Asia’s bear market will continue until February 2009. Markets (as opposed to earnings growth) will bottom first, while sectors (as opposed to country allocation) are the key to creating alpha in a bear market. These are the key conclusions of our analysis of Asian bear markets since 1990. The initial market slump in Asia bottomed on 17 March, the day the Fed orchestrated a bail out for Bear Sterns. The peak to trough drop for our benchmark MSCI Asia Ex Japan was 30%, similar to the initial market slump in 1990 and 1994. We are now in the Bear struggle phase, marked by substantial swings into positive and negative territory. Investors are rightly concerned about the surge in commodity prices and the effect these increases are having on inflation and corporate margins in the region. Our analysis highlights that commodity prices and inflation rates are linked with market performance trends and earnings growth forecasts. Specifically, in previous bear markets the peak in inflation tends to coincide with the bottom in the bear market.

When will it end? The key question for most investors is, “When will the current bear market end?” In the US the S&P500 has experienced 20 bear markets since 1914. The average length of these bear markets was 16 months, with an average peak to trough drop of 37%. Asian equity markets have a high correlation with the S&P500, with index heavyweights such as Korea, Taiwan and Hong Kong having an average correlation of 59%. In combination with the short history of bear markets in Asia and the origin of the current market instability being American as opposed to home grown, we believe it is reasonable to use the S&P500 as a proxy to estimate the timing of an end to the current bear market in Asia. Our own forecast, based on past market cycles, is February 2009. However, this forecast could be 10 months late if this bear market is more similar to the 1990 US recession bear, implying the bear market is already over. Or the forecast could be 21 months early if this bear market has more in common with the dot-com bust in 2000. Clearly we need other leading indicators to support our forecast of the bear ending in February 2009. One such leading indicator for markets is inflation. Just as we identify the change in CRB index leading the bottom in earnings growth forecasts, we have also identified the peak in inflation as occurring prior to the bottom in the bear market. Exhibit 1-4 highlights in four out of four bear markets since 1990 inflation peaked near the bottom in equity markets. The relationship between inflation and markets during the emerging market bust cycle of 1994 is particularly strong and has some implications for the current cycle. Asian inflation peaked at 17% in 4Q94, which was also the peak in Chinese inflation at 28% in October 1994. While inflation rates are not at the same levels in the current cycle, China is once again leading the regional march higher, although Vietnam is winning the top prize with inflation of 25% in May. Our economics team is forecasting Chinese inflation to peak in 4Q08 at over 10%. Focusing on our pan-Asia inflation forecast, which is where the link with markets exists, we are forecasting inflation to peak this year at 9.1% compared to 4.4% in 2007. A peak in the 4Q08 for regional inflation is our best estimate; however, this timeline could be pushed back if upward pressure on food prices does not ease as we expect. Food price increases in China and across the region will start to come up against a high base for comparison this year, implying that barring a further supply shock the rate of change in prices should start to ease. However, a reduction in energy subsidies is offsetting the impact of decelerating food prices, putting upward pressure on headline inflation.  Focusing on soft commodities, following the recent price spike, the outlook for grain production is improving. Australia’s wheat harvest is forecast to almost double to 23m tonnes in 2008-09, relative to last year’s drought-induced collapse in the harvest. Rice production is also expected to pick up as farmers react to the surge in prices. A peak in inflation during the 4Q08 period coincides with a reasonable margin for error in our forecast for a bottom in the bear market in February 2009. We note that forecasts for the peak in the inflation cycle have been consistently underestimated, as there is a high probability that the peak in inflation may be pushed back to 1Q09, creating a neat fit with our forecast of the timing of the bottom in the bear market.

Earnings outlook Three factors we are monitoring to gauge our position in the market cycle are: earnings growth, valuations and margins. Specifically, only when consensus earnings-growth forecasts become more realistic will valuations move back in line, and in some cases below long-term averages earnings. Additionally, only when inflationary pressure ease will corporate margins stabilise. As highlighted below earnings forecasts lag the recovery in the market. As such while they are important we are focusing on the peak in inflation for a signal that we are close to the trough in the bear market. The primary leading indicator for earnings we have been focusing on is the Earnings Revision Index (ERI). Since September 2007, we have been recommending investors focus on this ratio for a signal of the future direction of regional and country level earnings forecasts as well as markets. As is highlighted in Exhibit 6 the ERI acted as a leading indicator for our benchmark as well as other markets – Exhibit 7 illustrates the trend in Singapore. With the ERI now in negative territory, earnings growth forecasts for 2008 have started to weaken: decelerating from a peak of 12.7% forecast growth in November 2007 to 7.3% currently. However this positive trend is partially offset by analysts shifting profits missed this year into next year. Consensus EPS growth for 2009 has accelerated from 11.6% at the start of this year to 15.2% currently. While we could quibble with this action by analysts, which is akin to moving the deck chairs on the Titanic, we remain focused on the trend for 2008 earnings; however, we are de-emphasising the importance of the ERI for reasons set out below. Since the start of the 2Q08, the debate has clearly moved on from when earnings growth will decelerate to focus on when they will start to recover. Our analysis of past trends for earnings during bear markets indicates that one of the best leading indicators for identifying the bottom in the earnings cycle is the CRB index. As is highlighted in Exhibit 8-11 highlights in three out of the past four bear markets the change in the CRB index peaked two-to-five months prior to the trough in 12-month forward consensus earnings growth forecasts. In anlaysing consistent leading indicators of earnings growth forecasts we were able to identify factors that were correlated with earnings in individual cycles; however, none were consistently (in all four cycles) linked with the bottom in earnings growth forecasts aside from the CRB index (three out of four cycles). We are placing considerable emphasis on the peak in inflation in the current cycle, as historically it has been closely correlated with the bottom of the bear market. However, this is not the only factor we are focusing on. We are also closely monitoring the cost of equity (CoE) and its impact on analyst target prices and earnings forecasts. Our assumption of further market declines over the summer implies higher market volatility. As this is a key component of our CoE model it implies that analysts will be forced to cut earnings forecasts further, exacerbating the downward pressure on markets. Our asset allocation recommendations centre on Overweight MSCI Hong Kong, Taiwan, Singapore, materials and energy. We are Underweight China, India, Industrials and Consumer Discretionary.   Click the link in the left download box to see charts and read more.