Context is Everything: 7 Ways to Assess the Bigger Picture

Given the historic events in the financial markets and the economy that have taken place over the past two months, it is helpful to take a step back and review the bigger picture:

1. From September 19 through October 10, we had a market crash. The S&P 500 (SPY) fell from 1255 on September 19 to an intra-day low of 839 on October 10, representing a 33% decline in 15 trading days. Measured from its October 9, 2007 closing high of 1565 to its October 27, 2008 closing low of 849, the S&P 500 declined 45.8%. The ultimate lows may or may not be in place, but this already ranks as the third worst bear market in the post-WWII era. The two worse bear markets - 1973/1974 and 2000-2002, registered peak-to-trough declines of 48% and 49%, respectively.

2. Since the panic lows made on October 10, the market has been in a highly volatile trading range between 850 and 1000 on the S&P 500 on a closing price basis. Unfortunately, the extreme volatility, which is a strong repellent to conservative investors, has not abated. Last Thursday featured a 950-point intra-day range in the Dow, and Friday saw a 400-point range in the last hour of trading.

3. In the past month, we have had two important tests of the lows reached on October 10th. The first test came on October 27, which registered a slight new closing low, but quickly turned into a sharp rally that carried into the election. The second test is taking place now. We will know soon enough whether this test will be successful. Investors can take some comfort and hope from the fact that it is very typical for bear markets to end with multiple retests of major lows. Each of the past three major bear markets - 1973/1974, 1987, and 2000-2002 - followed the same pattern. There was an initial steep drop to a panic low in a "waterfall" decline, followed by retests of that low over the ensuing weeks and months. In some cases, marginal new lows were registered, but they were limited in price and time.

4. The combination of (i) the best valuations on stock and corporate bond indexes in 25 years and (ii) record levels of bearish sentiment should have produced a more sustained rebound than what we have seen thus far. The fact that we have not had a sustained relief rally reflects the extent of the lack of confidence that exists in markets today. Bearish sentiment is at its most extreme level since the 1970s. Market bottoms are by definition the point of maximum bearishness, and the current environment certainly holds that potential, but it is important to remember that NOBODY KNOWS what the future holds. The historical odds strongly favor that we are in the process of forming an important bottom, but a prudent investment strategy must account for a range of outcomes, including the possibility that market conditions could become even worse, or stay very bad for an extended period.

5. When we hear the question posed - "with the economy in such terrible shape, where is the catalyst for the market to recover" - we must remind ourselves to separate the timeline and trajectory of the economy from that of the financial markets. We have been in a bear market for over a year, punctuated by an all-out market crash this fall. Yes, the economy has fallen off a cliff. Yes, the fourth quarter is shaping up to be awful for the economy. Yes, consumer spending has collapsed. Yes, there will be more pain from de-leveraging. Yes, the prospects for an economic recovery in the foreseeable future are slim-to-none. But the markets are already priced for a deflationary bust, which has not happened in this country since the 1930s.

6. Don't believe anyone who says that stocks aren't very cheap at current levels. They may be historically cheap for a good reason - namely a very grim economic outlook - but they are cheap nonetheless. Global equities are currently valued in the cheapest quartile of very long-term (i.e. past century) historical ranges based on price-to-book value or price-to-trend line earnings. Importantly, periods where stocks were cheaper than they are today typically featured demonstrably worse economic conditions (e.g. some combination of double-digit unemployment, inflation or interest rates). Attempts to value stocks based on a current quarter's or current year's earnings reflect an ignorance of what ultimately determines the value of stocks, which is a very long-range stream of future cash flows.

7. If the S&P 500 significantly breaks its October 27 closing price low of 848, we may see another round of panic liquidations, and a short-term vacuum may open up that could lead to a decline to the 2002/2003 bear market lows of 775-800. At those levels, we would undertake additional buying in our managed and model portfolios because valuations and appreciation potential would become that much more attractive.

Comments

[patio:]

Stocks are not cheap.

2008 Nov 18 08:34 AM

[investor88:]

I also think stocks are not cheap, all things considered. Obviously valuation is a subjective matter, so this is far from the last word.

2008 Nov 18 08:49 AM

[waterlily57:]

Remember, just before market peaks, people say "stocks are not expensive".

2008 Nov 18 09:46 AM

[sickofthehype:]

Just as you won't compare a beautifully restored historic home in one of the prime central locations in any of our cities, to a tract home in BFE, you also won't be able to compare just any 'stock' to another. Some aren't cheap, but there are many who are a screaming bargain.

