Five Criteria for Timing the Market Bottom

A common query among most equity market participants is when is it time to buy. Timing a market bottom is usually a very dangerous play and it traditionally makes sense in the context of cost averaging down (assuming one doesn't make a 20% return overnight), and of a significant liquidity backstop. In other words neither we, nor any responsible financial advisor, will ever recommend betting even half the farm on a hunch, based on technicals, fundamentals, tea leaves, kaballah or other sound investing methods.

The current market environment is unique in that since essentially the entire non-financial equity world trades as one asset class, on huge momentum swings, and with the mania of an overcaffeinated daytrader, i.e. with a lot of embedded risk, one could flip the argument and claim the reward should be commensurate.

This leads to the question of what are the key criteria that analysts, pundits and talking heads look at when they make bold market bottom claims. We present a list of conditions, which while not exhaustive, provide a good framework to analyze whether conditions are ripe for a substantial move up (or down).

1. Is forward looking data bottoming?

The equity market tends to bottom when the deterioration in the labor market and economic growth are at their worst. The S&P historically bottoms near a time when new unemployment claims are at their highest levels.

Another major metric followed by forward-watchers is the reading on the ISM (Institute for Supply Management), or the manufacturing index, which measures manufacturing activity. Again based on historical data, the S&P has usually bottomed one or two months before an ISM inflexion. As the chart below demonstrates, out of 8 economic cycles, the only time this did not occur was in 2001, after an ISM low of 40.8 was hit in October with the market proceeding to sell off for another 15 months.

It is arguable that the post 2001 bubble was an aberration resulting from the double whammy of the still lingering Internet bubble and the "one-time" event of September 11. For the current cycle, the ISM hit a 28 year low of 32.9 in December and staged a modest rebound to 34.9 in January, which would imply based on empirical data the S&P bottomed in November. It is important to remember that the absolute value of the ISM is not so much the determinant here as its derivative, i.e. the bottoming out. A March ISM reading higher than 34.9 by even 1 point would likely incite a substantial market rally. Then again the ISM reading is so low that it is debatable how valid its indicative power is at these significantly depressed levels. And we would strongly caution a singular focus on ISM as employment numbers keep deteriorating, and we believe that metric is substantially more relevant from a forward looking perspective. The combination of a flattening in both ISM and new unemployment claims would undoubtedly cause a significant market rift. (click on chart to enlarge)

2. Are foreign economies stable?

When we wrote about the situation in Russia, Eastern Europe and Korea recently, we were focusing on their capital market deterioration. However, it is only a matter of time before that weakness spreads to the overall economy (and neighboring countries). While recent foreign business surveys have shown improvement along some metrics, the overall foreign data are conflicted, with recent deterioration being observed among global trade routes, most notably in Asia. There is also a second issue: investors may have been overoptimistic for a rebound in EMs: the YTD Brazil index is up 8% while China A-shares are up 24%, thereby pricing the "good" side of the news. The inflexion point of the business cycle will inevitably present good and bad data, although care has to be taken to analyze the potential risk of the credit crisis' spread catching up with more important lagging indicators.

3. Are lending conditions improving?

Empirical data (click on chart to enlarge) shows a very close inverse correlation between the S&P and the spread on the HY index. While spreads have tightened over the past 3 months, a lot of this has to do with the pricing in of the recently announced Finance Stability Plan, which at this point may only lead to further disappointment. For a sustainable rally, credit spreads, especially for high yield names, have to collapse by a substantial amount which will likely be contingent on many of the postulates of the FSP kicking in. Other credit improvements such as a decline in write downs would be a welcome metric. Of course, to keep things confusing, January was one of the best months in history from a new Investment Grade debt issuance standpoint.

4. Is the Finance Stability Plan effective?

Arguably the most critical part of a sustainable market rally, the Fed and Treasury's new plan has three main goals: i) Monetary easing, which at this point can go no lower with ZIRP already in place. Additionally the Fed is now involved in quasi-fiscal policy by purchasing treasuries (presumably), mortgage backed securities and other risky assets, bringing spread tighter. ii) Fiscal stimulus, with a redesigned $780 billion stimulus package on the verge of implementation. This will provide a needed short-term temporary boost to spending and aggregate demand, at the cost of significant government indebtedness and inflation hazards down the line. iii) Bank rehabilitation. Arguably the weakest point in the government's interventionist practice, due to the FSP's nebulous treatment of bad assets via a new version of TALF, as well as ongoing asset value deterioration, leading to increasing threats of systemic banking insolvency, and raising the specter of nationalization. Furthermore, the lack of disclosure on many of the FSP's tenets will not be read favorably by investors, and is an indication that the policy response is still a substantial work in progress.

