Beware the bear market rally

published 25 March 2009

Some 15 years ago, over a long weekend in Minakami a small mountain village two (bullet-train) hours west of Tokyo a man from what was then Warburg's explained to me why I should give up my teaching job in Nagoya and join his broking desk in Tokyo.

His pitch was simple. The Japanese bear market was over. After years of uncertainty, it had rallied on the back of a clear-out of bad debt and a much-improved economic outlook and it would continue to do so. If I joined his team, I would catch the upturn and make a fortune.

It didn't quite work out like that. Instead, that weekend pretty much marked the end of the first of a series of massive bear market rallies in the Nikkei. It rose more than 30% in 1994, 50% in 1995, 35% in 1999 and 100% from 2003 to 2006. But, after each boom, it collapsed back to new lows. There was to be no bull market and, rather sadly from my point of view, no fortune.

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Which brings me to today. Since 6 March, the S&P is up 14% and the FTSE 100 is up 9% leading to a growing belief that we may have seen the back of the bear.

This, say the new bulls, is as low as stocks can go: not only are they now trading at or well below fair value on most measures, but there is finally evidence of green shoots in the global economy.

I'm not sure I can accept the green shoot sightings. Sure, there are bits and bobs of relatively positive data UK house prices rising slightly on one measure, retail sales being less bad than expected in the US, and so on.

But nothing moves in a straight line up or down not even misery so the odd positive number is, I'm afraid, meaningless in the great scheme of depressing figures.

Note that while UK house prices may have crept up for one month on one measure, gross mortgage lending in February was still down 60% and payment arrears rose 30% in the last quarter of last year. Find me a green shoot in that.

However, I would accept that stocks look cheap on some measures. The problem is that, in a real bear market, that doesn't mean anything.

For starters, a valuation is only as good as the numbers you feed into your calculator in the first place and who can be confident of those?

Who can say where earnings will actually bottom, when dividends will stop being slashed or when the asset deflation that's shredding balance sheets will end?

Even if the numbers do tell a version of the truth, they still can't stop stocks falling. Russell Napier, of CSLA, the Asian investment firm, points out that in real bear markets, stocks end up not just cheap but grossly undervalued. And to hit the historical lows seen in his "four great bottoms" of 1921, 1932, 1949, and 1982, the US market still has to fall almost another 50%.

But, historical context aside, there is one other major reason to be suspicious of this rally: it has been led by bank shares.

Might this have something to do with the conversations this week in the US about a shift away from the current "mark to market" rules under which banks have to assign a value to all their assets based on the current market price for similar assets? The Financial Accounting Standards Board isn't intending to do away with the standard altogether but is considering allowing banks with hard-to-value assets (say, mortgage securities) to use "significant judgment" when valuing them, instead.

If this goes ahead, banks will be able to use their "significant judgment" in time for first-quarter results. It is, says James Ferguson of stockbrokers Pali International a bit like telling a career criminal he can organise his own court proceedings. We can expect the banks to judge that their assets are worth rather more than the market would be prepared to pay for them, and enjoy paper profits all round.

But fiddling the figures can't change the facts. You can assign whatever value you like to your assets in the short term, but what happens when the assets backing those securities default? Then you've got real losses losses that should bring the sector tumbling back to earth again.

Note that new bull markets are rarely led by the sector that brought them down in the first place: the post-dotcom recovery was no more led by the technology sector than an eventual new bull market will be led by the banks.

Still, given how far and fast markets have fallen, I wouldn't be at all surprised if even the most cynical of bears have Minakami moments.

But just as the Warburg's man got it wrong all those years ago, I'd be pretty sure that the new bulls will be wrong today. Bear markets last a long time and are always interrupted by massive rallies. Just like this one.

This article was first published in the Financial Times on 20 March 2009

Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).

After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times

Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast - but still writes for Moneyweek monthly.

Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.