Grin and bear it when the bubble bursts

By KEVIN ARMSTRONG

Is now the time to panic and what's special about 30 months? Stock markets worldwide have suffered some of their most dramatic declines of the past 50 years and now, 2 1/2 years after the peak, many of the accepted norms that became conventional wisdom through one of the most profitable and enduring bull markets are being questioned.

The idea that all an investor need do was "buy and hold" for the long term, and that equities always outperform other assets, was heard more and more as the bull market rolled on.

Unfortunately these ideas built complacency and became synonymous with the bull market, born out of the bull market and, to some extent, the cause of its final manic phase.

It is the manic nature of the last bull market that makes comparisons hard. Undoubtedly it was a mania and it produced the largest speculative bubble the world has seen. Now we must deal with the aftermath of it bursting. The reason comparisons are hard is that the mania distorted most traditional valuation techniques; why else at the peak would everything be rationalised with talk of a "new paradigm"? It is of little value comparing what we have just been through with anything but other manias, and it is in reviewing other post-bubble bear markets that the significance of 30 months first becomes apparent.

It is now 30 months since the bull market peaked. Expectations from here, both economically and for the stock market, are modest at best and we're beginning to hear more talk of a worst-case scenario. So how bad could equity returns be from here, having already been so poor for so long?

As mentioned earlier, the only sensible comparisons are the declines and recoveries after other manias or burst bubbles.

The accompanying tables and charts pull together the details of the declines and subsequent rallies of a selection of history's biggest burst bubbles and bear markets. The sample begins with one of the most famous bubbles, the South Sea Bubble, and then reviews the US after 1929, Britain from 1972, New Zealand after 1987, Taiwan from 1989 and Japan from 1990. It is also interesting to compare the bursting of the gold bubble in 1980 with the actions of these equity bubbles.

Admittedly, none of these bubbles was as global in nature as that of the late '90s, but at the time and for the markets they were in, they all produced devastating bear markets that ranged in size from 40 per cent to 90 per cent declines.

The US, British, Japanese and gold declines have been well recorded. But some background to New Zealand and Taiwan may be warranted.

For the decade up to 1986, New Zealand had been the best performing market in the world. There truly was a belief that this time it was different, and that New Zealand had a new breed of entrepreneur. The public poured money into every new issue and many borrowed to invest even more. By 1987 the market was up more than 1500 per cent from 1974 and expectations were sky-high. The bubble was finally burst with the 1987 crash and the decline was more dramatic in New Zealand than just about anywhere else in the world. Even now, the market has still not recovered to those levels seen 15 years ago, although after 30 months of decline, opportunities were appearing by 1990.

Similarly, Taiwan had its own remarkable boom and at its peak the Taiwan market was one of the most active exchanges in the world.

Its collapse was as spectacular as its rise. Nonetheless, the chart shows that about 30 months after the bubble burst, much of the damage had been done and far more upside than downside existed over the coming five years.

There is certainly nothing magic about the passing of 30 months except that history shows the worst excesses of a major bubble appear to be worked off if a market falls sharply for about this length of time. It does not, however, indicate or imply a final bottom.

Very large bubbles take time to work off, as has been seen over the past 12 years in Japan. Given that we're now dealing with the largest bubble yet, it's not unreasonable to expect that its ultimate unwinding will take time.

Even if the final low does lie another 10 years into the future, as it was with Japan in the summer of '92, forecasting that final low may well be less rewarding than recognising the present opportunity.

An investor who capitulated after 30 months of decline in Japan would have been correct in the very long term but would also have missed out on three bull market opportunities, each of which lasted between one and two years and produced gains of 50 per cent.

The long-term real return history of the S&P Composite shows a clear mean reversion around a trend return of about 6 per cent. Back in 1999 to 2000, returns had been as far above trend as they had ever been and it was then (and still is) reasonable to expect that at some point in the future, not necessarily in the near future, returns would again be well below that trend.

Right now, as a result of the past 30 months of bear market action, we have returned to trend.

Deciding to give up on equities now, after 30 months of bear market action, may also be right for the very long term, but it's a brave call to be prepared to sit out totally and wait for the ultimate bottom.

When the final low arrives, whenever that may be, many of the valuation approaches that have been so distorted by the great bull market bubble will probably finally indicate the bottom. The real questions will be how many observers will be there to witness that historic event and who will be interested enough to listen.

So after 2 1/2 years of decline, now is not the time to panic. Worrying about the decline that has already occurred and "corporate malfeasance" (the new media phrase) will probably be as rewarding as getting excited about the "new era" was at the peak of the bull market.

Panicking would have been useful advice at the top when we were still in the "new paradigm", but not now.

History shows that even if things are now as bad as Japan in the '90s or the US in the '30s, it may be the time to look for opportunities rather than focusing on all the well-publicised risks.

* Kevin Armstrong is chief investment officer, Private Banking Division, at the National Bank of New Zealand.