The markets peaked together - will they trough together?

William Hester, CFA
January 2009
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Last week the Bank of England cut its benchmark rate to its lowest level since the Bank's creation in 1694. It said that the availability of credit to both households and businesses had tightened further and the output in the UK was likely to fall sharply this year. Japan's economy is currently in recession using similar standards used to determine US recessions. The recent Tankan Survey there showed the worst change in outlook by manufactures in 34 years. The ECB is likely to cut its benchmark rate this week in an attempt to offset slowing Euro-area data.

All of this suggests that the global economy is likely now entering into its worst recession since the early 1980's, when the rate of growth slid from double digit growth to contraction. The duration of the recessions in individual countries could also end up mirroring that period, where, for example, the UK was in recession for two years and Germany's contraction lasted almost three years.

The graph below plots recent growth trends along with the expectations for GDP growth in the major economies over the next two years. Economists are expecting US economic growth to drop sharply in the just-ended 4 th quarter, rebounding through the first half of the year until it begins to expand in the 3 rd quarter of this year. The pattern for other developed economies is marked by shallower declines in output, but that are more drawn out. Economists expect the UK economy to contract all of this year, eventually recovering in 2010. The Euro area faces similar prospects, according to forecasts.

So if the recoveries of other major developed countries lag the US, will the eventual rebound in those countries stock markets also lag? Or would these countries be likely to recover along with the US if its economic prospects were to improve? So far, the major markets have rallied impressively off their respective lows. The EAFE index is up about 20 percent from its late November closing low. The Dow Jones Industrial Average is about 14 percent. Interestingly, the outperformance of the EAFE versus the DJIA is at about the same ratio that occurred during the previous cyclical bull market lasting from 2003 to 2007. So far, it looks like global investors are taking their cue from broadly rising markets and less so than on individual economic outlooks.

One way we can examine this question is to look at the performance of individual developed markets during periods where the US and each non-US developed country shared economic prospects, and compare those results to when they differed. To do this I received permission from ECRI , an economic forecasting service, to use a set of recession dates they've created for 20 countries. ECRI applied the same standards used to determine US recessions to these individual countries, noting where recessions occurred. Our sample will be nine countries for which ECRI has business cycle dates and that are are included in MSCI's developed market index with sufficient price history.

Since 1970, four important global recessions have occurred: from 1973 - 1975, 1980 - 1982, and somewhat lesser global retrenchments in the early 1990's, and in 2001 through early 2003 (a fifth occurred in 1998, but was experienced mostly by developing countries). The early 1970's recession might well turn out to be a blueprint for the current global retrenchment. The United States economy troughed in March of 1975 while most European countries troughed later that year in July and August. Japan's recession matched the US economy's slowdown nearly identically through that period. The early 1980's showed more divergence in the outcomes. The US economy experienced back to back recessions, the last one ending in November 1982. Germany's economy recovered at about the same time, but the economies in France and Italy didn't recover until well into 1984. The recessions in Europe in the early 1990's generally began later and also lasted later than the brief slowdown experienced by the US economy.

I've created three graphs below which attempt to provide clues as to whether global markets will continue to outpace the US market even if their economies are not expanding. The first graph shows the performance of each developed market during periods where both the US and that country's own economy were in expansion. This is the largest block of time, which includes the late 1970's, the late 1980's, and during most of the 1990's. The vertical axis measures the correlation of returns between the US and each country. The higher the country is on the axis, the higher the correlation. Not surprisingly, this is determined partly by geography. Canada and the UK have a higher correlation of returns when compared with Australia. The horizontal axis measures the average monthly return net of the US return over the same periods. Countries lying to the right of the zero line have outperformed the US market, on average, during these periods. Countries to the left of the zero line have underperformed.

The graph shows that developed international markets typically outperform the US market when the global economy is expanding. The data is surprisingly consistent through our list of countries. Australia, Sweden and Germany have outperformed more than the others, on average. The performance of the Canadian and UK markets has been closer to the average return of the US market, with higher correlation.

