Expert Visions

Fasten your seatbelts, but don’t panic!

Many things in life move in cycles. We know economic cycles, product life cycles and even an elusive hormonal cycle which supposedly leads to an itch every seventh year!

As you might expect, it is no different for stock markets, where we make a distinction between upwardly trending periods (bull markets) and downwardly trending periods (bear markets) and can even qualify those as mature or immature.

Recently, the term “mature bull market” has been used regularly when describing the present environment. This is not by accident. The present bull market, which started in 2003, is clearly entering a new phase now. This so called “mature” phase tends to be much more volatile and unstable than the previous period, but can still deliver attractive returns. The main characteristic of this new phase is a clear slowdown in corporate earnings growth. From 2003 till 2006 earnings growth was still explosive, with earnings roughly doubling and stock prices doubling with them! The valuation of equities did therefore hardly change.

However, in order for markets to rise clearly from here on, earnings growth will not be sufficient anymore. Price/Earnings ratios will also have to go up. Since P/E’s are largely driven by macro data and sentiment, they are a less stable driver of equity prices than high earnings growth.

Other typical characteristics of a mature bull market are re-leverage of corporate balance sheets (companies taking on more debt) and an increase in merger and acquisition activity. Also ‘bubbles’ may form in this phase, especially among the winners of the preceding immature bull market. Examples of the latter were Japan in the late eighties and technology and telecoms in the late nineties.

The mature phase of a bull market historically lasted around two years. The present one can only last a decent period when we can avoid a US recession and get enough central bank rate cuts and large mergers & acquisitions to feed the “greed”. At this moment, there still is a distinct lack of greed. Only in emerging markets can we find high risk appetite and it is here that a new bubble could materialise. Arguably, China already is a bubble, but other emerging markets certainly are not. Elsewhere in the world, risk appetite is very modest. Bears and bulls can be found in almost equal quantities, both with sound arguments. One side will argue that the bear market is near, as the credit crisis continues and the risk of a US recession is growing fast. The other side will argue that the central bank intervention will avoid a recession and that traditional “end of bull market requirements” do not seem to be in place yet. Bull markets usually end with over-valuation, over-optimism, bubbles and stretched corporate balance sheets, none of which are visible right now.

We are still inclined to see the glass as half full, rather than half empty. It should still be possible to make money in equity markets in the coming 6 to 12 months. Investors should focus on large stocks with strong balance sheets and above average earnings growth, even if they look somewhat expensive. In mature bull markets, real growth stocks usually only get more expensive! It may be a rocky ride, but still a ride which is worthwhile. So, fasten your seat belts!