Stocks made headway again this week, and the Dow re-crossed 10,900 in early trading yesterday, despite surprisingly bad numbers for US gross domestic product growth during the fourth quarter. But was this the aimless volatility of a directionless bear market, or a bull market regrouping?

You can present the data to support either secular interpretation. If you believe in a secular bear market, it started in early 2000. None of the major US indices has yet returned to their highs of the turn of the millennium. Or you could say that the bottom in 2003, at which point the S&P had roughly halved, signalled the beginning of a bull market, which is encountering turbulence at the moment.

The strength of the economy and corporate earnings, combined with more reasonable valuations, are all taken as pointers that the market is now on a well-supported advance.

But the evidence from history suggests that we are still in a bear market.

Earnings are on course to log their tenth successive quarter of double-digit growth. This is often cited as cause for optimism, although earnings last year would have been less impressive without the exceptional gains made by the energy sector.

This is not quite the bull point it appears. Ed Easterling, of Crestmont Research, who is convinced the market is still in a bear cycle, shows that the relationship of economic growth - which correlates over time with earnings growth - with bull and bear cycles is counter-intuitive.

According to his analysis of historical data, during bear markets, stocks decline on average 4.3 per cent a year while nominal GDP grows 6.9 per cent. In bull markets, when stocks rose 14.6 per cent per year, nominal GDP growth was lower, at 6.3 per cent.

Breaking earnings per share growth into decade-long periods, he found that the 1960s, 1980s and 1990s all saw average earnings growth of between 5.6 and 5.9 per cent. As earnings growth so far in the 2000s has averaged 7.5 per cent, we are overdue to regress to the mean.

Downswings in earnings per share last 1.6 years on average, and bring an average decline of 15 per cent. If that happens, price-earnings multiples will have to expand to the low 20s - above the historical norm - for the stock market merely to stay where it is now until 2008. So Mr Easterling may be right to believe in a bear market.

The dramatic reactions registered over the last week to earnings numbers that were sometimes even ahead of Wall Street consensus estimates adds more weight to the bear market hypothesis.

Current valuations embody a lot of optimism on earnings: it is a stretch to expect multiples to expand as earnings go down. Research by Abhijit Chakrabortti, of JPMorgan, on stock market corrections (where the S&P 500 falls by at least 10 per cent) provides more gloomy reading. He believes a "momentous" market correction is on its way, and that earnings disappointments provide the final necessary catalyst.

On his reading, another catalyst is already in place. Of the last 10 corrections, seven occurred when interest rates were rising, or when the Fed had just finished tightening.

Historically the market declines badly at the end of a Fed tightening cycle. And almost everyone expects the Fed to stop tightening sometime this year. So it looks like we can expect the directionless choppiness of January to continue a while longer. The bears are still in charge.