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We are now officially in a bear market, but shrewd market operators can still make a profit. Dan Coatsworth looks at sector and stock trends to show how investors can take advantage of the volatility

It is exactly one year to the day since global equity markets felt the first tremors of the credit crunch. The now-defunct US investment bank Bear Stearns revealed crushing losses at two of its sub-prime mortgage-related hedge funds. UK and US stocks alike plunged. A year on, we are now officially in a bear market.

But this does not mean investors cannot beat the bear market at its own game, and turn stock market volatility to their advantage. Careful analysis of the past year can highlight clear sector and stock trends from which shrewd market operators can profit, either by simply avoiding names which look set to fall further, by taking the bold move of shorting the likely fallers or by piling into those areas capable to breaking free of the gloom and appreciating in value.

Consumers in price trap

There can be no denying the last 12 months have been a horrible experience for most investors, as billions of pounds have been wiped off company valuations. Price plunges in certain stocks and sectors have prompted allegations of price manipulation by hedge funds. This has yet to be effectively substantiated, despite feeble attempts from the Financial Services Authority (FSA) to increase transparency of short positions in the market, and in the end most of the selling has not been indiscriminate. It has simply picked out those firms which have produced the greatest earnings disappointments or have the greatest exposure to the deteriorating macro-economic environment.

Consumer-facing stocks have been hurting for months and there is worse to come. High street retailers, pubs and restaurant operators are facing a severe downturn in consumer spending as the UK’s population faces price deflation on the value of goods where there are fixed costs – such as houses and cars – and price inflation on essentials such as food and petrol. Travel companies such as Thomas Cook and TUI Travel could suffer from this savage pincer movement on the UK’s wallets, even though both have been bullish about trading to date, arguing consumers are finding ways to fund their traditional summer holiday. Unfortunately, it seems highly likely that bookings beyond that point will suffer. The high oil price is making travel expensive and the weakness of sterling against the Euro, and virtually every other currency except the US dollar, is further adding to the costs of trips abroad.

The latest Halifax price index survey revealed a 6.1% year-on-year drop in the average price of a UK house in June and the collapsing property market has dragged down house builders. They are cutting back staff numbers and trying to secure additional capital to support their business. Stocks such as Barratt Developments have bounced back each time job cuts have been announced in the belief all the bad news has been now discounted. Further price spikes are possible when the first round of land bank write-downs and dividend cuts is unveiled, but this could be a short-lived recovery. Until consumers regain confidence about their finances and house prices stop falling, there is little to suggest house builders will do anything but continue to see their share prices suffer. Stockbrokers KBC Peel Hunt, Numis and Landsbanki reckon Barratt Developments could be the exception, having last week issued a positive trading statement, secured new financing and written off less of its land bank than Bovis and Taylor Wimpey. Landsbanki’s Simon Brown believes this is enough to ‘draw some of the shorts out of the market and encourage further revival in the share price.’ The three brokers have ‘buy’ ratings on the stock.

Profit warnings from car retailers such as Pendragon show fewer people are buying new vehicles. May saw a 9.5% nationwide drop in new car sales for private use. Better engineering has enabled cars to run for longer and motorists strapped for cash would now rather make small repairs than invest in a new vehicle. This in turn could result in a major decline in steel consumption, leaving mining companies facing lower iron ore prices. The severity of the situation was seen earlier this month when shares in car maker General Motors hit a 53-year low over bankruptcy fears. GM’s sales have fallen as US consumers have cut back on spending and higher fuel costs have seen them keep existing models or switch to smaller, more efficient cars. Iron ore prices have been rising due to demand from Chinese steel demand for infrastructure projects. Such an increase in raw material costs, coupled with higher fuel and transport costs, has caused the share prices of leading steel makers, ArcelorMittal, US Steel and Nucor all to break down this month.

Mining could feel a knock-on effect

The Automobiles & Parts sector has fallen nearly 50% in the past year to reflect sales problems and it could stay on a downward trajectory. The mining sector, on the other hand, has risen around 20% in the same period as commodities prices continue to rise. Mining could soon be facing a correction as analysts consider the impact of lower construction and consumer activity. Higher operating costs have held back higher margins and merger and acquisition (M&A) activity, which had previously driven up share prices, has almost ground to a halt. According to John Meyer, head of resources at investment bank Fairfax, mining analysts are not yet expected to cut earnings forecasts but the sector is under close scrutiny. The mining team at Royal Bank of Scotland is less confident. They do not expect earnings momentum to be maintained by mining companies, given softening metal prices, and recent share price action looks to support this view. While the sector is still generating year-on-year gains, shares in Anglo American and BHP Billiton have dropped by 17% and 23% respectively since May.

