Is It Time to Buy? What History Shows

The market can be frustrating. Just a few weeks ago it looked like the markets were about to reach lows we haven’t seen since the early 90’s.

The commodity bubble was bursting, hedge funds were imploding, and it seemed like the selling would never stop. To add fuel to the fire, unemployment was getting worse, consumers started saving again (seemingly all at the same time, which isn’t very helpful), and practically every week another bank failed.

It was disastrous. The government was handing out cash to banks and guaranteeing private companies’ commercial paper while putting trillions of dollars it doesn’t have at risk. It seemed like a depression wasn’t out of the question, but all of that’s starting to change.

Consider what’s happened over the past few weeks. Citigroup (NYSE:C) practically failed. It has become painfully obvious that despite a multi-billion dollar bailout, one of Detroit’s Big Three is going to go away, either through merger or through bankruptcy. Retailers reported the sharpest holiday shopping season declines in decades, and the unemployment rate is climbing faster and faster.

There’s almost no good news, but the market is still up. Sometimes it just doesn’t make any sense. However, it could be telling us something - the recent rally could be a giant signal the worst is behind us.

All the Signs of a Market Bottom

A few weeks ago, we looked at the five telltale signs of a market bottom. At that time, we saw four of the five signs, but were still waiting for one more in order to start seriously considering a market bottom.

The first four signs a bottom was nearing were confirmed. Investors were bailing out of mutual funds at record pace, the VIX set new highs, more than 90% of closed-end funds were trading at a discount (much higher than normal), and a perma-bear like Jeremy Grantham was turning bullish.

We were just waiting on one more: the market to react positively to horrible news.

Over the past few weeks, we’ve seen just that. When Citigroup declared it was about to go under, the market went up. When the market learned 533,000 jobs were lost in November (much more than even the worst-case expectations), stocks went up. The market is skipping right past otherwise horrible news.

That’s not all. Although we have all five signs of a market bottom we’ve been waiting for, there are quite a few more reasons to start turning more positive on the markets.

Discounting the Future

The market is supposed to be a forward-looking discounting machine. It’s supposed to price in what’s expected to happen over the next few months and years.

Is the market perfect at this? No. If it were, there would be no real opportunity to do well in it.

The market is, however, very good at incorporating what the masses expect for the future. It does it all in one quantifiable place, and right now, those expectations are for a turnaround to come sooner, rather than later.

The recent rallies have shown the market is anticipating the economy to stabilize and possibly begin its recovery in a matter of months. Just take a look at what is happening.

Goldman Sachs’ research department (yes, I know, who would listen to them after all that’s happened between a $200 oil forecast and the credit crisis and all?) released some historical precedents on how the market anticipates a recovery. In their defense, predicting the near-term future is darn near impossible, but these are historical facts. According to the bank:

The S&P 500 tends to bottom:

One quarter before the GDP bottoms
3 months before the ISM manufacturing survey bottoms
7 months before the peak unemployment rate
4 months before the largest decline in non-farm payrolls and
4 months before the bottom in consumer confidence surveys

If the market truly did hit rock bottom in November, we can expect a genuine economic recovery somewhere between March and June of 2009.

Believable? I wouldn’t bet on it, but it’s certainly possible. So, here’s what to do.

Where Do We Go From Here

If history is any evidence, it’s time to buy stocks.

The five signs of a market bottom are in. All the investment legends have turned bullish: Buffett, Grantham, Heebner, etc. We also got the market starting to anticipate this recession ending in less than a year. (Granted, I’m still concerned too many people are watching for a bottom to actually happen).

Of course, I’m still hesitant on calling “the bottom.” Trying to time the bottom is a fool’s game. Even though, it’s certainly tempting to do so after watching the market climb for two days. Frankly, there are still a lot of unanswered questions posing a lot of risk.

When will the housing market hit bottom? How will overleveraged commercial property companies fare? How bad will this holiday shopping season really be?

However, there still are some even bigger questions we have to deal with. Like, how high will the unemployment rate go? I’m still expecting it to top out over the summer in the 8% to 9% range. From that point, an economic recovery will really take quite a bit of time to get going again.

The government isn’t helping matters either. For instance, when will the government stop borrowing hundreds of billions of dollars from the banks (T-bills currently yield 0.01%) and trying to figure out why the banks don’t have the extra cash to lend to profit-seeking businesses? How much capital is going to override market forces and determine the best place for investment? Will it be roads and bridges, alternative energy, or electric cars?

There’s just too much uncertainty out there right now to go “all in.” I still recommend sticking to the plan of buying stocks consistently over the next year. You have to keep enough cash on hand to live and just in case an even better buying opportunity comes along to pick up stocks even cheaper. For now though, I’m still buying stocks and sticking to the plan.

