26 SPE NEWS November/December 2008

Economic Analysis

The Australian Economy And Performance Of The SharemarketBy Noll Moriarty, Director of Archimedes Financial Planning

This year has been very testing for Australian sharemarket investors. For many, it is their first close encounter with the real meaning of investment risk. People are naturally concerned as to what impact an economic slowdown or recession will have on the value of their sharemarket investments.

The global credit crisis brought on by US sub-prime loans has caused world sharemarkets to decrease in value considerably. Now attention is turning to what impact lack of credit will have on economic growth – will sharemarkets fall further?

While no-one knows for sure, we can get a feeling for the most likely outcome based on the study of historical data of Australian economic slowdowns/recessions and sharemarket machinations over the last 50 years.

The Reserve Bank provides statistical data, in particular quarterly Australian GDP since 1960. This can be combined with the sharemarket ASX All Ords Price Index monthly returns, reformatted to quarterly values to match the GDP data.

Figure 1 shows both quarterly GDP value and the rolling annual GDP from 1960 to June 2008.

Although quarterly GDP figures are highly variable, note it is rare to have two or more consecutive quarters with low values. Long-term GDP has averaged around 3% pa (0.75% per quarter).

Since 1960, there have been 10 periods when the Australian economy has been in recession (two or more consecutive quarters negative GDP) or slowdown (here defined as two or more consecutive quarters with annual GDP < 1% pa):

• seven technical recessions: 1960-1; 1965; 1972; 1975; 1977; 1982-83; 1990-91

• three slowdowns: 1974; 1986; 2000

These periods are shown with pink rectangles in Figure 1. On average, these recessions and slowdowns tend to happen every five years or so.

Observe for April-June 2008, the last quarter GDP for which data is available, GDP shows a significant fall to 0.3% cf ~1% growth in previous quarters.

Figure 2 shows a cross-plot of length of slowdown/recession against the minimum value of rolling annual GDP during that period.

Observe there is a strong relationship between the severity of the slowdown/recession and for how long it persists.

Recessions tend to last 6–12 months, but have been as long as 21 months (1982-3; 1990-1). Note rolling annual GDP growth is not necessarily negative during a recession: ranged down from 1% pa in 1975 down to -3.2% pa in 1982-3. If a slowdown is ‘shallow’ (ie GDP annual growth less than 1% pa), slowdown typically lasts around six months, but has been as long as 12 months.

Occasional periods of economic recession and slowdown should be welcomed by investors. In a financial Darwinian sense, these periods weed out less sustainable companies based on too high debt or financial over-engineering. This underlines the value of a diversified portfolio – for every company that implodes, other companies double or more in value.

Since 1991, there has been only been the 2000 slowdown. This economic out-performance is consistent with many other developed economies, including the US and the UK. On the balance of probability, the economy was overdue for a reality check.

The present economic crisis in Australia has caught too many commentators by surprise. Not so long ago, bullish sentiments from the media and stockbrokers pontificated that the Australian economy and sharemarket would power along at high growth rates because of the commodities boom. Competition for superla tives remained intense as ‘stronger for longer’ was superseded by ‘100-year boom’ and ‘it’s different this time’.

Sharemarket investors were swept up in the euphoria, believing there is a strong link between economic performance and market returns. (This article will call in question this belief.)

Now there is fear of economic recession in Australia and the developed world. Contrary to popular opinion, the credit crunch should not be blamed as the cause of Australia’s present economic woes. Instead, the final 2% of rate rises by the Reserve Bank of Australia were the culprit.

While the credit crunch has amplified negative impacts, many key indicators such as job creation and building approvals were fading by early 2007. The RBA was targeting so-called inflation (increase in cost of living) but the increase was largely coming from higher mortgage payments and rents, caused by the interest rate rises. It’s like a cat chasing its tail!

The RBA is currently slashing interest rates to counteract the slowing economy. Ponder what if the rates are cut too low or stay low for too long – will it sow the seeds of the next debt binge boom and bust?

The Australian economy faces two main risks: firstly if the US economy stays in prolonged recession; secondly if Chinese economic growth falls below 6% pa since it needs a growth rate of 9–10% to absorb about 24 million people joining the labour force every year. If these risks happen, the Australian economy is likely to

Fig. 1. Australian economic GDP 1960-2008

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Economic Analysis

suffer several years of patchy economic growth, similar to the early 1970s or 1990s.

The effectiveness of US President-elect Barack Obama’s eventual stimulus packages is the biggest unknown. The present credit crisis marks the end of an economic era with expansion based on a debt binge. The de-leveraging of developed world economies is a painful process that will last many years. However, it is necessary this occurs and the worst may be behind us now.

The consensus view of economists is that the Australian slowdown/recession is likely to be ‘shallow’, given the underpinning of Chinese demand for resources. While the Chinese economy is slowing from >10% to around 8% pa, this is still very healthy. China has US$2 T in cash reserves (the largest in the world) and will spend a massive US$586 B over the next two years upgrading infrastructure, raising rural incomes via land reform, and social welfare projects.

