Do share markets have nowhere to go but up?

All the signs are showing that the share market is reaching its low point, argues Dominic McCormick.

It has been hard to miss the extreme pessimism about the share market from both professional and unsophisticated investors in the lead-up to Christmas 2011.

Confirming this pessimism there was little sign of any ‘Santa Claus’ rally last year, although 2012 has begun slightly better.

However, the surprise is not just that there is so much pessimism around. Rather it's that some widely followed investment professionals and commentators have become even more bearish recently in the midst of such extreme pessimism – sometimes with 180-degree turnarounds from more bullish views.

Long-standing and increasingly scarce bulls such as the Australian Financial Review’s Market Monitor, Glen Mumford, have recently recanted the bullish stance  held through most of 2011 and gone bearish.

Alan Kohler recently communicated to his subscribers that he planned to move his equities allocation down sharply, possibly to zero.

Even Shane Oliver of AMP Capital, who this time last year was calling the S&P ASX 200 to 5500 by end 2011, is now expecting the index to fall as low as 3800 within the first half of 2012.

The point is that these dramatic moves to the bearish side are the sort of recommendations commentators would normally aim to make at a market top, before a major fall of at least 20-30 per cent.

However, if looked at objectively I believe such recommendations are part of an environment with characteristics more like a market bottom than a market top. This capitulation may be indicative of the widespread investor frustrations that typically occur around a market bottom.

One of my favourite books on the stock market that virtually no-one has ever heard of is by Kiril Sokoloff – "The thinking investor’s guide to the stock market".

It's a bit dated (originally 1978), out of print and quite US-centric, but it is excellent at explaining the psychology of market movements and what to look for in determining where we are in the stock market cycle.

Toward the end of the book Sokoloff provides a checklist of factors/questions to consider separately in determining major market tops and bottoms. A sample of the first nine (there are 15) for a market top include:

• Have interest rates moved up?
• Is business activity booming, and is it as good as it possibly can be?
• Have stock prices been rising for so long that investors have thrown caution to the winds?
• Are the newspapers full of optimistic news? Are the major concerns of the previous bear market totally forgotten by one and all?
• Are you very confident in the future and totally optimistic about buying and owning stocks?
• Is enthusiasm feeding on itself? Is this enthusiasm widespread and pervasive?
• Is it now generally accepted that the stock market is a superior place for investment funds? Is this view now so widespread that it is no longer a subject for debate?
• Are you so sure about the upward direction of the market that you feel confident about buying stocks on margin? Does everyone else feel the same way?

Does this sound like today's environment? Clearly not. Yet in getting out of, or recommending getting out of shares, many amateur and professional investors are currently acting as if we are now at a major top and the appropriate course of action is to dramatically reduce their exposure to equities.

Conversely, Sokoloff also provides a list of factors/questions indicative for a major bottom. Here is a sample of them.

• Have monetary conditions started to ease? Are utilities and bond averages and the government bond market all advancing nicely (yields declining) after the previous declines?
• Is the economic news starting to get bad? Are major publications devoting cover stories to the forthcoming decline in economic activity?
• Are all stocks declining together, especially the high flyers of the previous bull market? The sharper and more pervasive the declines the closer the bottom is.
• Are professionals who had been waiting to buy stocks now convinced that the market will go lower still? Is that conviction now so widely held that it’s no longer even a subject for debate?
• What’s happening to volume? Has it slowed dramatically from the previous peak?
• Are you so turned off by stocks that you want to hide your money under a mattress?
• Has the market made a ‘test’ of its bottom? Has it come back to the low and proved that it wants to bottom? Do investors get even more scared at this test? If so that’s a good sign.
• Have most of your acquaintances who own stocks liquidated some or all of what they hold?
• Is the brokerage business consolidating and going through a major contraction and elimination of the previous period’s excesses?
• Do stocks show resistance to further decline?
• Is it easy to make money by short-selling stocks? Can you indiscriminately pick a high-multiple stock, short it, and quickly make money?
• Have interest rates begun to decline, thereby confirming the slackening in business activity?

Clearly, this seems a pretty good description of the current environment. Interestingly, in terms of the Australian market the common investor perception seems to be that the market is making new lows on a monthly or even weekly basis.

However, the reality is that in early January 2012 the S&P ASX 200 index is actually around 10 per cent above its early August 2011 intra-day low, plus more than 2 per cent has been paid in dividends in the subsequent five months.