The Three Places I’m Buying

Here are three places that I really think some great returns can be had in the next few months, and years:

1. Biotech

Over the next 10 years, stem cells will change the world we live in. Every week a new development is made and the research is ongoing. It’s reaching that point where stem cells are at the verge of going mainstream.

There are already some amazing stories cropping up about the effectiveness of stem cells and there are only going to be more and more over the next few years. Stem cells are making miracles happen and the last 20 years of research are starting to pay off.

Here at the Prosperity Dispatch, we fully expect biotech (stem cells in particular), after years of underinvestment, to have all the legs of a major bull run and the real possibility of forming the next bubble. It’s only a matter of time until the market realizes it.

2. China

Over the past few months, shares of Chinese companies have held up remarkably well. This time around, the China boom is going to look a lot different. The last decade has been led by China building infrastructure and working aggressively to become the manufacturer to the world.

The next boom in China will come from the maturing of the economy as it slowly starts to move away from the highly cyclical manufacturing industries and into less-cyclical service industries.

If China is where the U.S. was at 100 years ago, then there are many great years ahead. If the U.S. were where the U.K. was at 100 years ago, I’d definitely continue to look outside the U.S. for long-term opportunities.

3. Gold

Although we’ve taken the past few days to look at gold and when (and if) a bull market will resume, and a few different ways to get in on what could be a big bull run for gold, there’s one thing that really has caught my attention recently.

The XAU/Gold ratio is a measure of index of leading gold mining companies (XAU – Philly Gold and Silver Sector Index) relative to gold price. Over the past 25 years, the XAU/Gold ratio has been 0.25. That means the XAU index would be about ¼ the price of an ounce of gold.

On Monday, the XAU closed at 94 while gold closed at $760 an ounce. This makes the XAU/Gold 0.124. That’s less than half the ratio’s long-run average and just off the 25-year lows.

It’s either a very bullish sign for gold stocks or a very bearish signal for gold. Something has to give and I’m currently working out a short gold/long gold stocks trade to capitalize on it.

All signs point to a bottom, at least in the near term; however, in a market like this, it all could change in a matter of minutes. A single warning of more trouble ahead for China, another surge in unemployment, or more disastrous retail spending in the U.S., could easily put the brakes on any rally.

There are several concerns still facing the market and two strong up days like we’ve just had can easily create a false sense of confidence, but if you develop a plan, buy top-quality stocks in sectors which have exceptionally bright futures, and are willing to go in for a couple of years, you should be just fine.

Disclosure: None

Comments

[The LFB]

I really don't know why you and everyone else who writes about this stuff doesn't see this:

Put EPS on an S&P chart. You will see that the sustained 2003-2007 rally didn't begin until long after earnings had crashed and AFTER they begun to rise once again.

And if you look at the EPS during the rally, you'll see it goes up.

Of course there will be intermediate ups and downs-we're in a 18% upswing on the S&P right now from the Nov. 21 low. But these are moves for traders, not investors.

Stocks are probably more likely to move up and down like this without a sustained rally for several years because earnings still have further to fall.

The ones who saw price declines coming and bought debt are way ahead of the game. Why? Because in the three months to October, headline CPI fell at a 4.4% annualized rate which means during that time they were earning maybe 8% annualized. And they got to sleep at night.

2008 Dec 09 06:52 AM

[Roger Knights]

"On Monday, the XAU closed at 94 while gold closed at $760 an ounce. This makes the XAU/Gold 0.124. That’s less than half the ratio’s long-run average and just off the 25-year lows.
"It’s either a very bullish sign for gold stocks or a very bearish signal for gold. Something has to give and I’m currently working out a short gold/long gold stocks trade to capitalize on it."

That's a valuable tip--an arbitrage play looks like a near "cert." And it's an "angle" that neither gold bugs nor gold bears is likely to notice, they being too emotional and one-sided in their view of the topic. (I suspect the mining stocks got pushed down relative to bullion when the cost of oil spiked, but the market failed to readjust when the price of oil declined.)
**************

LFB said: "Stocks are probably more likely to move up and down like this without a sustained rally for several years ..."

I agree--I think people are too focused on the question of UP vs. DOWN, and ignore the more likely possibility of sideways thrashing, which will whipsaw investors. I think that 8900 is a near-term top, for instance. A less volatile play than stocks, IMO, for a person who doesn't think the roof will fall in, would be junk bonds, which seem oversold. (See the Dec. 15 issue Business Week column on them, "How to Judge the Junk.")

2008 Dec 09 09:47 AM

[sg hammer]

My site shows my Delineator analytic which currently is supporting long signals. The Delineator turned up on November 21st and as a first target has 99.5 on SPY which should be achieved within the next two weeks.

