Stock market historian Russell Napier focuses on great times to buy; When the answer is 400 in great scheme of buying opportunities

October 6, 2013 6:39 pm

When the answer is 400 in great scheme of buying opportunities

By John Authers

Could the S&P 500 drop to 400? At present, with the world’s most-tracked index at 1,690, barely below its all-time high, such a question seems outlandish. A fall to 400 would require a crash of more than 75 per cent. Even after the Lehman Brothers disaster, it never fell below 666. And yet the stock market historian Russell Napier has been making that forecast ever since the market hit its lows four years ago. He has cult status among investors for his book Anatomy of the Bear , which looked at the lows of the four great bear markets in the 20th century, all of which were excellent times to buy.In that book, he tried to nail down the conditions that would show that a buying opportunity had arisen – and he never saw conclusive evidence of a bear market bottom back in 2009. Judging by his two favoured valuation metrics – the cyclically adjusted price/earnings ratio (Cape) which compares stock with 10-year average earnings, and Tobin’s q, which compares prices with the replacement cost of assets – the US stock market only ever briefly reached fair value then. It did not become compellingly cheap, as usually happens at the end of a bear market.

Also, there was despair at that point: but at a bear market bottom the prevalent emotion is usually apathy. People are no longer interested. In 2009, traders still very much “wanted to play”.

Instead, the gush of support from the Federal Reserve thwarted what appeared to be an imminent risk of deflation, and sent stocks charging higher, before the cathartic or revulsion phase that is normally needed to end a bear market had worked its way out.

Once it was clear that the risk of deflation had been averted – because real bond yields were increasing, commodity prices were rising and credit spreads were narrowing – Mr Napier correctly predicted a long rally, long before many others. The Fed was “bribing” people to buy stocks.

But looking at history, he was confident that final catharsis had only been postponed, not cancelled. As the rally has continued, that call has looked ever more contentious. But Mr Napier’s bottom line remains that catharsis still awaits.

Thankfully, Mr Napier has given four video interviews to the FT since the March 2009 nadir, so we can track how his views have changed since then. All of his interviews are available in one post on the FT LongShort blog.

Back in 2009, he predicted that the final “catastrophic bear market” would break out once fears of inflation forced treasury bond yields above 6 per cent, an event he predicted would probably happen in 2011.

That year saw a brief bear market in stocks after a downgrade of the US sovereign credit rating by Standard & Poor’s. But bond yields fell during that incident, and remain below 3 per cent. The bull market in stocks resumed.

By 2011, however, he had changed his mind and made what he calls a “Great Re-set”. It grew ever clearer that even exceptionally easy monetary policy was not creating credit growth, or even money growth, in the US, while China and other emerging markets were not passing on the inflation in their real wages. Rather than push up prices in the developed world, it ate into their companies’ profit margins.

Historically, periods of deflation have overlapped with terrible stock market performance – think of the US in the 1930s, of Japan in the 1990s.

So Mr Napier argued that as emerging markets were forced to put on the brakes to stem incipient inflation, they would export deflation back to the west. That deflationary shock will eventually push the S&P down to a bear market bottom. Such a shock can be seen in the continued attempts to create inflation by the Fed, in falling commodity prices, in sagging emerging markets, and in falling gold prices over the past two years.

Where does the 400 number come from? Mr Napier believes that stock valuations move in long cycles, reverting to a mean. Both Cape and q, his favoured yardsticks, imply that the S&P must drop to between 400 and 500 before stocks are as cheap as at previous bear market bottoms.

As has been well aired in these pages, Cape and q are under attack. Critics complain that Cape makes stocks look too expensive, thanks to changes over time in the accounting conventions, and that q fails to take into account intangible assets. Both are driven by prices, and analysts looking at long-term price trends thought a bottom had been reached in 2009.

These are the greatest criticisms to be made of the Napier approach, and the debate will continue. His basic case that there is a risk of deflationary shock remains strong.

But he does offer consolation. Once 400 is reached, such a buying opportunity cannot last long. People can buy stocks, and “go to the beach for two decades”. Best to think of that, and not the journey to get there.