Market review: Nothing to fear but fear itself

The ugly overseas sharemarket environment continued for most of July but a substantial market lift provided some hope at month's end.

After the extreme sell off earlier in the month the United States sharemarket had its biggest gain over any four-day period since 1974. Even so the S&P 500 was down about 8% for the complete month.

The key issue now is: does this mean the bottom of the bear market has been reached or is this a brief pause before further sharemarket weakness resumes?

To analyse this issue we need to concentrate on the US sharemarket as this currently drives the sentiment of most of the other major markets.

Key factors to consider are: the US economy, corporate earnings, interest rates and investor sentiment.

The US Economy. All through the first half of 2002 most economists have forecast a bounce in the US economy later in the year. The traditional theory is that share market performance leads the actual economic outcome by six to nine months.

The dreadful performance of the US sharemarket so far in 2002 could mean either: the market does not believe in a US economic recovery or there has been a disconnect between the economy and the sharemarket.

The latter can occur in the short term but generally sound economic fundamentals do result in a healthy sharemarket.

The outlook for the US economy remains reasonable although data released in late July did raise some doubts. The ISM, which is an important leading indicator of industrial sector health, fell significantly and the August ISM result will be watched closely.

US consumer confidence has held up with good personal income growth, strong house prices, relatively low unemployment rates and low mortgage rates continuing.

On balance the US economy should be a positive influence for the market but risks to this view remain.

Corporate Earnings. A key factor behind US sharemarket weakness has been the collapse in corporate earnings over the past two years, accentuated by the profit misreporting by some companies. The June quarter profit results gave some hope as these were up 1% from a year ago, the first time since the fourth quarter of 2000 that the S&P companies have collectively posted a year-on-year earnings increase. Moreover, the majority of companies exceeded analysts’ estimates.

A disappointing aspect of the latest result round was that twice as many S&P companies said their third-quarter will be lower than forecast, as the number of companies who said they should surpass expectations.

In addition there is the uncertainty of whether 2003 earnings forecasts will need to be down graded because of previous over-reporting by companies and a slow economic recovery.

Interest Rates. This is very much tied to the economic outlook. However, there is no doubt that the US Federal Reserve’s reluctance to raise rates has been influenced by the dramatic collapse in US sharemarket values, with their concern being that this will negatively affect consumer sentiment. To overcome this risk the Fed is now likely to delay any rate increase until next year and there are some economists now even calling for a further interest rate cut, particularly if the August ISM number is weak. One cause for confidence is that Federal Reserve chairman Alan Greenspan will ensure low interest rates remain a positive influence on the market and the economy through the current volatile period.

Sentiment. This often drives market direction in extreme bull and bear markets. Prior to the last week in July sentiment had become incredibly negative.

One example of this was the Chicago Board Options Exchange Volatility Index (VIX), which was above 50% in late July. This was higher than after the September 11 terrorist attacks.

Another indicator is that the yield on 2 year Treasury notes has fallen to its lowest level since it began being issued in 1972. This flight to cash was also evident in the retail equity mutual funds market, with more than NZ$100 billion redeemed in the July month.

Ironically these examples of extreme gloom in world markets could also fuel a market lift as a turning point can occur when market participants are most negative.

A key test of investor sentiment will occur this month.

By August 14 nearly 1000 companies must attest to the validity of their recent financial statements to the Securities and Exchange Commission. The market is holding its breath on this in case further corporate corruption is unveiled. Of course, another factor that weighs on US sentiment is the now ever-present threat of terrorist attacks.

So where does this leave us?

When all of the above factors are added together one has to say the outlook for the US (and therefore world) sharemarket is positive.

The economic environment is reasonable (though not without risks), corporate earnings in 2003 should be higher, interest rates will remain low and negative sentiment may have peaked.

However, the lows we saw in late July may be re-tested as bear markets can go for longer than expected, for sentimental reasons.

The market should suit stock pickers rather than index huggers as negative sentiment can cause across-the-board market falls leaving some sound companies over sold.

While we think that the market outlook is positive on a 2-3 year view, there is no doubt that a volatile market environment will continue and the market remains vulnerable to any negative shocks.