2008 Nov 18 10:14 AM

[john the ba...:]

Just another article designed to pursuade you to keep buying the market. But stocks are not cheap. They still have a high average P/E of 14 or more. Stocks are cheep when P/E drops to around 6 as they have done in the past. And that would put the Dow at around 4500. Sorry but that is when stocks are cheap. In my opinion the market is just way to risky to be bothered with it for a couple of years. If the dow did go to say 4000 I might be tempted to buy in. But even at 4000 it could still then drop to 2000 before it came back up for the long term. Really anything is possible with then worldwide financial mess. These are not ordinary times.

2008 Nov 18 10:36 AM

[LeoTheDog:]

Stocks are cheap if you believe current 2009 earnings estimates. If you believe current 2009 earnings estimates you are going to lose your shirt.

Fourth quarter numbers will be bad, 2009 guidance will be worse, and 2009 actuals will be terrible. How do you justify 12% projected earnings growth for the S&P for 2009 when we are heading to the worst recession in decades?

2008 Nov 18 10:55 AM

[Mr. Cynical:]

"the markets are already priced for a deflationary bust, which has not happened in this country since the 1930s."

The bears have already weighed in above, but if you like Roubini, this comment is false. Analysts still have to revise downward their profit expectations for 2009 by 20-40%.

And, yes, there are investors who still base their decisions on such things.

Also: "Attempts to value stocks based on a current quarter's or current year's earnings reflect an ignorance of what ultimately determines the value of stocks, which is a very long-range stream of future cash flows."

there are also investors (traders?) who solely base decisions on short term market trends. Ignorant, maybe, but just as ingorant are long term investors who don't watch such trends. Long term investment shouldn't mean being asleep at the wheel.

2008 Nov 18 10:55 AM

[Kingsley An...:]

Interesting analysis in regards to the testing of new lows. As most have heard time and time again "we will not have a V bottom." In regars to the 2002 low, it took months before a new bull market began. In the meantime, I am content to sit on my hands and occassionally go short.

2008 Nov 18 11:39 AM

[bobbobwhite:]

It always pays to look at the position held and the resume of the person doing the recommending re: stocks and the market. If they run money, all positive comments in situations like this mess are self-serving and specious and should be held in total contempt.

Unless you are an ultrabear short, stay out of the retail buy market until clear signs of recovery show and stocks are on a consistent upswing, not just people talking about it "possibly coming soon". Giving away some very elusive and ethereal early gains for greater market stability always makes the soundest investment sense.

2008 Nov 18 12:48 PM

[Still Renting:]

"Don't believe anyone who says that stocks aren't very cheap at current levels."

I propose the converse is also true: Don't believe anyone who says that stocks are cheap at current levels.

When a bubble really hits bottom is when even the cheap prices seem expensive as everyone realizes a tulip buld is, at the end of the day, just a tulip bulb.

2008 Nov 18 03:12 PM

[doubleguns:]

Understand that cheap is relative. Cheap to last years earnings? If that is your yardstick they are NOT cheap. One would be a bit naive to think we are going to get those same earnings going forward with out the consumer. P/E right now aint diddley if the E is no longer a known. I propose that stocks are not cheap and may in fact still be very overpriced. Everyone keeps looking back to the good ole times. Lets compare to actual earnings next year and/or dividend yield. Also remember dividends are getting thier heads cut off right now.

2008 Nov 18 05:41 PM

[mrresponsible:]

General Background Statements:

Looking in the real view mirror doesn't necessarily predict the future.
The stock market is not the economy.
Most cycle studies usually go back only to the early 1900's
but I have seen studies back to the 1700's.
Most statistics stated below go back to 1854
Most stock market cycles in recent years have been less than 4 years.
Averages are not particularily good at predicting cycles.
The stock market reaches bottom prior to the really bad news.
It is likely we are in a primary bear market that started in 2000 and could last a long time.
Some are saying this is the "lost decade" but we will have bear market rallies.
Perspective: U.S. markets are not back to 2002 low levels yet - despite all the media bad news

Useful Statistics?

Stock Market Declines
The U.S. stock market peak in this cycle could be defined as October 2007
On average, the U.S. stock market peak to trough is 22 months in length.
U.S. stock market bottoming process: has been 3-8 months in length since 1970.
The total time spent in bear markets has been 31% of the last 107 years.
Since 1953 the S&P stock market index bottomed 4.1 months prior to recession trough.

Recessions
It is likely the U.S. Gov't will declare that a recession began in April/May 2008.
Historically, the length of recessions have been:
17 months in length since 1854
14.4 months since 1902 - Average stock market decline -24.2%
22 months since 1929
10.2 months since 1945 - Average stock market decline 34%
During a couple of bear stock markets, no recessions were ever declared - not likely now.

