As a Discounting Mechanism, the Market Will Rebound Before the Economy

As we head into 2009, the economic backdrop looks gloomy. Two important measures in particular, employment and corporate earnings, are set to deteriorate further throughout next year. The unemployment rate has risen from 4.4% to 6.5%, but many are now predicting a peak of 8%-9% sometime in 2009. Corporate earnings will fall for the second straight year in 2008, but many top-down forecasters expect a third year of declines. Does that mean stock prices have a lot further to fall still? Not necessarily.

Remember, the stock market is a discounting mechanism. It reflects future events ahead of time, as the 50% decline over the last year or so reflects. At some point, stock prices reach levels where they already are reflecting the assumptions of continued weakness in unemployment and corporate earnings. Bill Hester, of Hussman Funds, helps to shed light on this concept. He writes:

The four-week moving average of the jobless claims data breached 500,000, which has happened only 4 other times. It occurred in December of 1974, in April of 1980, in November of 1981, and in March of 1991. During the 12-month period following these periods, the S&P rose 32 percent, 30 percent, 20 percent, and 9 percent, respectively. These periods also shared attractive valuation. Over the four periods the price-to-peak earnings ratio averaged 8.75, which is about right where the market's current valuation is. Although it's a small sample, low valuation, coupled with economic data confirming a substantial contraction in the labor market, has offered longer-term investors very strong average returns.

Those returns aren't restricted to bull markets that follow the worst recessions. Returns following all of the recession-induced bear markets have been quite strong. First-year returns following a recession have averaged 37 percent with surprisingly little variation. Not including the out-sized gains following the 1982 bottom, all of these first-year bull markets gained between 29 and 44 percent.

Even if we assume, as the market has already begun to grasp, that both employment and earnings don't trough until mid or late 2009, we should not assume that the market will not hit bottom until those numbers stabilize or improve. Examining market history shows that the market rebounds before the economic data signal the recession has ended. As always, the market is a discounting mechanism.

Now, I don't know if the economy will bottom in early 2009, mid 2009, late 2009, or during 2009 at all. As a long term investor, I don't find it very helpful to try and guess between outcomes that are only a quarter or two away from each other. Even Nouriel Roubini, the biggest proponent around of a doomsday economic scenario, thinks the recession will end by the end of 2009. Even if you believe in his forecast, the market would start a new bull market in Q3 or Q4 of 2009 (3-6 months before the recession ends, as history suggests). If he is proved a bit pessimistic, it could be even sooner than that. As a result, long term investors should be buying, not selling at this point. Equity market valuations are too low to make the case that the market has not yet discounted most of the bad news we are likely to get in coming quarters.

Comments

[Prudent Man...:]

A discounting mechanism? Real estate topped in 2006 and the derivative bust has been hanging around for fifteen years. What was it discounting at 14000 a boom while we were entering a recession?

How sophomoric! Like people like this on the other side of my trades.

2008 Nov 24 04:06 PM

[willynill:]

Yup, it is a discounting mechanism. The price today is the present value of all future cash flows that it KNOWS about, discounted at a rate consistent with the risk. I think PrudentMan is really saying that the market is not efficient, and I agree with that.

2008 Nov 24 04:50 PM

[jepittman:]

Chad's position is similar to another investor named Warren Buffett. Chad is trying to point out something more investors should perhaps pay a little more attention to: markets bottom and begin rising long before the economy and unemployment bottom. If you wait for economic recovery to be apparant the stock and bond markets will have already moved much higher. Successful long term investors are finding fabulous values and are cherry picking every day.

2008 Nov 24 06:05 PM

[Schweizer:]

If you read Russell Napier's excellent book "Anatomy of a Bear" he has researched this idea that "the market recovers before the economy," and he found it to be a complete myth.

Here are his set of basic conclusions on Bear markets (FYI):
1. Economic and stock market recoveries roughly coincide.
2. Recovery in the auto sector precedes recovery in the equity market.
3. Bear market bottoms are characterised by an increasing supply of good economic news being ignored by the market.
4. While numerous bulls bang the drum for equities even at the bottom of the market, they will be ignored.
5. Many commentators will suggest the worsening fiscal position will prevent economic recovery or a bull market in equities. They will be wrong.
6. Decline in reported corporate earnings will continue well past the bottom of the market.
7. The bottom is preceded by a period in which the market declines on low volumes and rises on high volumes.
8. The end of a bear market is characterised by a final slump of prices on low trading volumes.
9. Confirmation that the bear trend is over will be rising volumes at the new higher levels after the first rebound in equity prices.
10. There will be a large number of individual investors shorting stocks at the bottom of the market. Short positions will reach high levels at the bottom of the equity market and will increase in the first few weeks of the new bull market.

Don't listen to Bill Hester of Hussman Funds. He just wants you to be a buyer of his funds which are also down 30% and have only mustered 4.2% over 5 years.

2008 Nov 24 07:19 PM

[Demographer:]

I agree with you Schweizer. A recent paper by Claessens, Kose and Terrones titled "What happens during Recessions, Crunches and Busts" comes to the same broad conclusion that there is not much evidence to show equities recover months before the economy does. In fact the evidence from previous US downturns shows that private consumption, and output all turn up at about the same time as equities.

2008 Nov 24 09:50 PM

[John Lounsbury:]

willynill - - -

Good point. The efficient market hypothesis has been thoroughly disproven for many market conditions. It may have some merit in a smoothly trending market with few corrections, but otherwise, it is clearly invalid.

2008 Nov 25 05:35 PM

[John Lounsbury:]

jepittman, Schweizer, Demographer - - -

I don't think your opinions are in serious conflict with each other (or with Chad). It is true that several studies have shown that market turns and turns in the economy are nearly coincident, while an older adage has market turns preceeding turns in the economy (by 3-6 months). However, as an investor, the practical detailed differences between the two perspectives are relatively minor. Many successful investors maintain that their success depends more on being too early, rather than waiting too long and being late. If one can read the economic tea leaves and start increasing investment before an economic bottom and continue investing through the bottom, I believe they will outperform those who wait until a bottom has been proved, usually several months after the fact. This entire question is worthy of a good research paper.

The biggest flaw in the entire process I described above is the tea leaves. How many can successfully call a bottom within 3-6 months in advance?

2008 Nov 25 05:49 PM

[Blair:]

The trillion dollar question is whether this bear market and recession is the same as others since world war two?

I say that it isn't because what needs to be wrung out of the economy are the excesses of leveraged investments and spending that has occurred over the past 60 years.

This will *not* be the typical recession seen in the past decades. The Fed's actions and stimulus spending will do an excellent job of killing the real estate market for the indefinite future because savings will go to federal bonds and the like. What do you think of what has happened in Japan? Over 15 years of slow economy!

Most conservative investors, those that have escaped the bear market in both investments and real estate, are not going to put their money in higher risk investments. In the book, "Unexpected Returns" the author points out that we could be in a 15 year trading range market, starting in 2000.

Keep your gun powder dry!

2008 Nov 29 08:41 PM