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A Calendar Affair: Five Signs Before a Market Downturn

It has been a sizzling week for markets in Asia, with Australia, Hong Kong, Singapore and South Korea all closing at lifetime highs today. But what goes up must come down. In this week’s A Fund Affair, our guest writer, Mah Ching Cheng, Research Manager at Fundsupermart.com, takes a look at the signals that markets give off just before a downturn. Mah shares her opinion with us.

Barring a sharp but brief correction in late February this year, markets have been hitting all-time highs. When markets hit record levels, investors become concerned that a sharp downturn may follow. It is hard to predict when markets will reach their peak or undergo a correction. But according to our studies, there are certain indicators, which can give hints on whether a particular market is due for correction.

We have closely examined various bull and bear runs over a 36-year period (up to mid-2006). We studied 29 scenarios that fulfilled our criteria for a bull run, and 32 scenarios that qualified for a bear run.

Our criteria for a bull run:

  • A market must double after more than one calendar year;
  • A market must post an annualised return of more than 15% per year during the period of the bull-run; and
  • There must be no negative returns during the period under study.

Based on these criteria, the Asia ex-Japan region was in a bull run before the correction began in late February of this year. Table 1 shows the performances of various Asian markets since the upturn began in 2003. Other than Malaysia, Taiwan and Thailand, markets had more than a 60% return from 2004 to 2006.

Our criteria for a bear run:

  • A fall of 30% in the market’s index over a 2 to 3 year period.

Table 2 shows examples of markets that were classified as bearish over a certain period. Two of the more recent examples come from the Asian Financial Crisis (from 1997 to 1998) and the technology bubble (from 2000 to 2002).

We also studied the East Asian, Singapore, Japan and Technology markets during these bear runs and found some interesting similarities.

Five Signs Before A Market Downturn

During our in-depth study of various economic crises, we looked to see whether there was some obvious signs investors could observe before the start of an imminent market downturn.

In these times of crises, we observed five signs before the market entered a sustained downturn. These were the following symptoms:

  1. Market valuations are driven to very high levels, not by sound economic or corporate fundamentals, but more by investor sentiment
  2. Earnings growth does not support the current valuations; they are either low or negative
  3. Overheating within certain large and important sectors in the economy, e.g. the banking, technology or property sector
  4. Signs of market euphoria with investors generally 'punting' on equities, ignoring economic fundamentals in the process
  5. Adverse economic situations, e.g. the two oil crises in the 1970s and early 1980s, the Asian Financial Crisis, political unrest or instability, and wars

It would be far too long a process to go through every single bear market mentioned in the Table 2. However, when applied to the most memorable bear markets in recent times – the Asian Financial Crisis and technology bubble, these signs are startling clear and hold true.

Fundamentals In Asia Ex-Japan

How are market fundamentals in the Asia ex-Japan region now? Table 3 shows some of the data that we looked at to see if the outlook remains healthy in Asia ex-Japan. They include earnings growth and valuations. We can see that the estimated valuations of these markets still remain at either low or reasonable levels (with the exception of India), and earnings growth is still healthy.

A bubble is typically formed when investors, turn overly optimistic and invest without examining fundamentals such as earnings growth and valuations. Investors should observe if economies are in debt and if so, whether the country has sufficient foreign reserves to manage their debt situation.

At this point of time as seen in Table 4, Asian economies have a current account surplus and ample reserves. We do not believe Asia ex-Japan equity markets are experiencing a market bubble. Many of the potential factors that have led to market crashes are not present in Asian markets now. We believe that the upward trend in Asia’s equity markets is likely to continue.

However, given that many Asian equity markets have enjoyed a strong rally, it is likely that there may be blips along the way, when investors take profits during corrections. This is indicative that investors should brace themselves for a slightly bumpier ride ahead.

Send us your questions and comments to us at fundaffair@cnbc.com. Mah Ching Cheng will answer as many of your e-mails as possible on ‘CNBC’s Cash Flow’ airing on Monday, July 16, 10 am to 12 noon Hong Kong/Singapore time.

For more information on this study, visit www.fundsupermart.com.