Recovery is all in the timing

The equity market tends to lead the economy by about six to 12 months, indicating it is important to know where the economy is in its cycle. One consequence of the equity market downturn experienced as a result of the global financial crisis could be a return to a more active focus on economic fundamentals and their impact on financial markets.

The equity market over the past 18 months

The S&P/ASX 200 Index reached a closing low of 3,145 on 6 March 2009. This day looks like it marked the end of the collapse in share prices that had begun in late 2007 and accelerated through 2008, with a peak to trough fall of 54 per cent. In this period, the GFC resulted in the near-collapse of the global financial system, a globally synchronised downturn in economic activity and a broad loss of confidence among financial markets, consumers, businesses and investors.

The Australian equity market has since risen sharply from its lows in early March 2009. As of 21 October 2009 the S&P/ASX 200 Index has risen about 53 per cent from its low in March 2009.

The recovery was driven by a number of factors. Fears of the worst-case scenario of a repeat of the Great Depression did not eventuate — as a result of unprecedented policy action by governments. In addition, the credit crisis has largely passed, and stability appears to be returning to global financial markets.

Companies have successfully raised capital to improve the health of balance sheets. Recovery in economic activity has emerged, particularly in Australia and significant Asian countries. Finally, investor risk appetite has returned.

The Australian equity market and the ‘investment clock’

First published in the London Evening Standard in 1937, the investment clock has long been one way in which investors can analyse the economic cycle. The

original theory behind the clock was that economic cycles moved in an identifiable pattern, taking about seven to nine years to complete a cycle.

Of course, economic cycles have changed a lot since the 1930s, with Australia not experiencing a recession for about 17 years (until the current, very mild one, hit) and with markets no longer following some of the simplistic patterns shown in the clock. Nevertheless, in March 2009 the ASX Investor Update newsletter included an investment clock, with an estimate that the cycle was now a little past seven o’clock — consistent with a period just after the bottom for interest rates and just ahead of rising share prices.

Where the hand on the investment cock is now positioned is clearly open to debate. With the recent monetary policy tightening from the RBA, this signals a level around one o’clock. However, perhaps the move in the cash rate could simply be interpreted as reversing a policy easing that was simply no longer required — pointing towards a position around eight o’clock. Equity market prices have also been rising fast, with the market up sharply from its March lows. Commodity prices have also risen well off their lows of February.

On the more bearish side of the ledger, the commercial property sector likely remains under pressure, while the access to credit (money) globally remains relatively tight.

Nevertheless, most local economic and financial market indicators are past the six o’clock point and are, therefore, more consistent with a recovery in markets — rather than the declining periods.

Where to now?

While recent Australian economic data has been better than expected — with the Reserve Bank responding to the news by raising interest rates — further improvement in the economy will likely be needed to support further equity market recovery.

Company profits are also central to gains and falls in the equity market. The 50 per cent fall in the Australian equity market over the past year or so suggested that the equity market had factored in a fall in company profits of close to 50 per cent, compared with a 42 per cent decline in the early 1990s recession.

Based on data from the Australian Bureau of Statistics to the second quarter of 2009, company profits in Australia were down about 15 per cent over the past year and down about 25 per cent from their peak in the third quarter of 2008. This better-than-expected performance of company profits (due to the better overall economy and cost control) is one of the reasons why the Australian equity market has been able to recover a significant amount of lost ground over the past six months.

Other factors to drive the equity market are capacity utilisation and cash looking for a home, both of which point towards a positive outlook — although these factors tend to more long-term drivers.

The resilience of the Australian economy and its prospects for continued economic recovery should be good news for the equity market. However, given that the equity market has already risen about 50 per cent, companies will need to deliver on rising profit expectations over the next year to ensure prices can remain at higher levels.

Stephen Halmarick is head of investment markets research at Colonial First State.

James White and Belinda Allen from the investment markets research team also contributed to this article.