Can equities recover?

By Craig Alexander, Vice-President and Deputy Chief Economist, TD Bank Financial Group

A couple out with their mountain bikes pause for a break on a grassy hill.

A strong case can be made for equities to eventually begin posting solid and sustained gains.

For equity markets around the world, 2008 proved to be a brutal year. Share prices sank in response to the financial fallout of the credit crunch and expectations of a global recession. Given the deep bear market, it is not surprising that some investors have had their confidence shaken.

A question on the minds of many investors today is whether equities can recover from their recent plunge. Some have cited concerns about a repeat of the Japanese experience, where stocks never recovered from their losses in the wake of a housing bubble collapse in 1989. However, the parallels with Japan’s slump are limited, and other historical experiences show that stocks can rebound. The timing and extent of the rally are uncertain, but a strong case can be made that the pieces are falling into place for equities to eventually begin posting solid and sustained gains (see “A blueprint for recovery” below).

Bar graph, “A blueprint for recovery,” illustrating TSX pre- and post-recession performance from 1960 onwards, shows the tendency of Canadian stocks to rebound from their lows, sometimes dramatically.

Similarities to Japan’s bubble

In Japan, the popping of a real estate bubble in 1989 led the domestic banking system to accumulate billions of dollars in bad real estate loans. This drove Japan’s economy into a protracted period of economic weakness, which resulted in periodic bouts of deflation. It also caused a deep correction in Japanese equities, with the Nikkei index falling more than 56% in the three years immediately after the bubble burst — a decline from which equities never recovered and which became more pronounced in the years that followed.

The current financial crisis is the product of a global credit bubble that developed after 2001, which was characterized by real estate bubbles in several countries — including the United States. When the bubble burst, the international financial system was severely damaged.

Similar to the events in Japan, the result is likely to be a recession, but this time on a global scale. The world downturn foretells lower inflation, and it was in expectation of these trends that global equities declined dramatically.

The differences are key

While there are similarities, there are key differences between Japan in the 1990s and the world today that are critical in shaping the future. The main difference is the policy response. The Japanese government and the Bank of Japan were initially slow to respond to the deep-seated problems in the banking system. Financial institutions also failed to acknowledge and write off their bad loans in a timely fashion. The ineffective policy actions and their economic consequences were extremely damaging to Japanese equities, which were extraordinarily overvalued when the real estate bubble popped.

Japan’s experience shows what can go wrong, but other historical examples illustrate how the economy and financial markets can recover. The Nordic countries also experienced a real estate bubble in the late 1980s that led to a financial crisis and a 30%-plus correction in the Swedish stock market in the two years that followed. The Swedish policy response was to act quickly and nationalize the banking system to restore its balance sheets. This proved extremely positive for equities, which recovered all of their prior losses over the following three years.

Lessons learned

Today, policy makers have learned from the past. The responses of governments and central banks over the past 18 months have been dramatic and have aggressively targeted the source of the problem — the weak state of financial institutions’ balance sheets.

Monetary policy was also eased spectacularly. Huge new government lending facilities to help financial institutions weather the storm have been critical. If the actions to date prove insufficient, further capital injections and fiscal stimulus will be provided. However, the policy responses could take many months to be fully implemented and cannot prevent the global economy from weakening in the near term.

Equities should recover

If the policy actions have their desired impact, and we believe they ultimately should, the recession and weak inflation environment should pass in late 2009 or 2010. This would be extremely positive for equities.

Equity valuations look attractive after the sharp market sell-off. Interest rates are expected to remain at historically low levels, which is supportive of equities, relative to other asset classes. Also, a turn in the economic cycle would help boost corporate profits.

In Canada, an added boost could come from a renewed rally in commodity prices in late 2009 or 2010. The rise in corporate earnings should support a moderate rally in equities if price-to-earnings ratios do not change, or might fuel a major rally if price-to-earnings ratios rise significantly from current levels.