Why this is not a bear market despite a brutal October
OCTOBER'S sharp equity selldown has raised fears about whether this marks the beginning of a bear market, as defined by a fall of more than 20 per cent from peak to trough. US and world stock indices fell close to 10 per cent within the month.
Market participants are beginning to draw comparisons with 1987's "Black Monday" due to several similarities. First, both were October events. Second, the current selling has in part been attributed to algorithm models, not unlike the programme-selling that arose from portfolio insurance hedging in 1987.
To stretch the argument further, some have also likened the latest selloff in technology stocks to the "dot-com" bubble crash around 2000. Given these comparisons made with past bear markets, we conducted two sanity checks.
Sanity Check I: 1987's yield gap vs today's
The S&P 500 Index fell 20.5 per cent on "Black Monday" (Oct 19, 1987) amid mounting concerns over rising inflation, which reached 4.4 per cent. The US Treasury (UST) 10-year yield hovered at 9 per cent.
In contrast, inflation today remains modest at 2 per cent - half the level in 1987. More importantly, the UST 10-year yield is at a low of 3.2 per cent.
In 1987, there was an attractive investment alternative in Treasury bonds compared to equities, given that an investor could attain 9 per cent then (vs 3.2 per cent today).
This relationship between equities and bonds can be captured in the "yield gap", which measures the difference between the US earnings yield and the UST 10-year yield.
In 1987, the negative yield gap made equities especially unattractive as an asset class relative to bonds. This triggered capital flight, resulting in the ensuing crash on "Black Monday". The same observation can be made during the "dot-com" bubble as the yield gap was also negative.
Today, the situation is vastly different. The yield gap stands at 1.7 per cent as the US earnings yield of 4.9 per cent is higher than the prevailing UST 10-year yield of 3.2 per cent . We believe this positive yield gap ensures limited capital flight, thus protecting against much further downside to the stock market.
Sanity Check 2: US technology in 2000 vs today
US technology stocks had seen strong selling pressure of late. Are we going to see a repeat of 2000's "dot-com" crash?
We do not think so.
First, the current forward price-to-earnings (P/E) ratio of 17.5x for technology stocks is not stretched, as opposed to the "dot-com" bubble's euphoric levels of 50x.
Second, technology earnings have been on an upward trajectory since 2002; this has come on the back of improving pricing power and healthy margin expansions. The free cash flow yield of 5 per cent, meanwhile, is higher than the UST 10-year yield - and this has been a vital catalyst in driving sectoral re-rating.
Technology stocks are also on a much stronger footing today. Balance sheets of bellwether technology companies show strong net cash buffers.
In sum, despite a brutal October, we do not hold the pessimistic view that it is the start of a bear market. On the contrary, as argued in our Q4 18 CIO Insights report, we believe a window of opportunity has opened. Investors should re-engage with equities, since value has now emerged.