2008 Dec 09 10:10 AM

[Carl Spackler]

All of these signals - high VIX, the gurus buying stocks, market rising on bad news, etc... have been flashing for 5 months. What has that gotten investors - losses. I am always amazed at how many people will try to find the bottom of a market only to get hammered further. To me, it is the surest sign that there is more room to go down.

Too many people still have the psychology that this is another in the line of shallow recessions. Wake up folks! This is a one in a hundred year event. This is a deep recession. This is a deep bear market. Periods such as this when researched show that the bottom is in place when we have at least 6 months of trading within a narrow range. We hit a new low just last month, so I have not seen 6 months of sideways action yet.

Keep on trying to find that bottom. If somehow on your ninth try you actually hit it - yipee!!! The smarter money however will hold off establishing longs until the market shows signs of stabilizing (at any price) for 6 months. Big drops like this take a long time to stabilize and do not do it in a month or two, so you have plenty of time to get on the bus when it actually gets here, mso what's the hurry?

2008 Dec 09 10:45 AM

[Maya_]

Article title needs changing. It is time to buy; has been for a while now with the valuations where they got to. Valuations can always get better, but what we have had the past month or so are good enough for me.

2008 Dec 09 10:46 AM

[kianator]

All will be bear market rallies until the S&P 500 monthly chart closes above the 10 EMA. Very reliable (yes, lagging especially on a monthly chart) indicator to tell you when the long-term market trend has changed from bear to bull.

Volume and money flows will indicate how far this rallies goes.

SPY volume was actually 80 million less yesterday than on Friday's rally. See if that continues to give you a good idea of how long this pre-santa claus rally lasts.

2008 Dec 09 10:57 AM

[Bottom fisher]

www.wilshire.com/Index...

Current Wilshire 5000 has P/B ratio: 1.6
1982 Bottom P/B ratio: 1.0
1974 Bottom P/B ratio: 0.75
1932 Bottom P/B ratio: 0.50
How can a long term bull market start with Market P/B at 1.6? This is more like a sucker's rally of Spring 1930.

2008 Dec 09 11:07 AM

[The LFB]

Show me a sustainable rally while earnings are decreasing. You can't because one doesn't exist.

Earnings are going down a lot further than estimated and the employment situation has much further to worsen. Consumers are deleveraging and they won't use credit (if it's even available) for quite some time.

Why on earth would anyone expect consumers will spend when their assets (home and 401k) have been devastated.

Mohamed El-Erian of PIMCO has it exactly right. We are not returning to business as usual. Rather, we are facing "the more nasty reality of a volatile journey to a different destination."

2008 Dec 09 11:17 AM

[bobbobwhite]

Attended a Woodward and Bernstein lecture where Woodward told of a lunch he had with Al Gore. When he asked Gore what percent of things going on in Washington the public knows about, Gore said, "no more than 1%".

That about tells it also with this so-called "market recovery". Much, much more social and economic damage and corruption is covered up in Washington than we ever know about, and anything done to "correct" now merely covers it up until the next time. Nothing is ever really solved, and the house of cards called capitalism ges weaker each time until final collapse. No way anything substantive and permanent gets solved if this present system repair takes less than 10 years of national pain to do it.

2008 Dec 09 11:34 AM

[Roger Knights]

PS: I've had an afterthought on my comment above (#2), in which I wrote: "I think people are too focused on the question of UP vs. DOWN, and ignore the more likely possibility of sideways thrashing."

I think we need a term for people who envisage a sideways, zigzag market. (These people have been overlooked--they're the excluded middle-of-the-roaders.... It needs to be an animal whose name begins with a "B" for the sake of alliteration. The only animal I can think of that habitually runs in an unpredictable, zigzag fashion (to evade predators) is the hare or rabbit. Fortunately it has a third "handle" that fits the bill: Bunny.

I have spoken.

2008 Dec 09 11:49 AM

[Nhoj]

Jeremy Grantham a permabear? Huh? JEREMY GRANTHAM WAS RIGHT! He knew the smoke and mirrors of home-as-ATM would catch up with us. He was prudent!

The folks who think, like Mr. Grantham, are sitting atop piles of cash awaiting opportunity. The sheep who follow, like most, have been sheared.

2008 Dec 09 01:51 PM

[jrs87sch]

Things will get worse before they get better in the U.S. One thing we can be sure of is that even though prices may have not hit rock bottom yet, it's almost impossible to time the market perfectly.

There are TONS of Undervalued stocks out there waiting. Start to pick at them now because the market tends to rocket up quickly at the beginning of a recovery. You could miss these low prices.

I have posted a series of Value Investing articles on my site that guide investors to picking undervalued stocks. Buy within the next few months, or you could miss the train.

