Are U.S. Stocks Headed for a Sweet Spot?

With the way stocks are being whipsawed, investors often ask me how to tell when the market is ready for a rebound. While there’s no way to ever be 100% certain, I usually just let history be my guide.

And history has a very interesting story to tell right now.

Just take a look at the following chart. Since 1927, the markets have shown beyond a shadow of a doubt that the worst of times for the U.S. economy have literally proven to be the best of times for stocks when it comes to choosing a time to buy.

The best buying opportunities are typically found when the market is represented by points inside the box located in the lower left-hand corner of the chart. This is when valuations are most favorable, as they were in 1932, 1941 and 1982.

When the markets are anywhere above and to the right of the box, they are statistically more at risk of falling than rising. There are naturally times when the markets rise from points above the box, but those are the historical exceptions.

For instance, take a particular note of March 2000, represented by a point way up in the right-hand corner. Take a minute to drift back in time and recall just what everybody was saying then about U.S. President Bill Clinton’s "New Economy," the Dow Jones Industrial Average heading to 15,000 (and beyond), the Internet-technology boom, etc.

Everyone was encouraged to buy in. One of the reasons why I refused to buy into that - pun absolutely intended - is because of this valuation chart. I could see that the markets were ludicrously overvalued at that time versus any other period going all the way back to 1927.

The markets certainly aren’t that overvalued now.

GDP Declines Bode Well for the Dow

Interestingly enough, this data is supported from another angle using gross domestic product (GDP) data. Since 1947, of the 11 times the quarter-over-quarter change in GDP was a minus 4% or more, the Dow was higher by an average of 25% one year later and 35% two years later.

What the data in this second chart tells us is that the latest projections suggest we’re right in line with historical norms, given that economists expect that the U.S. economy suffered a mind-numbing decline of 4.35% in the final quarter of last year. When everyone else believes the worst, that’s when you should be buying.

Obviously, we have to take this kind of phenomenon with a grain of salt, but any time one data source corroborates another, it’s worth noting - particularly when there are companies out there that meet our very strict investment guidelines.

Original post

Comments

[Conan the B...:]

There is no way to make comparisons when the charts provided are identical.

But one thing is obvious:

3 of the listed declines in GDP overlap within the 2 year allocation shown.

June,1980:GDP decline 7.8% Dow at 867.92, 1yr to 976.88
Dec, 1981:GDP decline 4.9% Dow at 875, 1 yr to 1046.54
Mar. 1982:GDP decline 6.4% Dow at 822.77, 1yr to 1130.03

This particular recession was long and deep and the upside moves did not occur immediately, nor were they sustainable as the 1982 figure after the Dec.1981 decline indicates.

This recession is bound to be worse. What is sorely lacking is what occurs after back to back qtrly GDP declines.

Grain of salt: I do not have a clue as to what is undervalued now relative to plummeting earnings and opaque forecasts.

Jan 16 09:09 AM

[frosty:]

It looks like you didn't attach the chart you referred to. What's upward and to the right of a column?

Jan 16 09:34 AM

[prudentinve...:]

I agree with the author that the best time to buy is in recessions, when stocks are beaten down and close to a long-term low. There is always the risk that some "value stocks" in a weak economy end up with bankruptcy and go to zero, but if one is diversified and prudent, this risk is worth taking, as the winning stocks should compensate.

The only question now is whether we are near a long-term low or not. My own guess at the moment is 50-50 chance between the low of this cycle being around SP750 (or perhaps already passed) or whether there will be another big leg down, to perhaps SP500-600.

Some commentators keep saying that stocks are now "cheap". I disagree and think that stocks are expensive by measures like P/E, dividend yield, and ratio of market cap to GDP, all of which indicate another significant leg down. The extreme volatility is because investors seem about equally divided between those who think the market is cheap and those who don't.

Jan 16 09:34 AM

[sieraromero:]

Prudent Invest---I agree with you. There are far more investors who are fearful of missing the next leg up than there are , who think that there is still room to go on the downside. Many people have been trained to think this way due to the multiyear run in stocks of this last great bullmarket. We have not seen the "BAD" that is coming our way yet! There should be a short term bounce brfore we resume the downside move. Only the government attempts to save the system is preventing[temporarily... the collapse and the proper valuation of stocks.

Jan 16 09:45 AM

[phaf:]

I imagine all situations are somewhat unique, but I'd be curious to see what inflationary effects followed each of the downturns in your table.

I'm sitting on the fence- stocks are looking cheap, but I'm fearful of another downside move to occur in the first two quarters of this year.

Jan 16 10:12 AM

[john the ba...:]

Funny how his charts do not go back before 1949.... I guess the data from 1929 - 1947 would not look too hot. What could be on the cards is a world wide recession, depression for the use (thanks banks) and implosion for china! Dow 6000.

It is so risky right now and we are so far from the end of these sestemic economic problems that its just not worth trying to catch the bottom. Don't go long stocks in 2009! Trade stocks or just save your cash. Massive bargins will abound in many areas of investment before we are done with this mess.

Jan 16 10:16 AM

[thatguy57z:]

well the government is going to make it worse then ever before, its a number game brought on by the banking system. on the first bailout was no good the banking is still loosing, all it did was put lost money back in there pockets of the friends of the president, buy taken money from the tax's payers. when is everyone going to open there eyes and start taken your money out and set on it before you lose it all. the stock market is going to drop to 6500 to 5000 between now march if not sooner. good luck and look around.

Jan 16 12:03 PM

[icandoitdon:]

i suspect we could see another significant leg down in the stock market. all we need is a catalyst, e.g. a large industrial company that fails or a treasury auction that is ignored by our foreign creditors. the model for this is what has happened to the banking industry over the last month, with the XLF coming off 25%. that's just the index. the major banks have been destroyed because there is growing recognition that they are essentially bankrupt.

Jan 16 12:21 PM

[icandoitdon:]

crap like this doesn't belong on this site. do your advertising elsewhere.


On Jan 16 12:39 PM L. SMITH wrote:

> The stock I love most happens to be one of the "falling angels" (fell
> below $1) . When a stock fell below $1, many mutual funds dumped.
>
>
> Thermogenesis (seekingalpha.com/symbo...) had a minor product
> recall at the worst time of stock market. No debt, no competition,
> plenty of cash, just about to become profitable for the 1st time.
>
>
> How many companies can raise price on its products 25% now? KOOL
> just did. Do your dd before investing as always.
>
> KOOL a 10 baggar? you tell me...KOOL is like the TECH hardware 10
> years ago.
>
> This stock should be a core holding for anyone looking to buy a big
> winner in its the early days.

Jan 16 04:44 PM