Q109? Q2? When the Market Will Recover

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.

Comments

[Larry House:]

Thanks for a thoughtful piece. BP Capital is all in cash at the present, and T. Boone Pickens says he doesn't know when he will go back into the market. He said it might be next week after they clear money refunds today, or he said he might be out of the market for weeks or months. He said his fund will be left with about $500 million after a loss of about $2B. Even he couldn't read the signs on when to sell. I believe stocks will move higher when investors get some idea as to when growth will return to the economy. That is certainly not yet in sight, and cheap stocks can always get cheaper. Thanks again for a good read.

2008 Oct 31 12:10 PM

[Consider_this:]

This crisis is not started as an Equity crisis, so it won't end with Equities.

It will be over when housing no longer drops. Which will eventually make Credit lending feasible again, and *THEN* you can talk about Equities having some footing.

There's a quick way for housing to stop dropping, and a very slow way:

1. Let house prices correct to a level that makes sense, quickly. Encourage policies that speed up this price discovery. Accelerate homes to where Price/Income ratios and Price to Rent ratios make sense, and you'll start to see nibbling of the home stock.

2. Drag this out, so that home prices nominally stay the same or drops slowly, like 10% a year, over many years. Pray that you have some kind of wage inflation for affordibility to catch up. EVENTUALLY homes will start to be purchased again.

Our Glorious leaders and everyone with a vested interest wants #2, to drag it out.

With that in motion, don't count on a quick bounce in Equities.

2008 Oct 31 12:11 PM

[Consider_this:]

By the way #2 won't work if you don't get wage inflation and get economic deflation instead.

Also, it didn't work for Japan, 18+ years and counting.

But it's the one every politician wants each time they're screaming to save the homes, or invent some kind of foreclosure prevention program.

The damage is *DONE* 5 years ago, the money spent all the way back then, we're in the "recognize your losses" phase and we don't want to recognize our losses. Until we do and move on to rebuilding, we'll all just collectively waste our time/productivity/atte... on crying and hoping.

2008 Oct 31 12:17 PM

[Wefwef:]

Recovery? 2010-2012. Meanwhile, enjoy the bear market rallies. Anyone buying to hold gets to be the bagholder.

2008 Oct 31 01:51 PM

[Pipo:]

When it comes should we buy stocks or commodities.

Jim Rogers says that commodities will do far better.


jimrogers-investments..../

2008 Oct 31 03:20 PM

[investor88:]

Cam has put up very good points about a recovery in 1q2009 but some readers feel it could be 2010-12 with bear rallies in between. All in all a good coverage of the possibilities.

2008 Oct 31 09:36 PM

[haydete:]

Cam, your analysis points to a recovery early in 2009, and you also state hedge funds are in cash for the rest of 2008. This would mean hedge funds might start buying before the next bottom? Can you explain your expected timing of hedge funds vs. the bottom?

2008 Nov 01 08:27 AM

[peterthepai...:]

this ain't over yet...too many bad things still to come out...see mish on japan or go here -
peterspension.blogspot...

2008 Nov 01 01:17 PM

[Steven Hansen:]

using historical data to project economic recovery means you need to correlate all elements which caused the recession in the first place to validate that you were comparing apples to apples. and i dispute the economy went into a recession at the beginning of 2008 anyway. there was a strong economic period between March and August. A more credible recession start is September which using an uncorrelated historical timeline means the recession would end at the end of 2009.

the fed currently has fired a multitude of bazookas. and i do not understand what weapons are left to stimulate the economy out of a recession. recovery from this recession must be consumer lead. where is the consumer going to get his money? he is at his credit card limit, can take no more equity from his house, and has seen his 401k mutilated.

sorry, we are a credit based economy where the consumer is short of credit. predictions about when the economy will recover need a little more real data to be credible.

2008 Nov 01 07:40 PM