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When is a share market sell-off really a crisis?

The word ‘crisis’ is often used in descriptions of, and forecasts for, the share market, but over the years, many ‘crises’ have worried investors and affected their investments.

Some were real crises with huge effects, such as the 55% collapse in Australian share prices from late 2007. The vast majority, however, were false crises. With today’s overload of swiftly-transmitted information and opinions, as well as computer-based trading, false crises are even more prevalent than in earlier years.

Buying or selling on the dip

A false crisis is a major sell-off in shares brought on by widely-held expectations of an impending disaster that fail to eventuate or were massively exaggerated. A false crisis can inflict heavy losses on investors who dump quality assets at depressed prices during the panic. On the other hand, they can provide opportunity for investors to acquire good assets at low prices.

When a crisis – real or false – first hits the share market, many investors fear it’s the beginning of a long and painful bear market. But as Robert Buckland, a global strategist at Citigroup, puts it: "Every bear market for shares begins with a dip but not every dip starts a bear market." Investors need to distinguish between a sell-off that should be bought and one that should be sold.

In my Cuffelinks article in July 2017, I chose the collapse of share prices in early 2016 as the cause célèbre of false crises. (To attract readers’ attention, I used the words ‘fake crisis’ in that article).

The dominant view in investment markets in January 2016 was China’s economy was contracting and the US economy would fall into recession. Share markets, commodity prices, and the Australian dollar all plunged. The prevailing expectation was that we would be in for a long drawn-out bear market in shares.

As things turned out, China’s industrial production did not ‘contract’. China boosted demand on a scale the doomsayers had not allowed for and the US economy rebounded. Shares, commodity prices, global GDP and the Australian dollar bounced higher.

The false crisis of December 2018

More recently, we had an even clearer example of a false crisis: the turmoil and panic in share markets around the world in December 2018, which was quickly followed by an ebullient rebound.

In late December 2018, average US share prices fell to a level that was 20% lower than four months earlier, mainly because of fears the Fed would aggressively tighten US monetary policy. Other share markets followed the US lead, and predictions of a long-lasting bear market in shares abounded. US shares not only recovered their earlier big losses but in a few months were setting record highs.

Judging whether a particular crisis is true or false

Australian investors need to keep an effective watch on the key influences affecting US shares, including where the US is in its economic cycle, what’s happening to monetary policy there and how stretched valuations are on US shares. The dominant view in investment markets for economic conditions in China are also important.

Five factors to watch in judging a current sell-off are:

  • US shares generally set the direction that other share markets follow, and when the US goes into recession, investors need to expect a deep and sustained bear market in shares around the world.
  • The best warning sign of an early US recession is given by the relationship between short-dated and longer-dated interest rates in the US (that is, the shape of the US yield curve). When the US yield curve becomes ‘inverted’ – say with the ten-year bond yield lower than the yield on a two-year bond – for a sustained period, the risk of an early US recession is higher, though its precise timing is uncertain.
  • Some investment strategists look at a number of indicators that have good track records for forewarning investors of earlier bear markets in shares. In late 2018, a Citigroup survey found that only four of their 18 indicators had ‘red flag’ settings. This suggested it was too early to call the end of the 10-year-old bull market in shares. Instead, they suggested “buying the dip”. Their April 2019 survey again contained just four red flags, led by stretched corporate balance sheets and the hints of an inverting yield curve.
  • In December 2018, the majority view in markets was the Fed would raise cash rates two or three times in the coming 12 months, and also tighten liquidity by selling bonds. Instead, the Fed soon signalled that, because of “global developments” and “muted inflation pressures”, it would maintain an accommodative stance in its monetary policy. Investors assessing whether a panic is real or false need ask how likely is a change in policy?
  • Expectations the Chinese economy would soon experience a hard landing keep recurring – for example in the late 1990s (during the Asian crises), 2008 (the global financial crisis), 2016 (the so-called ghost cities because of over-building) and 2018 (from attempts to reduce credit). In fact, China’s economic management has been more effective than is generally recognised by commentators in the West, helped a bit by the country’s high rate of saving and abundant foreign exchange reserves.

What if sentiment turns too bullish?

When sentiment in investment markets turns highly positive, investors often do well to take a cautious view, by building up cash holdings to benefit from the next dip in share prices, focusing on the quality shares best placed to deliver good growth in earnings when conditions are tough, and being highly selective in shares they take up in new listings.

Certainly, the prevailing view in the US share market has recently been highly optimistic. Indeed, investor sentiment lifted so much in early May 2019 that the phrase the “melt-up of shares” was often featured in share market commentaries.

The mood of investors could sour quickly – triggered from tariff wars, or higher inflation, or signs that global growth is fading – and bring on predictions of a long-lasting bear market.

In coming years, investors will again be facing new crises in the share market. They will need to distinguish between the sell-offs that should be bought and the ones that should be sold.

 

Don Stammer has been involved with investing since 1962, variously as an academic, central banker, investment banker, fund manager, and company director. He writes on investments for The Australian and is an adviser to Stanford Brown Financial Advisers. This article is general information and does not consider the circumstances of any individual.

 

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