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Counter-cyclicalists can do well

By Peter V O'Brien

Friday 11th July 2003

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Major sharemarkets recovered well from a slump earlier this year, leading to different views among professional investors about the immediate and longer-term future.

The bulls reckon it is the beginning of a sustainable recovery, subject to normal blips. Bears say it is no more than a rally that occurs regularly as markets maintain medium to long-term downward trends, known crudely as a "dead cat bounce," a term also applied to a modest recovery in a share price that is heading for the cellar.

The start of the US reporting round next week could provide evidence about the validity of either view, although that is subject to the usual caveats regarding markets' traditional volatility.

The table shows the volatility apparent this year. It starts at end-February/ March 1 because the latter date was the official introduction of the NZX50 index, despite calculations constructing it to earlier in the year.

Much has been made of the improvement in indices over the past four months, an observation that ignores the fact that March and April were dismal. For example, Japan's Nikkei index hit a 20-year low and the others in the table reached their lows for the year.

A counter-cyclical trader would have bought them and be showing handsome gains, even on paper, now. Counter-cyclical investing, whether as a trader or for longer periods, requires nerve and some arrogance.

It presumes the bulk of professional and individual investors are sheep and usually heading for the wrong pasture. You have to buy when everyone else sells and sell when they buy.

The technique must have merit, because there had to be a buyer for every seller in March-April and a seller for every buyer today.

A report from the US earlier in the year quoted a fund manager as saying when everyone expects the same thing do not believe it.

That is a succinct, albeit perhaps cynical, summary of the counter-cyclical viewpoint. Investment folklore and fact has many cases of fortunes made from a counter-cyclical approach.

An example was the famed action of US investor, or trader, Bernard Baruch, who sold virtually everything in the late 1920s when Wall Street was in a buying frenzy, having bought earlier in the decade when the market was in decline.

Mr Baruch was out of the market in 1929, when the Dow-Jones index hit a then peak of 386.10 on September 3 before suffering a major two-year crash. The Dow was 40.56 on July 8, 1931, a decline of 89.5% since late 1929.

There have been many other examples of counter-cyclical investing in the ensuing years, including the boom-bust of the 1980s and the recent mania and subsequent disillusionment with high-tech stocks.

Counter-cyclical investing is based on more than intuition, although that intangible may have a role.

Proponents of the activity analyse markets and individual stocks on the basis of fundamental values and back it up with examination of technical factors.

Shares are eventually "worth" only what they can produce in actual and potential earnings growth, which is related to underlying economic data and prospects for specific industries and companies. Prices can get well beyond, or well below, sustainable potential earnings (from whence prospective price/ earnings multiples) and/or yields and gains available from alternative investments.

Counter-cyclical investing can be roughly divided into three types:

* immediate, very short-term, buying or selling as markets react to apparent good or bad news, which may include the "dead cat bounce" syndrome;

* medium-term action, particularly when companies have actual profit falls or forecast lower future earnings and market reaction produces a price fall; and

* long-term investments after structural reorganisations, which may include executives "retiring," resigning" or whatever euphemism is used for being sacked.

The last can come unstuck, because a company may take years to recover or go under.

Anyone who analysed what happened recently in New Zealand and elsewhere after companies downgraded profit forecasts can see the merit of the counter-cyclical approach, after taking companies such as Tranz Rail, AMP and Tower out of the frame.

Those three companies would fail the tests mentioned earlier for counter-cyclical action.

Sharemarkets are currently subject to contradictory bullish and bearish influences. A short-term outlook, at least, should come next week when US companies start their reporting round. Counter-cyclicalists will keep watch on results and forecasts.

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