In 2002 a colleague suggested I compare the bear market then under way with previous big falls in share prices. The three largest peak-to-trough declines in UK shares over the prior 100 years were 1929-32, 1936-40 and 1972-74. I rebased the respective bull market peaks to the FTSE 100 peak in 2000 and calculated an average of subsequent performance. Smoothing this average generated our “three bears forecast”.
As the first chart shows, the three bears forecast proved remarkably accurate in pinpointing the level and timing of the low in share prices in the early 2000s as well as the tracking the recovery over the subsequent four years.
The second chart decomposes the forecast into its three historical components. The latter began to diverge significantly in late 2007, suggesting the forecast – based on the average – would break down, as it has indeed done.
There may, however, be some life left in this data-mining exercise. As the second chart shows, stocks seem to be following the pattern of the interwar years. The early 2000s bear market tracked the 1929-32 decline while recent falls so far mirror the 1936-40 bear.
The third chart extends the interwar comparison over the next five years. Share prices are now below the historical template, suggesting a near-term rally. An extended plateau is then indicated followed by a final lurch down to a bottom around the levels reached in 2003. A sustainable recovery occurs only in 2011.
The 1936-40 bear market initially reflected a US recession but was extended in duration and magnitude by the onset of the Second World War – the final move down in 1940 coincided with the Battle of Britain. The current financial crisis is momentous but it is hard to believe it represents a threat to the British economy on a par with Nazi invasion.
It would be unwise to place strong weight on mechanical historical comparisons but the suggestion of an imminent base followed by an extended sideways movement is plausible. Valuations are now low – the price to book ratio of UK non-financial stocks is at levels last reached in 1992 – but buyers are likely to be slow to return after the confidence-shattering events of recent months.
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