The next graph shows the same mix of correlation and net performance but only looks at the periods where both the US and each country have been in recession. These periods capture the bulk of the global recessionary periods I mentioned above.The graph demonstrates that the trends we've seen in this bear market - where most international benchmarks are performing worse than the US market - are not unique to this bear market. Since 1970, international markets have tended to underperform the US market during global recessions. (The UK market's high average return can almost be entirely explained by a couple of months following the 1973-1974 bear market where the MSCI UK index rocketed higher as investors anticipated the end of that period's recession.)

The chart also shows that the correlation of returns across various markets increases during recessionary periods. As I noted in November 2007 in International Markets Show Important Divergences , global diversification is least useful when it's needed most. And this data shows that not only does the correlation between US and international markets rise during recessions, but that global returns trail US returns during these periods. Lower returns with higher correlation. This data implies that the benefits of international investing and diversification come predominantly during periods of global expansion, and not during bear markets induced by recessions.

The third graph shows the performance of international markets during periods where each country is in recession but the US economy is in expansion . Whether or not this actually occurs, this is the outlook currently embedded in economist's forecasts this year. The expectations are that the Euro countries and the UK will be in recession at least 6 months longer than the US.

The graph shows that international markets typically trail the US market during periods where that market's economy is in recession and the US economy is expanding (across the nine countries these periods make up roughly 15 percent of the data). On average, the monthly returns for these periods are 40 basis points less than US returns. But notice that because of the differing economic performances, the average correlation of returns across various countries also drops noticeably.

These results aren't surprising. US markets have reliably rallied only between two and three months prior to the end of US recessions. It's very much the same in international markets. Their performance is more mixed until closer to the end of recession. On average, international markets trail US markets through these periods. There's little evidence to show that individual global stock markets ignore dimming prospects for their own economies simply because prospects for the US economy improve.

Valuation

An equalizer in the current environment may turn out to be the valuation of international markets. Global markets fell further during this bear market and they've been left with valuations that are better than the levels on US stocks. The graph below shows the ranges of valuation of a selection of markets in the MSCI developed market index. The blue lines denote the range in P/E multiples for each country since the early 1970's. I created them using monthly prices and the peak earnings series for each country. Because each series - including the data for the US market - begins in the early 1970's, it doesn't capture the longer trading histories that some of these markets have. But it does include the early 1973-1974 global bear market where many global markets traded at single-digit P/E multiples.

The graph shows that average valuations are generally better globally than they are in the US on a pure price-to-peak earnings basis. Even taking into account the recovery through the end of the year, many of MSCI's country indexes are trading at a single-digit multiples on peak earnings. But there's a caveat to the valuation argument. The boom in global growth that occurred up through the middle of last year was more beneficial to EAFE members than US companies. While the growth in US earnings was impressive, earnings growth in the bulk of EAFE countries was more so. Earnings growth was in some cases was one and half to two times faster for individual EAFE countries than US companies the last few years. This was partly fueled by an even great expansion in profit margins above longer-term averages than what was realized in the US. Therefore, the earnings of these companies could be at a greater risk of falling further and for a longer period of time. And if recent peak earnings don't represent the true current earnings power of the index, the price to earnings figures may be overstating the attractiveness of their valuations.

Taken together, the data suggests that investors should not rely on outperformance from global markets in event that the US recovers first. In 1974 global markets bottomed within a month or two of each other, even though a number of the recoveries in European economies lagged the US recovery. In general, the stock markets of economies that are in recession tend to lag the returns of the US market when the US economy is expanding.

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The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

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Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 reflect our standard valuation methodology, focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle (see for example Investment, Speculation, Valuation, and Tinker Bell, The Likely Range of Market Returns in the Coming Decade and Valuing the S&P 500 Using Forward Operating Earnings ).