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Analyst report - shares
Market turbulence - should you buy or run for the hills?
February 13, 2008
Tim Morris, Analyst, wise-owl.com

The recent falls we have all witnessed in our market have been the biggest since October 1987. This has left many investors wondering if the share market is the best place for their money.

Should we buy, sell, or run for the hills? If history is any guide, a buying opportunity may now be upon us. Since 1991 the market has fallen by over 20% five times. On four of those occasions, the following year provided strong returns for investors. The fifth fall greater than 20% was in January this year.

We will examine some charts shortly but let’s first take a look at the global economy.

1. The latest data shows that China and India are growing by 11.2% and 8.9%, respectively. The World Bank predicts China will grow by 9.6% this year.
2. The world economy is still in expansion phase with above average growth.
3. Australia’s resources are still in high demand.
4. Unemployment is at a record low of 4.4% in Australia with companies still hiring.
5. Consumer confidence is high. 6. Businesses are flush with cash after years of record profits.
7. When inflation is taken into account, global commodity prices are coming off 200-year lows.


Source: BHP Billiton Ltd

Despite the subprime mortgage mess and slowing US growth, our most important export partner, China, is continuing to expand with the recent GDP data showing 11.2% annualised growth over the December quarter. A slowing US economy will no doubt affect China but not as much as some people might think. In fact, a minor slowdown in China would be a welcome change for policymakers as it would cool down inflationary pressures. Having taken into account the trade effects of a US and European slow down, the World Bank estimates that China should still grow at a healthy 9.6% clip this year.

The scale of industrialisation and urbanisation in China is unprecedented. This will keep our mining sector ticking along and gives credibility to the "stronger for longer" case. One just needs to travel to Perth to see the impact the mining boom is continuing to have. The growth in China and India should provide Australia with an element of insulation from a US slowdown. Most of China and India’s need for our commodities is for domestic use, a fraction of which is used for the production of US exports.

The last commodities boom, which started in the 1970s, lasted for 15 years and was a result of the industrialisation of Japan which had just 2% of the world’s population. The current boom is being led by the industrialisation and economic growth of China and India. Combined, these two countries have 36% of the world’s population. With more than a third of the world’s population enjoying elevated economic growth, the commodities boom will continue for many years to come.


Source: Wise-owl.com

Combine this with real commodity prices close to inflation adjusted 200 year lows, and you have a very bullish long term macroeconomic picture on your hands.

The worst may already be over

Market falls of more than 20% are often an indication the market is close to rock bottom. Recent history suggests that when a market falls, the bulk of the sell-off occurs early as people try realise any gains they still have. Since 1991 there have been four 20%+ falls and every one of them was a precursor to strong gains. The January 22 market fall was the fifth time this has occurred, and hindsight may soon show us it was indeed yet another good buying opportunity.

The Crash of 1997

In 1997 the market had a large fall due to the Asian Crisis. On October 27, 1997 markets around the world fell due to†an economic crisis in Asia (a.k.a. the Asian Flu). It started in Hong Kong where the Hang Seng index fell 6% overnight prior to October 27. However, the Japanese market only fell 2% and European markets fell by the same amount once they opened.

Everyone was expecting the Dow Jones to fall as well and fall it did. By the end of the session the Dow Jones had fallen 554 points or 7.18%. The Australian market fell by an equivalent amount over those days.

The following day the Hong Kong market crashed by a staggering 12% while the Nikkei fell close to 5%. Heavy falls were again expected on Wall Street and although the market opened lower it started to rally and finished up with a record gain of 337 points. Most of the time, mini-crashes or even full blown crashes are best viewed as outstanding buying opportunities.

Once all the fear was priced into the market, stocks had fallen by more than 20% from their peak. The recovery was swift though and in six months time the market was breaking all-time highs. Those who bought in the height of fear and panic were in profit long before this.


Source: Wise-owl.com, Bloomberg

The most recent bear market of 2002 bottomed once it had fallen 22.5% from all time highs. Once again, when people were at their most bearish the market turned and within one year was 27% higher. This proved to be yet another buying opportunity.


Source: Wise-owl.com, Bloomberg

The recent falls have taken the market 24.3% from all-time highs. As in previous pull backs, when fear and panic had reached a peak and many were throwing in the towel the market provided compelling buying opportunities.


Source: Wise-owl.com, Bloomberg

Know when fear in the markets can bring opportunities

So how do you know when fear is reaching extreme levels? The most widely used measure of fear in markets is the VIX, or volatility index. It is commonly also known as the ‘fear’ index. When volatility spikes a freefall it is often at hand which is what we saw on January 22. These capitulation sell-offs are often a sign the market has bottomed and is ready to charge back up again. Weak hands selling to strong hands, one might say.


Spikes in volatility or fear are often short lived. Source: Wise-owl.com, Bloomberg

As is clear in the chart below, rapid spikes in the VIX, or fear index, frequently coincide with a market bottom. In the last nine years this has held true 83% of the time.


Over the last nine years, spikes in volatility have frequently pointed to good buying in the market. Source: Wise-owl.com, Bloomberg

Fear explained

Markets are often dictated by emotion which can go a long way toward explaining large falls. Nobody likes to lose money, even on paper. It is difficult keeping a cool head when your stocks keep falling. Fear and greed are powerful emotions and often make people look beyond the facts and sell irrationally.

Yet, a cool head is what separates the professional from the pauper. The fact is that people have not technically lost on a stock until they sell and crystallise a price decline. A famous quote after the 1987 crash was when a wealthy investor was asked how much he lost during the slump and his answer was "I lost nothing because I did not sell a single stock". Of course, people with facing margin calls may be forced to sell.

For the wise investor, fear brings opportunities

Fear brings panic selling which can in turn bring value and buying opportunities. Master investor Warren Buffet said it best himself, "Most people get interested in stocks when everyone else is. The time to get interested is when no one else is."

Bull markets are renowned for climbing a "wall of worry". One thing to ask yourself is this: if things are so bad in the world economy yet the market is close to all-time highs, what will it be like when economies truly start firing?

Long term value is now apparent in our market, and outstanding bargains are in the wings. Make sure you know which bargains to snag when the time is right.