Investors certainly seem to be getting more pessimistic even while the market is showing considerable resilience in a very challenging environment.

At a pre-Christmas (working) lunch for our broader investment team we went through each of the above indicators and tried to get a team view on each of the questions/issues relating to market tops and bottoms.

Acouple of them were ambiguous, but the majority agreed that almost all the elements Sokoloff describes as being indicative of a major market top did not currently exist – and almost all of the characteristics of a major bottom were currently present.

The essence of Sokoloff’s approach is contrary thinking and investing. The simple premise is that when the crowd is extremely positive financial assets will likely fully reflect this optimism and there will be few potential buyers left to drive prices higher.

In contrast, when the crowd is extremely negative, prices will be discounted and there will be a large supply of potential buyers to take prices higher at some point. Warren Buffet puts it this way: “be greedy when people are fearful and fearful when they are greedy”.

No one can doubt that the prevailing mood of the investing crowd today is fear and pessimism. To further highlight this, below is a list of article headlines from just two pages of The Australian's business section from 4 January, 2012:

• “Tremors shatter old paradigm”;
• “Growth outlook cloudy for island nation”;
• “Investors batten down the hatches”;
• “Asian exports feeling the heat”;
• “It’s a make or break year for Europe as economic woes threaten to engulf the world”;
• “It’s all gloom and doom at Bridgewater”; and
• “Winter of discontent for Britain’s retail sector”.

Of course none of this suggests that the market has definitely bottomed or will do so in coming months. The bottoming process can sometimes take years and 2012 could still be another tough year with high volatility.

Further, there is some validity to the view that this is not just a cyclical bear market but a secular one associated with the end of a 30-year leveraging cycle that may have many years to run.

Still, even if this is the case, there are likely to be strong rallies and opportunities arising out of periods of excessive pessimism. Even Japan has had numerous rallies of 20 per cent or more in its 20-year bear market.

But what about today’s major macroeconomic challenges that can easily be translated into more extreme ‘Armageddon’ scenarios (eg, a disorderly collapse of the euro, a major crash in China)?

As noted in previous articles, I have long believed it makes little sense to bet one’s portfolio on just one scenario.

Therefore it can make perfect sense to consider some of the more extreme or Armageddon scenarios and try to include some ‘tail hedges’ or investments that can perform in these extreme environments.

However, given the extent to which these scenarios are at least partly priced in; that valuations in equity markets currently look reasonably attractive; and the low probability of these scenarios occurring, it hardly makes sense to build a total portfolio with a version of Armageddon as your core and only scenario.

If I had to take a best guess at how 2012 is going to pan out, it is for a significant multi-month rally in the early months of the year in which many investors (especially retail) largely sit on the sidelines with high levels of cash only to eventually begin to come back in towards mid-year as frustration and the sense of missing out grows.

Only then when some of the current pessimism dissipates are we likely to be hit by a renewed fall from mid-year and renewed frustration and pessimism.

However over the course of the year I see more risk of upside surprises overall given the extreme pessimism around – and even if the market makes little overall progress this is still a far cry from the 20-30 per cent fall that various ‘get out of equities’ calls imply, particularly with the attractive dividend yields available in many markets.

Having said this, investors and financial advisers need to stop searching for the guru who will successfully tell them exactly when to buy and when to sell.

They don’t exist. Instead, try answering the above questions/issues raised by Sokoloff for yourself.

While it doesn’t help with precise timing, it does suggest we are closer to a major bottom than a major top.

Professionals who are suggesting the opposite to this by suggesting selling most or all equities (particularly if they have recently done a 180-degree turn) should probably be ignored and will likely turn out to be good contrarian indicators.

If indeed we are closer to a major bottom than a major top, then these are the times true investors should be considering buying equities, not selling.

If you are still selling now and/or refusing to even consider buying into current or future weakness, then you are not an investor but simply a follower of the current pessimistic fashion. It may make you and your clients feel better in the short term but it won’t do much for their wealth in the long term.

Economist and investor John Maynard Keynes emphasised that individual investment success is largely determined by how investors behave at market tops and bottoms.

This is where price volatility concentrates and where the big investment mistakes are made. It’s a time for rational thinking and assessment, not emotional kneejerk responses to widespread negative news or hyperactive recommendations.

We may be at that time.

Dominic McCormick is the chief investment officer of Select Asset Management.