Weekly outlook

How far can this rally go?

By Tom Stevenson, 6 May 2009

Is this the start of the next bull market or just another short-lived bounce?

Stock markets around the world have enjoyed a healthy rebound since early March, with global shares rising by around 30% in just two months. What every investor wants to know – especially those who have watched the bounce from the sidelines – is whether this is the start of a sustainable bull market or just another bear market rally that will in due course run out of steam. Even if the conclusion is that this will turn out to be a rally in an ongoing bear market, a second question nevertheless arises: how much longer and how much further can it go?

"Bear markets can contain some rallies that feel very much like bull markets" Tom Stevenson

There are some good reasons to think we are due another bull market, especially if you accept that the 2003-2007 period was simply a rally in the bear market that began in 2000 and is now almost ten years old. I think we have been in a bear market for this long because the multiple of earnings at which the average share has been priced has indeed been falling steadily over that period.

Lost decades like we have experienced have historically led to extended periods of outperformance, particularly when, as now, valuations are undemanding. Moreover, the long-run outlook for the global economy remains attractive – the emerging market growth story is still in tact and, within developed markets, trends such as clean energy and infrastructure replacement promise growth for years to come.

The very long-run history of stock markets shows that extended bull markets of 20 years and more are punctuated by less extended but still long periods of retrenchment. The post-war reconstruction boom led to the inflationary retrenchment in the 1970s, while the globalisation and technology boom of the 1980s and 1990s led to the past decade of relative market decline.

Are we poised for the next extended bull market? It would be nice to think so but I believe investors will need to be patient for a little while longer for a number of reasons. First, the imbalances caused by the previous boom are still not fully resolved. Housing, for example, remains too expensive. The financial system has been badly weakened by the credit crunch. Inflation hovers in the background as the likely result of governments’ reflationary moves. Finally, valuations have not reached the kind of levels that typically signify the end of a long bear market.

Investors should not simply switch off, however, because the history of bear markets shows that they can contain some spectacular rallies that feel very much like bull markets. In Japan, for example, one rally in 1998-1999 saw the market rise by nearly 80%. No-one wants to miss that kind of bounce.

So, after a 30% gain in two months is there more to go for? Certainly the rally so far is larger and feels a lot more sustainable than previous bounces over the past 18 months. With some rallies increasing share prices by as much as 50%, investors should think carefully before leaving the party just yet.

Good news is starting to pile up on a number of fronts. In credit markets, for example, the interest rate at which banks are prepared to lend to each other (LIBOR) is falling, the gap between the yield on government and corporate bonds is narrowing and companies are able to raise money in the bond markets again. With inflation still subdued and likely to remain so, interest rates will probably stay low for the foreseeable future.

Other widely-watched indicators such as the copper price and a range of business and consumer surveys are starting to reflect a more buoyant mood, growth in China looks likely to surprise positively and the rate of decline in the US housing market is showing signs of slowing.

Industrial growth also looks likely to resume as the savage liquidation of inventories that followed the collapse of Lehman Brothers goes into reverse. Stocks of goods in the supply chain can only be run down for so long and the upswing that always follows is generally very good news for corporate profits and jobs.

Another reason to expect the rally to continue is the fact that many investors have not participated in its initial stages. This is usually the case, with money waiting on the sidelines until it becomes clearer that rising prices are not just a flash in the pan. Pulling in investors who have missed out so far could underpin a continued recovery.

The market is also rising on bad news – in the last week it has shrugged off the collapse of Chrysler, swine flu and dreadful US GDP numbers. This is a very good sign.

The parallels with 1975 and 2003 are instructive. In both years, rapid inventory rebuilding led to sharp stock market rallies that saw prices rise 50% in 6 months, with barely a dip for latecomers to buy into.

Some words of caution. First, the market has moved very far, very fast. A pull-back is usual in these circumstances. Second, the economic data is by no means all good – volumes through the port of Shanghai (Asia’s second largest) are still falling. More selling of shares by company directors may indicate that the rally has been too enthusiastic. Don’t forget also that unemployment continues to rise fast and that swine flu, although milder than initially feared, has not gone away.

There are certainly major risks still and investors would be well-advised not to get carried away after a sharp rally such as we have just enjoyed. That said, the rise since March feels more sustainable than any of the bounces since the market turned down in 2007. Long may it last.