Excerpt from the Hussman Funds' Weekly Market Comment (11/17/08):
If we seriously need to talk about the Great Depression (I personally believe that it is an outrageously dire comparison), we should recognize that even during that prolonged decline, it rarely made sense to sell into a major break of a previous low, because investors invariably had a chance to sell on a later recovery to the prior level of support. Below is a chart of the Dow Jones Industrial Average during the Depression. Even if one hung on after the enormous rally of nearly 50% that followed the initial 1929 low, the market's initial break of that low (the first horizontal bar) was followed several months later by a rebound to that prior level of support. The break of the second intermediate low of early 1931 (the second horizontal bar) was followed by a rebound later in the year to that same level. Third break, same story.
It is a typical market dynamic to have massive rallies toward prior levels of support, even within ongoing market declines. Once valuations are favorable, that tendency is even stronger, even in a weakening economy. Only the final panic decline of a bear market offers investors virtually no chance to get out on rebounds, but it is precisely that final decline that is recovered almost immediately in the subsequent bull market.
Even if the U.S. economy experiences a much deeper recession, I believe that the 1000-1100 level on the S&P represents a reasonable estimate of “fair value” for the S&P 500. That estimate is somewhat conservative since I am adjusting for the fact that earnings in recent years have been based on very wide profit margins, but could be too conservative given that long-term interest rates are very low. Long-duration instruments like stocks should not be priced off of short-duration instruments like 10-year Treasury bonds, or even 30-year Treasuries, so low interest rates shouldn't make investors recklessly optimistic about their valuation estimates. In any event, I do believe that current levels represent value from the standpoint of long-term investment prospects.
As for extreme and less likely benchmarks, the 780 level on the S&P 500 would represent a 50% loss from the market's peak, and would put the market in the lowest 20% of all historical valuations. I would expect heavy demand from value-conscious investors about that level if the market was to decline further, and a decline below that level could be expected to reverse back toward 780 fairly quickly. Further down, but very unlikely at this point from my perspective, the 700 level on the S&P 500 would represent the lowest 10% of historical valuations, 625 would put the market in the lowest 5% of valuations, and anywhere at 600 or below would put the market in the lowest 1% of historical valuations. I don't expect to see such a level, but there it is. Note that these estimates are unaffected by how low earnings might go next quarter or next year. Stocks are not a claim on next quarter's or next year's earnings – they are a claim on an indefinite stream of future cash flows.
Recent market conditions seem like they have no precedent only because so many investment professionals know only the data they've lived through. If one actually examines market data from the Great Depression, 1907, and other less extreme panics, one realizes how much the recent decline has already discounted potential economic negatives. At this point, further declines in stock prices simply increase the long-term returns that investors can expect over time. We can't rule out the possibility that investors could get more frightened, or that they might abandon their stocks at prices that would offer extremely high long-term returns to the buyers. It is important to establish exposure slowly, but long-term investors who ignore attractive valuations are not investors at all.