Investors tempted back into equities following the FTSE 100’s second-best day in history could be unwittingly stumbling into a bear trap, if history is anything to go by.
The index rose 9.05 per cent yesterday on the prospect of a $2trn US stimulus package, which is still to be approved by Congress.
However AJ Bell’s investment director Russ Mould warned that while this has brought equity investors some much-needed relief after a month-long drubbing, the lessons from the most recent crash suggest there is still plenty more pain to come.
“Six of the FTSE 100’s 10 single-largest percentage daily gains of modern times came between September and December in October 2008, but the index only bottomed in March 2009 after further heavy falls of nearly 30 per cent as the collapse of Lehman Brothers and the ongoing global recession continued to hit confidence, corporate earnings and cash-flows,” he said.
“A hefty rise in the FTSE 100 is welcome, should it transpire, but there remains the risk that any such advance proves fairly temporary should news on the viral outbreak continue to get worse and policy measures require a longer lockdown – and potentially deeper hit to global economic activity – than currently hoped.”
Mould pointed out that seven of the 10 biggest gains in the index all took place during the bear markets of 1987 and 2007 to 2009. The sole exceptions came in April 1992, as the UK emerged from a recession, and March 2003, as the UK again began to show some improved economic momentum following the collapse of the technology bubble in 2000.
“The FTSE 100 has just entered its fifth bear market in its history,” he continued. “Analysis of the four previous downturns in 1987, 1998, 2000 to 2003 and 2007 to 2009 show that those bear markets were actually littered with sharp rallies which cruelly turned out to be nothing more than bear traps for the unwary, who were tempted into a ‘buy-on-the-dip’ strategy, only to quickly find themselves in trouble.
“The sharp-and-swift 1987 bear market happened so fast that investors only tried one failed rally before dip-buyers were swept away by Black Monday, 19 October 1987, and then even heavier losses on the following day as London caught up with a 20 per cent single-day fall in New York.”
Investors who have just bought in on the back of the rally may be hoping the recent crash follows the pattern of the 1998 bear market. This was brought on by a currency and debt crisis in Asia, then a Russian debt default, which first threatened to spill over into economic activity in the West and then destabilise financial markets when the LTCM hedge fund collapsed after suffering huge losses.
A Federal Reserve co-ordinated bail-out of LTCM enabled markets to regain their poise, as did a rapid sequence of interest rate cuts.
There were no attempted rallies as the rout was swift but short and policy response shored up confidence equally quickly.
However, Mould said the danger this time around is that US interest rates started at 1.75 per cent (and have already been cut to 1.25 per cent), not 7.5 per cent, and the early signs are the economic hit could be greater. In addition, equity valuations were much higher when the crisis began.
“This then takes us to the bear markets of 2000 to 2003 to 2007 to 2009, where the combination of recessions, lofty valuations and corporate earnings disappointments meant that a sequence of rallies became wicked bear traps for those who loved to buy on the dips,” he continued.
“The 2000 to 2003 bear market, which followed the collapse of the technology, telecoms and media bubble, witnessed seven major rallies. Those advances generated a combined gain of 4,590 points between them, even as the index fell by 3,643 points from top to bottom, showing how much additional pain would have been suffered by anyone who was tempted to pile into the market by these rallies.
“The same portfolio-pounding pattern could be seen during the 2007 to 2009 bear market. Nine rallies, some of them stunning upward spikes, only dragged investors into deeper trouble if they joined in. Those nine rallies added 5,853 points between them even as the FTSE 100 sank by 3,220 points during the course of the bear decline.”
Mould pointed to charts of the two previous bear markets showing numerous rallies were short-lived and crumbled in the face of more corporate profit downgrades and economic bad news.
The vast majority of these rallies failed to reach the high set by the previous attempt to break free of the bear market and gave way to new lows.
“It is this classic sequence of ‘lower highs and new lower lows’ that investors hope to see broken and broken quickly,” the investment director added. “If it is not, the further nasty falls could follow, at least if history is any guide.
“If the virus is rapidly contained and the hit to economic activity proves limited, then UK equities could rally sharply. But if it is not and corporate cash flows are severely crimped by the knock-on effects of the outbreak, investors may need to be wary of big rallies and – if they are minded to be contrarians and put money into the market now – instead look to buy after any further big falls to patiently average their way in over time.”