It is still too early to sell off mining stocks indiscriminately, but the sector may well have had its day. The long-term picture of demand from China, India and the Middle East as they battle to meet their vast infrastructure requirements remains beguiling. Mining assets also remain a rare resource which are impossible to replicate and lengthy project lead times mean supply is unlikely to suddenly explode. Yet some caution is required, as both stories are well known, the sector has outperformed over a one-year view and the suspicion remains that too many investors remain huddled here, seeking safe haven. After all, even the emerging economies are showing some sign of cooling – Chinese imports grew 31% in June, but this was down from 40% in May and if the West slows down, the trend toward globalisation means it is hard to see how emerging markets will not suffer some form of slowdown at the very least.

The same comments apply to industrial companies who are tied into emerging market infrastructure. Their profits should continue to thrive but the market is very familiar with this theme and has priced it in accordingly. Industrials overall look a riskier proposition than they did a year ago, particularly those firms who make machinery and equipment. As aerial platform to electric vehicle maker Tanfield illustrated earlier this month with a major profit warning, end-user markets are freezing up. Companies are under pressure to sweat industrial assets for longer, so replacement programmes are being delayed. Tighter capital markets mean tougher decisions must be made over ordering new equipment and supply chains are slowing down.

Anecdotal evidence suggests that the luxury goods market has yet to be hit by a downturn in sales. The Royal Institution of Chartered Surveyors says the market for high-value arts and antiques remained relatively stable between April and July. Yet this is not really indicative of the broader market, as sales here tend to be driven by the super-rich Russians and Middle Eastern nationals. A slowdown in spending among the aspirant middle- and upper-middle classes is now easy to discern. The 68% drop in yacht electronic equipment group Raymarine since May and 15% decline in fashion retailer Burberry’s share price since mid June

suggests demand for the luxury goods market is starting to crack. Shares in German-listed car manufacturer Porsche have fallen by a third since May and Danish high-end consumer electronics manufacturer Bang & Olufsen has just issued its third profit warning of the year. Even Aim-quoted luxury kitchen maker Smallbone, historically a resilient stock, has fallen 18% in the past few weeks.

More cost cutting likely

Companies are coming under increasing pressure to cut costs to preserve profitability as top sales momentum starts to sag. Boardroom and investor scrutiny leaves no margin for error and 2008 could be remembered for the most management changes in a single year. Chief executives and finance directors have been quick to reassure investors over trading concerns, only to then disappoint by revealing the worst.

In many cases, investors have had every right to worry about the stability of companies. Bradford & Bingley for example, said it would not require a capital raising. Just weeks later it revealed a rights issue, which has subsequently had to be restructured twice, leaving management credibility in tatters. Last month, house builder Taylor Wimpey said it had found new financing only to admit two days later that the £500 million had not actually materialised.

If management fail shareholders, they are going to be shown the door, as illustrated by the recent departure of Southern Cross Healthcare finance director Jason Lock and the resignation of Taylor Wimpey group finance director Peter Johnson. Investors even gave Sir Stuart Rose a poke in the eye last week, when 22% of shareholders voted against his elevation to executive chairman at Marks and Spencer’s AGM.

Recruitment companies spent the first quarter of 2008 insisting they had not seen a drop in job placements. Come Easter and the likes of Michael Page started to paint a bleaker outlook on the UK market, particularly for banking jobs. Hydrogen issued a profit warning in June and it will not be the last company in its group to do so this year. Life is going to get much worse for staffing agencies and this will not be restricted to jobs in financial services.

Up to 350,000 UK jobs could be axed over the next 18 months as firms continue to suffer in the economic turmoil, according to a study by Hay Group and the Centre for Economic & Business Research. They believe UK companies of all sizes may reduce staff numbers as they battle the prospect of lower profits for at least the next two years.

There is already plentiful evidence of retrenchment beyond the stricken financial services sector, where insurance group Zurich recently warned its UK workers 900 jobs are at risk. Nearly 5,000 jobs have been cut this year by the house builders Barratt, Bovis, Persimmon, Redrow and Taylor Wimpey. Tanfield is planning 30 jobs cuts after a slowdown in orders and more could be at risk if business doesn’t pick up. Indeed, even the recruitment agencies are cutting back, with Hays having cut 5% of its UK and Ireland workforce in the past quarter.