2008 Dec 09 05:08 PM

[Capt "V"]

Weeell, it's always pleasant to think positive thoughts for that warm, fuzzy feeling, but the reality is that this recession is unlike any this country as ever endured and rehashing historic recessions in no way prepares us for the vast unknowns of this one. For example, how are we going to pay for all these trillion $$$ bailouts? Simply run the presses 24/7 or sell bonds to who---? My advice, think "CAUTION."

2008 Dec 09 08:26 PM

[UCBKID]

We are nowhere close to a bottom. There are 10 months of new housing out there. Earnings warnings are just starting (FedEx- today.. Obviusoly the bad news was not priced in as it fell around 17%)... There will be many more. Oh FedEx ships products so that's a tell on demand. Oh yes, jobs- job cuts accelerating. I really think we will retest the lows.. Time will tell.

2008 Dec 10 01:36 AM

[gdog]

Sideways?

Maybe for some...

Govt allows banks to use toxic assets for loans to buy treasuries, pushes price of treasuries up, foreign govt's also want treasuries as their currencies tank. Interest rate goes to zero.

Gov't is flush with cash, goes on the biggest building spree since whatever year. Bridges, barracks, roads, bio tech, clean energy tech, stem cells, tunnels, levees for new orleans, schools, hospitals. Everything a caring government might build with oodles of free cash. If this creates any economic activity at all, it's a net gain for the gov't and everyone who invests.

Probably also a great time for small business sub contractors.

Allocate accordingly.


On Dec 09 06:52 AM The LFB wrote:

> I really don't know why you and everyone else who writes about this
> stuff doesn't see this:
>
> Put EPS on an S&P chart. You will see that the sustained 2003-2007
> rally didn't begin until long after earnings had crashed and AFTER
> they begun to rise once again.
>
> And if you look at the EPS during the rally, you'll see it goes up.
>
>
> Of course there will be intermediate ups and downs-we're in a 18%
> upswing on the S&P right now from the Nov. 21 low. But these
> are moves for traders, not investors.
>
> Stocks are probably more likely to move up and down like this without
> a sustained rally for several years because earnings still have further
> to fall.
>
> The ones who saw price declines coming and bought debt are way ahead
> of the game. Why? Because in the three months to October, headline
> CPI fell at a 4.4% annualized rate which means during that time they
> were earning maybe 8% annualized. And they got to sleep at night.
>
>

2008 Dec 10 02:09 AM

[decoflair]

1) I am not a technician or expert. However, large corporations are only beginning to announce lower revenue and earnings as we write. We are only beginning this bear market.
2) In addition, don't we need to retest the 7500-7600 level on the DOW that occurred on Nov. 21. No, it just cannot be as easy as you have described.
3) There may be substantial tax changes coming next year. History has demonstrated that major tax changes upset the market due to the uncertainty of the effects of the changes.

2008 Dec 10 05:01 AM

[investor88]

Quite sensible article by Andrew. Time to trade long towards 20Jan2009 when the new President is in, then re-evaluate from there.

Right now we trade what we see which is good market action [until proven otherwise].

2008 Dec 10 08:57 AM

[agent]

The market will be churning out more and more bad news next year. There will be more unemployment, foreclosures, personal and corporate bankruptcies, and missed earnings targets. The only way for the market to improve or remain the same is if the government prints more money to throw into the market and the economy, which it will. But what good does it do if the market improves and the dollar goes down so you gain nothing in real terms? Maybe when things get really bad, maybe next year, who knows, it will be less risky to buy commodities like gold (to protect against certain currency devaluations) and oil and foodstuffs (as a bet on currency devaluations and growing demand due to population growth and shrinking supply due to global warming ). I would use rallies to liquidate US paper assets.

2008 Dec 10 08:59 AM

[Roowns]

For those who waited till now I simply don't see why not doing it forward since nothing is clear.
It's true that we had a rally but after a free fall market. It's sure that news were not good, still market got up, but take in account that 2 month ago news were a disaster, with many institutions failing and plans of billions running.
Yes, now companies make lower predictions and fire people, but this has not such an impact as bailouts in financial sector.

2008 Dec 10 10:20 AM

[M-P]

I think we are in a bear rally personally ... it's not a "free" market at this point ... it has a major governmental overhang that is changing the dynamics, which is why it's hard to play. One reason the market was up after the 533K job loss figure is that everyone thought it was bad enough for the government to step up the auto bailout and the fill-in-the-blank bailout. The credit card shoe will fall in the next few months, along with numerous other credit lines ... the government can create jobs, but it will take some time before the major corporations start hiring again - also, look at the wage delta between jobs lost and jobs created ... financial services jobs pay at the top of the scale - public works jobs do not. Add-in the delevering piece and I think we will challenge previous lows.

2008 Dec 10 10:49 AM