The International Monetary Fund (IMF) recently predicted the Australian economy in 2009 will grow at 1.8% pa while the developed world will be in recession, averaging -0.3% pa. Treasury forecasts Australian growth will be below the long-term average rate: 2.25% pa in 2009/10 and 3% pa for the next two years.

While organisations such as the IMF and Treasury tend to underestimate the severity of economic slowdowns, the positive takeout for the Australian economy is that forecast growth is only a little below the long term average rate.

The Australian federal government will implement in December 2008 a $10 B stimulus package targeting consumer spending. Economists have estimated this

package will be equivalent to adding about 0.8% to GDP, most of it in the last quarter this year.

If the economy is to fall into negative growth during the last quarter of 2008, the rest of the economy would have a growth rate below -0.9%. Economists predict the likelihood of this happening is low. Therefore any recession in Australia is unlikely to start until the first quarter of 2009 (if at all).

If Australia does have at worst a ‘shallow’ recession, historical data suggests it would most likely last 6–9 months. If so, the Australian economy would start growing some time in the last half of 2009.

Now let’s turn our attention to performance of the Australian sharemarket during these periods of economic slowdown and recession.

Figure 3 shows ASX All Ords Price Index monthly performances since 1960 on a log scale, with the 10 periods of slowdown/recession marked in pink.

Observe that the sharemarket:• tends to start falling just before a slowdown/

recession• starts rising before the end of slowdown/recession

At first glance, it would appear the performance of the sharemarket is strongly related to the economy. However, an objective evaluation will question such a conclusion.

Figure 4 shows ASX quarterly returns (to match the GDP data) and rolling annual sharemarket return every quarter, with the periods of economic slowdown marked with pink rectangles.

The sharemarket is a very volatile beast with many quarters of negative growth.

Observe the rolling annual sharemarket return:• tends to bottom some time in first half of slowdown/

recession• starts rising before the end of slowdown/recession

At the quarter ending 30 Sept 2008, the ASX All Ords rolling annual return was -30%. This low market value was only exceeded by the 1974 recession which reached -40%. (Note the rolling annual return is -41% at end of October 2008.)

The optimistic takeout from these observations is that the sharemarket, currently with a very negative rolling annual return, may now be positioning itself

The Australian Economy And Performance Of The Sharemarket – continued

Fig. 2. Recession severity vs. length in months.

Fig. 3. Performance Australian sharemarket 1960 - 2008

28 SPE NEWS November/December 2008

Economic Analysis

for a strong rise before the worst of any slowdown passes.

One could conclude, based on this historical analysis, it is unlikely the sharemarket will fall much further. The credit crisis has already savaged the market, so investors should not further punish themselves. However, since investors are not known for rational decision-making, the future of the market is always problematic in the short-term.

Now let’s critically examine just how reliable the sharemarket is as a leading indicator for predicting economic slowdowns.

Up to nine months prior to the identified 10 recessions or slowdowns, the magnitude of fall (or rise) in the monthly ASX All Ords Price Index (Figure 3) was determined. Figure 5 shows a cross-plot of sharemarket actual return versus lowest rolling annual GDP during this period.

The magnitude of the sharemarket fall appears to be a good predictor of the severity of a coming recession. When annual GDP did not fall below 1% pa, the sharemarket actually rose. The market fell when annual GDP was below 0%. (If this is true, the current -40% market decline suggests a recession whereby annual GDP growth could fall to about -3% pa.) However, it is human nature to search for patterns, even where none may exist. This theme is well explored by Nassim Taleb in his book Fooled by Randomness.

The ASX All Ords data (Figure 3) were examined to determine all occasions when the market fell by more than 10%. The annual performance of the economy just after the market fall was noted.

Figure 6 shows there were 10 other occasions when the market fell by more than 10% during 1960–2007

The Australian Economy And Performance Of The Sharemarket – continued

Fig. 4. Rolling annual return of Australian sharemarket 1960–2008.

Fig. 5. Performance Australian sharemarket during economic recessions.

Fig. 6. Falls in Australian sharemarket and corresponding economic performance.

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Economic Analysis

(excluding the current fall). However annual GDP growth did not fall below 1% pa. The supposed relationship between market and GDP is tenuous.

To further examine this, the rolling three-year correlation every quarter for annual GDP and annual sharemarket return (delayed by six months) is shown in Figure 7. (A six-month delay is chosen since it gives the highest overall correlation compared with zero, three and nine months delay.)

The market/GDP correlation is highly erratic. It mostly ranges between 0 and 0.8, averaging around 0.3. It is not a convincingly high correlation during times of GDP recession/slowdown. Note the correlation since late 1990s has overall been negative.

I conclude that, without the benefit of hindsight, the sharemarket is not a reliable predictor of coming economic woe. In particular, note the largest market fall occurred in 1987 during a time when GDP averaged 3% pa (Figure 1).