Overseas activities could provide guidance on what is next for the UK. German industrial conglomerate Siemens is planning to reduce staff numbers by 17,000 worldwide. American Airlines is cutting 7,000 jobs. If rumours about it merging with British Airways are true, then both parties could seek staff reductions in the chase for cost efficiencies.

Cash piling up

Further cost cutting exercises across a broadening range of industries is likely as the summer progresses. This expected increase in unemployment, in addition to the weak economy, has already prompted nervous consumers to take money out of the stock market, so they have ready cash in case of an emergency. If this cash is not being deployed to buffer finances, or help pay higher household bills, then it is being kept for a rainy day.

The Building Societies Association said the £853 million deposited into building society savings accounts in May was the highest figure for that month since 2002. The British Banking Association said high street banks reported record savings in April of £6.2 billion, although this fell to a net increase of £1.2 billion in May. The positive side of this trend is that investors could be armed with significant funds with which to buy shares again, once market confidence recovers.

The trick is to get in first, anticipating when a stabilisation in the market will lure in this cash. But spotting exactly when to pile in is not straightforward. The forthcoming financial reporting season, which kicks off in August, will suggest there is no need to hurry as the profit figures will not paint a pretty picture. Anyone with consumer-facing operations is going to have a cautious outlook, even if they have already warned of trading pressures. Manufacturing and service sector firms said last week in research by the British Chamber of Commerce that domestic sales and orders had slowed over the past three months.

PE ratios have dramatically fallen for most sectors over the past year, as share prices have collapsed. This has prompted some equity strategists to argue equities now look cheap, but this assumes the earnings forecasts upon which those valuations are based prove accurate. The last six months suggest this will not be the case, as analysts have consistently taken the knife to their earnings forecasts. A PE for 2009 of around 6 for the banking sector at first glance looks a bargain. Yet the banks have had to raise large amounts of cash from investors to keep their businesses on track, including Royal Bank of Scotland’s £12 billion rights issue breaking the former UK record of £5.9 billion held by BT. There is still no guarantee further cash will not be required, particularly as international banks which have also taken debt market hits, such as Switzerland’s UBS, have already had to come back to the market a second time. ‘With so much uncertainty there is no catalyst for a re-rating yet,’ says Charles Stanley analyst Tony Shepard.

The biggest buying signal for the market will be when the banking sector starts to outperform the FTSE All-Share again. Ian Harnett of Absolute Strategy Research told Shares just before Christmas last year: ‘Banks outperform [in a slowdown] when everything else has been trashed as they benefit from the steepening yield curve’.

This may sound a bit dangerous, but the banks led the market down in the first place, because of the credit crunch, so there is every reason to think they will be the first to bounce back. A stronger performance from banks should help to instill widespread confidence in both the broader economy and the equity market. A recovery in the US would also be a positive catalyst for UK equities. Unfortunately, we are not at that point yet, judging by reports that the Federal Reserve will extend a facility that gives investment banks access to emergency cash well into 2009.

Spotting outperformers

The equity market has already written off 2008 as a bad job and is now becoming ever more gloomy about 2009. As hopes for a ‘V’ or even a ‘W’ shaped economic recovery start to fade, the FTSE All-Share could retreat even further over the coming months. Negative pressures are building up, causing a ripple effect across the market. The credit crunch has destroyed several banks and left many more gasping for air as they call upon new capital to keep their business afloat. The property market has collapsed partly as consumers cannot secure mortgages to move home. To make matters worse, the slowing economy is at loggerheads with rising inflation, which has left the High Street on its knees. The costs of daily living has risen sharply, taking the leisure and retail sectors as immediate victims as people think twice about opening their wallets.

Just 15 of the 39 industrial sectors which comprise the FTSE All-Share have outperformed the market over the past year. Only five – chemicals, electricity, mining, oil equipment & services and oil producers – have managed to produce positive returns. These sectors are characterised by pricing power, near guaranteed demand regardless of the economic environment, or both.

In the US, Charles Schwab believes the two sectors offering the best prospects for the rest of this year are technology and healthcare – the latter being driven by the mandatory requirement to have health insurance. The UK market should still be led by natural resources and energy companies, but only at the cost of further pain in consumer-facing stocks. To pierce the gathering gloom, Shares has analysed what has happened over the past year and drawn key lessons for six key sectors, where good buying or shorting opportunities should help investors beat the bear market trap.

All Data is from 14/07/07 to 01/07/08. Source: Datastream