What are the three important factors to consider when determining whether a bear market has finished?
Bear markets are an unfortunate reality of investing and a necessary part of the market cycle. In this article, GSFM shares the views of its investment partner Munro Partners on current conditions in financial markets and what needs to happen to herald the end of the bear.
While bear markets don’t typically receive a warm welcome from investors, this part of the market cycle can be viewed as a time to cleanse the financial markets of excessive risk-taking and a time to normalise economic policy towards a more sustainable long run trajectory.
As time passes, the market will eventually start looking over the valley of uncertainty and toward what normalised earnings look like for stocks. The average bull market lasts 64 months, and you do not need to pick the bottom to enjoy the good times still when they return.
The current bear market shows all the hallmarks of its predecessors. Central banks globally have spent years trying to create inflation; they now have plenty of it and have been caught behind the curve trying to subdue it. Consequently, interest rates are rising aggressively and will cause, at best, an economic slowdown, at worst, a deep recession.
Elsewhere, rampant speculation has seen large parts of the financial system get aggressively overvalued. The resulting adjustment is, in turn, having its own effect on the economy but also leading to redemptions across most asset classes.
Lastly, like all previous bear markets, despite seeing the warning signs, many investors have been remarkably unprepared for the size and scale of the impending adjustment.
Investors need to respect the history of bear markets – and the past suggests the average bear market is generally worse than what we’ve experienced to date in this cycle. Despite this, there are still opportunities in this environment for experienced investors.
Is the end in sight?
To call time on the current bear market, Munro Partners believes there are three important factors to consider.
1. Interest rates
When interest rates rise, the price of everything generally falls. The multiple then comes out of the market and growth assets usually get hit first, which is what happened in January 2022. Falls in other asset prices, such as housing and private equity, followed.
It has been Munro Partners’ view that bond yields can only go up so much as there is simply too much debt in the world for long-term interest rates to get much higher than 3%. Initially, during July, there were signs that this was correct with US 10-year treasuries dropping from 3.5% to 2.5% on slowing economic data. This proved short lived.
Persistently high inflation data, increasingly hawkish rhetoric from Fed president Jerome Powell and three 75 basis point rate hikes have seen long term interest rates back up to touch 4% in September (figure one). This higher rates led to lower valuation multiples for all assets, with equities being no exception.
While interest rates might have indeed peaked now at 4%, the higher rates for longer will also likely lead to a more protracted economic slowdown.
Munro Partners believes the market is now adequately pricing where cash rates have to reach, which is roughly 3% in the US and Australia. This is apparent from the bond market where short-term rates are still rising but long bonds are not, and the yield curve is inverting. The bond market is telling us that 3% is enough to get the desired outcome of slowing the economy.
2. Earnings estimates
You cannot have interest rates rise at the speed at which they have and not have people and investors change their behaviour and spending decisions. Higher interest rates have caused havoc to valuation multiples throughout 2022, however we have only just started to see the economic damage that higher rates will do.
Earnings estimates have only come off marginally for 2022 and analysts still expect 8% earnings growth in 2023 for the S&P500. This seems highly unlikely. A US 30-year mortgage recently reached 7 percent, having started the year at 3 percent (figure two). Even if the Fed stopped hiking interest rates tomorrow, it will be very difficult to avert a recession in 2023.
Interest rates have simply moved too far too fast, if the Fed hikes further to kill inflation, then this will simply make the slowdown worse. At the same time, earnings are impacted by factors such as over-ordering and subsequent discounting of inventory, and general falls in asset prices. The next few months is likely to see a significant and necessary reset of earnings expectations for 2023.
Lower earnings estimates will eventually lay the foundation from which the market can sustainably recover.
3. Time
The last factor is a simple one: time. The average bear market lasts just under 300 days and falls 37 percent and, if history is any guide, this one may only be halfway done. Experience tells us to be patient in this environment and respect the history of previous down cycles. Munro’s team continues to be wary of further exogenous shocks that could be precipitated by the higher interest rate environment.
Obvious candidates include leveraged property players and leveraged countries. The UK’s recent mini budget has seen an unprecedented sell off in UK bonds and points to the government being unlikely to be able to fund their deficits. This is a warning shot to governments all over the world and suggests an era of fiscal austerity could be required exactly when most economies are going to require the opposite.
