4 Ways to Tell if This Bear Market Has Really Bottomed

Includes: DIA, QQQ, SPY
by: J.D. Steinhilber

Evidence is accumulating that the November 20th low may mark the bottom of the worst bear market and financial crisis since the 1930s. The S&P 500 (NYSEARCA:SPY) is now 20% higher than the 750 low recorded on Nov. 20, and has moved higher in nine of the past eleven sessions. Notably, the financial sector, which has been at the heart of the crisis, has led the advance, gaining 45% over this period after it became clear that the government was not going to allow another major financial institution (Citigroup (NYSE:C)) to fail. Stock valuations and sentiment conditions support the idea of a bottom.

Based on a variety of measures, U.S. stocks are trading at their cheapest valuations in 25 years. Foreign stocks are even cheaper, having fallen to valuations not seen since the mid-1970s. Sentiment has also plunged to extremes not seen since the 1970s and early 1980s. Since markets are a manifestation of mass psychology, market bottoms are by definition the point of maximum negativity. It is difficult to imagine psychology becoming more pessimistic than what we have experienced over the past three months. Although I am optimistic that the November 20th low will mark the depths of this bear market, there are a number of things I would like to see to be more confident that the worst is in fact behind us.

First and foremost, the 3-month T-bill rate needs to rise substantially above its present level of 0.01% to signal that the financial panic is over. No market price better expresses the present degree of risk aversion and lack of confidence in the future than a 90-day T-bill rate of essentially zero.

Second, the VIX volatility index needs to fall below 40, from its current level of 58. From 1990 to September 2008, the VIX fluctuated between 10 (during periods of calm and complacency) and 40 (during periods of high volatility and fear). Since early October, in the wake of the collapse of the modern Wall Street banking model, the VIX has fluctuated between 50 and 80, as the S&P 500 has experienced ten distinct moves of 10% or more. A significant portion of the trillions of dollars that are currently in the “bomb shelter” (i.e. Treasuries and money market funds) will not come back into risk assets until volatility subsides.

Third, there needs to be more evidence that credit markets are functioning normally. In contrast to the healthier action of the stock market in the past two weeks, many credit markets remain highly dislocated, evidenced by irrational pricing and exceptionally poor liquidity in many parts of the corporate and municipal bond markets. The Fed and the Treasury are acutely focused on shoring up the banks and unclogging credit markets, but there remains much work to be done.

Fourth, and perhaps most important in terms of building confidence about the sustainability of any stock rallies that develop in the short-term, we need to see signs of stabilization in the economy. Virtually every piece of economic data in the fourth quarter has reflected an economy in a disturbing freefall. Moreover, the leading economic indicators we track from the Economic Cycle Research Institute are still accelerating downward at the fastest pace on record since ECRI’s inception in 1949.

Just as the banking sector and financial markets have been trapped in a vicious downward spiral where selling begets more selling, the economy has been in a dangerous tailspin of self-reinforcing contraction in spending, production, employment and income. It is possible that recent economic data has been negatively skewed by the shock from the financial crisis. Confidence is the oxygen of the markets and economy; both have clearly been suffocating of late, but hopefully can soon begin to breathe more easily.