From these analyses, the probability of a market fall correctly forecasting a coming economic slowdown can be determined (Figure 8). If the market falls by more than 10%, the likelihood of an economic slowdown is about a one-in-three chance. It is slightly more probable that there will not be an economic slowdown!

Sharemarket falls are not reliable in forecasting economic health. However, note large market corrections did precede all the major recessions (1960-1; 1974-5; 1982-3 and 1990-1).

Now, let’s consider how the current correction compares with previous corrections. From ASX All Ords data (Figure 3), the magnitude of all corrections and time in months from market peak to ultimate trough

was determined (shown in Figure 9). This approach consolidates some corrections (for example 1973–4) giving a total of 15 corrections.

There is a reasonable relationship between the correction magnitude and length. Smaller corrections, less than 20%, stopped after 4–12 months. Larger corrections, greater than 30%, stopped after 1–2 years (with the exception of the five-month 1987 correction).

The current correction to mid-November 2008 is the second largest correction since the start of 20th century. The length (13 months) to date is about six months less than the average for a correction of this magnitude.

From these observations, I conclude the sharemarket:• is near bottom; is highly unlikely to fall more than

another 10%• will begin rising in one month (P10 basis)• will begin rising in six months (P50 basis)• will begin rising in 11 months (P90 basis)

These probabilistic predictions from past market behaviour are nicely consistent with expected length of a shallow recession. The economy would start growing in last half of 2009. Given the six month leading nature of any market turnaround, markets could start rising by the end of the second quarter of 2009 – in six months, the same as the P50 prediction.

Lastly, let’s consider the magnitude of market return 12 months after it regains upward momentum. After the 15 corrections during 1960–2007 (shown in Figure 9, excluding the current correction), and for reference the 1929–31 market crash, the market return for the next year after the correction finished was determined (Figure 10).

There is a loose relationship between the magnitude of the correction and the subsequent year return, with larger corrections mostly having larger gains. On average, the next year return recovered around 50 ±30% of the market correction. This is a good reward for long-term investors!

Most share valuation metrics indicate current world sharemarkets falls are a major over-reaction. These bouts of strong pessimism have happened before and will happen again. When markets improve, the average investor who is frantically selling now will swing into an over-optimistic state, beginning yet another cycle.

Many pundits speak convincingly when making predictions of near term economic performance. Sadly, their accuracy is no better than the seers of Delphi picking over the entrails of some unfortunate beast sacrificed in mankind’s eternal quest to get the jump on the opposition. The main message to draw from this historical analysis is that economic recessions and slowdowns are a natural part of the business cycle. They should be viewed as healthy cleansing periods.

Sharemarket investors who hold their nerve, investing in good quality businesses with sustainable earnings, will be rewarded when the current phase of irrationality passes. Investors should remain cognisant of the low probability of doomsday situations occurring.

The Australian Economy And Performance Of The Sharemarket – continued

“...Without the benefit of hindsight, the

sharemarket is not a reliable predictor of

coming economic woe.”

Fig. 7. Rolling correlation Australian sharemarket and economic performance.

30 SPE NEWS November/December 2008

Economic Analysis

The worst-case scenario is the economy and the sharemarket will remain in the doldrums for several

years, similar to the early 1970s and 1990s. While each of these times had similarities with present conditions, there also are important differences. The worst case could happen, but historical data says it is the low side case.

The most-likely P50 scenario for the future of markets is as follows. History suggests that if the Australian economy has a slowdown or shallow recession, it could end mid–late 2009. If so, the sharemarket, being a leading indicator, should start rising by the end of second quarter 2009. (This assumes no ‘X’ event materialises.)

Once the sharemarket decides to become positive after a large correction, it tends to recover at least half of the correction in the following 12 months. That is worth waiting for! Naturally, there is the lower probability case of a long period of sustained economic malaise. However, as this article has demonstrated, sharemarket behaviour is not necessarily influenced by economic performances. This is the challenging part of constructing a good investment strategy.

The trouble is no-one definitely know when sharemarkets will return to an upward momentum. Above all, investors should avoid making drastic changes to their approach now. This is not the time to sell a balanced portfolio and switch to cash, no matter how strong your emotions or any doomsday talk.

The markets will throw up more painful episodes such as the current one. The best way to avoid wealth destruction is have a realistic long-term plan in place that matches your risk capacity and the confidence to keep investing. ❖

Noll Moriarty is the Director of Archimedes Financial Planning (www.archimedesfinancial.com.au). Archimedes provides quality financial advice for resource industry personnel in Australia and throughout the world. Noll is an Authorised Representative of Professional Investment Services Pty Ltd, AFSL 234951; ABN 11 074 608 558.

The Australian Economy And Performance Of The Sharemarket – continued

The trouble is no-one definitely know when

sharemarkets will return to an upward

momentum.

Fig. 8. Probability Australian sharemarket forecasting poor economic performance.

Fig. 9. Sharemarket corrections - amount and length.

Fig. 10. Sharemarket gain 12 months after a correction finishes.