Stock Market Recoveries
Stocks and sectors provide some leadership- solid sales and earning growth and the stocks are traded well
U.S. stock Bull markets (from trough/bottom to stock market peak) have averaged 30 months in length since 1900/
There have been three long bull markets that lasted 9 years, 10 years, and 15 years 8 months
An average gain of 106% for all bull cycles
An average gain of 46% after one year from the recession trough.

Sequential Characteristics of Declines, Bottoms, and Recoveries

Concern - Decline of market over long period of time
Fear - Rapid acceleration in the speed of the market fall
Panic - Massive increases in volume and volatility - like convulsive seizures
when 14 of the 64 days where intraday volatility is 8%+ ... going back to 1928.
So out of 80 years, over 20% of the most volatile days have come in the past 6 weeks.
Shake-out - speculators - everyone gives up - no one is saying it is a great time to buy
Capitulation - You won't know it when you see it.
The idea of capitulation could be costly as investors wait for a bus that never arrives -
best if you are a long term investor 5-10 years
Geniuses are gone
Oversold conditions - maybe now?
Cheap is a Price/Earning ratio of 8 (problem 'E' is dropping) with a Price/Book ratio of less than 1.2 (currently 1.5 S&P)
Trust Building/Hope
Stock market volumes are low after a bottom.
Recovery
Average 1 year return after trough/bottom = 46%


If you wait for the robins, spring is over.


Some November 2008 musings:

We will probably see the sharpest slowdown/recession in decades. More fear!
Theoretically, the stock market bottoming process for this stock market cycle could
end February 09
The recession would end later in about June, 09
The market could rally summer, 09
This stock market rapidly declined about 10% more or a total of 44%. Average is 34%
Having watched the decline in 2000-2003, the market in 2003 never reached the bottom many people expected.
The housing debacle will have to be solved.
Stocks that purchase their own shares don't have any better ideas and the stock typically doesn't comparatively appreciate as much. Target (TGT) just halted investing in their own stock. They are probably going to spin off their real estate.
Wait before purchasing a stock in the news

Going forward in investing??? Looking for market fundamentals
For NOW- but IDEAS will change.
DO NOTHING may be a good idea - unless long term investment or
wait until 100 day moving average is broken.
Pawn shops - (EZPW) I'm serious - one of the best stocks in 2008
Ritchie Brothers - auctioners RBA or Vehicle Auctions CPRT
Private vocational/skills schools
PEY - ETF Powershares High Yield Dividend Achievers F
Utilities - XLU - less historical risk - dividend yield 4% Beta 7.77
REITS - apartments - not commercial retail or industrial real estate - high dividend yields will decline in a deep recession.
AIV - Apartment Investment and Management
AVB - Avalon Bay Communities
RQI - REIT ETF
VNQ - Vanguard REIT
Value REITS
JKF
FVD
Large Caps with history of dividends but be careful.
Microsoft - stock hasn't done much for years - dividends
Phizer
Johnson and Johnson
USB
UTX
PG
GE- 1996 stock price
Walmart WMT
The Perma Bears are predicting a DOW of 4,200

Long Term 5-10 years - becomes easier
Warren Buffet BRKB
LOWEST NOW SECTORS
Financials - ILF, PGF, VFH (Value)
Technology - second worst sector in last year
Materials/commodities - low/low
Machinery
Commodities

Small cap stocks recover the quickest (tech and financial lead the bull)
Individual small cap stocks are difficult to analyze - risk is high
IWC - Micro-cap ETF - spread the risk
IWM - Russell 2000 Small Cap ETF
VB - Vanguard small cap ETF
GWX - International Small Cap ETF
Small Cap Value Funds - mutual funds
HRV!X, PSVIC, STSCS
International Investing
China - slippery slope now - reason for huge infusion of cash 600 billion
Russia - RSX
Switzerland EWL
Japan
DFJ - Wisdom tree Japan Small Cap Dividend Fund 1.2 book value
EWJ - Over the next year
India
Brazil
Turkey
ETF's
GWX - international small cap
VEW - all world except U.S.

Never forget the six-foot-tall man who drowned crossing the stream that was five feet deep, on average.

Bounces off the bottom can be dramatic.
1973-75: Stocks up 80% within a year.
1982: Stocks up 65% within two years.
1990: Stocks up 60% in next three years; up 200% by 1998.
2002: Dow up in 2003.

Only twice have stocks not moved over a decade: In 1966-1975 and in the 1930s.

2008 Nov 18 10:48 PM