Elsewhere, Russia/Ukraine and China are a source of much uncertainty and could provide further negative or positive shocks to markets should these issues worsen or be resolved.
Area of interest: Innovative health
As a growth investor, Munro identifies sustainable growth trends that are under-appreciated, not well understood and mispriced by the market, and in its view, the resulting winning and losing stocks. The team believes that the investment success stories of the future will emerge from within the big technological and structural changes affecting global society and focuses on identifying and understanding these trends, which it calls its Areas of Interest (AoIs). Market conditions as currently being experienced can provide opportunity for astute investors.
Health is an industry facing unsustainable cost pressures and inconsistent outcomes; it is therefore fertile ground for innovation across diagnostics and patient care, in areas like genetic sequencing, virtual reality and 3D printed medical devices.
The three key drivers for investment in healthcare are:
- ageing population – baby boomers are now aged 58-76 and have an increasing demand for healthcare. Those aged 65 plus are 2.5 times more likely to have heart disease
- innovation – the large number of companies inventing new products/services to meet growing and changing needs
- cost of healthcare – 20% of US GDP is spent on healthcare – finding ways to reduce that expenditure can make for an interesting investment.
Innovative health focuses on using technology to provide better outcomes. It is divided into a number of areas including:
- life sciences – biologics and bioprocessing, cell culture media focused on producing drugs and vaccines with greater efficacy and lower side effects – this is taking share from traditional drugs that are processed through chemical synthesis
- healthcare service providers focused on taking cost out of the system
- medical technology and diagnostics
- geonomics – this is further out on the innovation curve and involves a lot of research and development, which means most companies in this sector are not yet profitable.
Case study: Danaher
US-based Danaher company designs, manufactures and markets products, services in the sectors of life sciences, diagnostics testing and environmental sciences. It has a market cap of US$195.30 billion[1] and is a core holding in Munro Partners’ Innovative Health Area of Interest.
Danaher is a decentralised organisation, focused on being the number one or two player in each market for its mission critical products. Among other things, Danaher provides the equipment to help these cell cultures, or filtration equipment to help grow these drugs.
The end market exposure is very attractive given the structural growth and resiliency in an economic downturn. The business has very predictable cash flows given a high proportion of products sold are consumables that act as recurring revenue.
Munro highly regards the company’s management team and investment philosophy, as well as its “Danaher Business Systems” (DBS) framework. Rather than grow margins by cost-cutting, the DBS process invests in innovation and aims to produce more innovative and therefore higher priced products to drive margin expansion.
Danaher saw its free cash flow grow from $3.3bn in 2019 to $7.1bn in 2021, as its Life Sciences and Diagnostics businesses benefitted from vaccine production and diagnostics tests for Covid-19. As the disease moves from a pandemic to an endemic stage, Danaher’s growth will naturally slow from the exponential growth rates of the past two years.
However, while this growth slows, the company has forecast growth to be much higher than it was pre-pandemic, with a higher proportion of revenue coming from consumables (higher recurring revenue) and at higher margins. The anticipated long-term annual performance outlook is for double-digit plus earnings per share growth.
In March 2022 there was a pullback in share price, which can be attributed to the growth rotation, re-opening trade and covid relaxation across the globe rather than fundamental long-term prospects, especially as it maintains a dominant position in diagnostics and testing. Accordingly, as biologics grow, so too will Danaher grow. Nick Griffin, Munro Partners CIO describes Danaher as “a shovel in the biologics boom.”
Glass half empty or half full
As investors wait for the earnings story to play out, Munro has invested around a third of the funds they had sitting on the sidelines earlier this year, focused on companies where the Munro team believes there are long-term drivers of earnings, and which will not suffer downgrades.
Market highs and lows will always have twists and turns. The market may have already bottomed, or it could still be on the way down. Longer term the sun will shine again, it always does. As time passes, the Fed will regain control of inflation, interest rates will peak, and the economy will bottom. Investors will eventually start looking over the valley of uncertainty and toward what normalised earnings look like for stocks and take a longer-term view. The average bull market lasts 64 months, and you do not need to pick the bottom to enjoy the good times still when they return.
The market doesn’t give a big ‘all clear’ sign when it reaches a bottom, but the three factors we have outlined earlier in this article provide helpful signposts for working out when the worst will be over.
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