Q109? Q2? When the Market Will Recover

by: Cam Hui, CFA

I wrote in early October that Mebane Faber had done a study indicating that equities could see positive returns in November and December because of the horrible month that stocks saw in September. Faber followed up with a further study entitled What happens after two bad months that point to median gains of 7% for the rest of the year if history were to be any guide. VIX and more came to a similar conclusion on market direction by comparing the current period in the US to Japan:

Japan's "lost decade" does bear some resemblance to the problems in the U.S. Looking at the historical record with a global perspective, it is tempting to conclude that the current situation ripe for another volatility bounce of at least two months.

Waiting for the retest of the lows
Without a doubt, last week’s market was a bottom fishers’ paradise. In addition to running my recent screen of beaten up financials, I ran other deep value screens and found all sorts of companies that were worth more dead than alive. There were 14 stocks trading below net cash (cash – total debt) that were profitable and therefore in at low risk of bankruptcy. There were also 42 stocks trading below net-net working capital (current assets – all liabilities) and were profitable. These are all indications of extreme cheapness that bottom-up value investors are fond of.

However, my sources tell me that many hedge funds have moved to cash and called it quits for the rest of the year (SAC Capital is just one well-known example). Any rally that we may see in the stock market for November and December cannot be regarded as enduring until it can be confirmed in January when hedge funds return to the market.

What bothered me was that a lot of individual investors have been too eager to jump on this rally. I wrote that sentiment was too bullish for this to be a durable bottom. However, sentiment models are not great at timing markets in the very short term. Come January, my guess is that the overly optimistic sentiment chickens will come home to roost and this market will retreat again to test the October lows.

Market undergoing a bottoming process
This market action points to the scenario of the stock market undergoing a bottoming process. Consider this NY Times chart of previous bear markets. While the depth of this bear is comparable to other Great Bears, this bear has been remarkably short so far compared to the others.

What's more, most bear market bottoms have been formed by two or three tests of the lows before the bulls take control. I went back and looked at previous bear market bottoms since the 1970s. The table below shows the time between the first and last tests of the market lows. In most cases, it takes 3-6 months before a low is established and proven to be durable.

Previous Bears: Time between first and last market low

2002 7-8 months
1991 3-4 months
1987 1 ½ months
1982 6 months
1974 3 months

Recession to bottom out in the Spring?
This market analysis is consistent with a study from Bespoke indicating that the recession would likely bottom out in the Spring:

The average length of US recessions is 14.4 months. Using the assumption that the recession began at the start of 2008 (using Industrial Production and Employment statistics), if the current period ends up just as an average contraction, we could expect the economy to bottom some time next spring.

The shape of the yield curve is also pointing to a growth revival in 2009. Now, some may say that all these financial problems are going to create an incredible drag on the economy and the US is not likely to emerge from recession any time soon. However, the historical evidence shows that while recessions induced by financial stress tend to be deeper, they don’t seem to any longer.

For investors trying to time the market bottom, Northern Trust put out a study that showed the S&P 500 generally bottomed out 2-5 months before the actual economic bottom. If we were to accept Bepsoke’s forecast of a recessionary bottom in the Spring, then this would also suggest a market bottom in early 2009.

Base case: The market bottoms in early 2009
In summary, the technical and economic analysis both point to the same conclusion. The market is likely to rally for a couple of months into year-end. Then expect a decline and re-test of the October lows in the January-April timeframe and that test would mark the bottom of this bear market. At that point, I would be getting ready and orienting my portfolio to take advantage of a Phoenix effect.

The greatest risk to this forecast is that the world’s financial system is extremely fragile and future events are highly dependent on policy response. Given that the US is facing an election and we will likely not see the economic team until early next year, anything can happen.