5. Is the housing sector stabilizing?

Pundits have been so focused on the first derivatives of this problem that they ignore just how bad the property markets are and likely will be for an extended period of time. For a true economic pick up, the housing sector needs to stabilize: plain and simple. Goldman estimates that if home prices are to decline a further 25%, this would result in an additional $742 billion in credit losses on credit products. Any indication that home prices are falling at a less rapid pace could be perceived as a sign of an inflexion point approaching. So far there is no evidence of improvement in prices and with a 12.9 month inventory overhang (click on chart to enlarge), it is not likely that a bottoming is approaching any time soon.

The preliminary assumption that the S&P 500 may have bottomed in November has so far been consistent with technical analysis - the market has been trading in a very tight range in the 775-850 (click on chart, below, to enlarge). This article will not delve into the technical aspects save to say, that the current level on the S&P may be priced surprisingly well given all the above 5 criteria. Investors should compare improvement versus deterioration in all five to determine what the impact will be over the coming several months.

Comments

[athena:]

Excellent analysis, thank you.

Feb 12 07:13 AM

[investor 101:]

At least, a sound analysis and without any forecast!!

Feb 12 08:03 AM

[Boon:]

Good analysis, and well researched. However, one point to note is that what has happened in the past may not necessarily happen in the future, even with historical trends that seem to be accurate. Just like getting 5 heads in a row when tossing a coin does not mean that the 6th toss will also be a head, a correlation between two things in the past several times does not imply that the same correlation will happen again.

From a personal point of view, we are probably experiencing a downturn that is systematically very different from previous recessions, and thus the conventional methods of predicting a bottoming are inaccurate. The key indicator that I will be looking for in the coming few months is the stability of the banks and bank lending, as without flowing credit again it will be hard for any sort of recovery.

Feb 12 08:39 AM

[MichaelJ007:]

ur very annoying. Please go peddle ur picks somewhere else.


On Feb 12 07:59 AM stem cell B wrote:

> Picking the bottom is not as important as you pick a winning stock
> no matter when the cycle is up. there's bull market somewhere everyday.
>
>
> What I like most is A leader in the emerging market with no competition.
> Thermogenesis (seekingalpha.com/symbo...) is the stock
> you need to buy for 2009 and beyond, check its foundmental and recent
> chart.

Feb 12 08:48 AM

[DrewS:]

I believe the bear market will be over when the following occurs:
= the dividend yield on blue chip companies is over 7.5%
= P/E ratio of less than 10
= current debt level of individuals, businesses and governments is decreased dramatically.

most investors will have given up on stocks and most investments in general. It took several decades to get to this point and it does not seem realistic that it would be over after one year. The main reason being investor confidence has been shattered and it seems apparent that it will take a lot longer than one year to rebuild that confidence.

Feb 12 09:11 AM

[JWhitling:]

Very interesting S&P graph. If you look at the recoveries, it's interesting to note that each recovery was weaker, and weaker, and weaker, until in 2001 we have a negative trend line. What's this mean? Dunno. But it begs the question .. what's the next "recovery" trend line.

Feb 12 09:46 AM

[Scotfree:]

Minor point: I think you have reversed the legend on your S&P/HY chart.

More important: I have read a couple of your analyses, and I think they are very good--as is this one. It's hard to tell from the charts, but an interesting analysis would be how much of a bull market you give up by waiting for a confirmed bottom in the ISM or other indicators. It doesn't look like you lose much and would get a higher degree of safety. Even in
2001, you would have got most of the rally and hopefully been able to at least break even before the next downleg took you out.

Feb 12 10:13 AM

[Larry House:]

One of the things I think we must realize is that this market bottom may be different from the norm in that the market may cling to or near that bottom for a LONG period of time. Equities may be a subpar (compared to past returns) place to be for years--not just for months. I expect some bounces, even strong bounces, in this market, but does anyone believe the market is going to jump 20-30% and hold it?

Feb 12 10:26 AM

[ROLEX18:]

Market bottom is a marketing tool for funds who milk your last pennies.

Feb 12 12:47 PM

[Jim Hawthorne:]

Finally! At long last an attempt to quantify and test a bottoming hypothesis.

An interesting piece of work that recognizes the fact that bottoming is a process rather than a singular event!

I would add:
1. that investor/consumer confidence will also have to see a good deal more sunshine before we get any sustainable moves to the upside, and,
2. we will have to see the emergence of a new leading sector/industry grouping; quite possibly in an area where we would least expect to find it!

I doubt we can rely totally on a simple re-inflation of the sectors you mention to pull off a sustainable recovery!

Feb 12 04:13 PM

[Moon Kil Woong:]

Good work, the market is a complex thing and many components of the economy are linked to one another. Declining employment feeds mortgage defaults, defaults feed bank losses, bank losses deteriorate market stability causing people to save, lowering credit demand, etc. It appears as a vicious cycle, but just like they are all linked, a positive in any one component can forestall or reverse the vicious cycle as well.

Any individual or government trying to meddle too much in a developed free market will result in inevitable disaster because the market is necessarily too complex to manage. You may say, what about managed economies like in Asia? That is why I state developed free markets, which the likes of China is not even though people try to tell you that's so.

Beware investing in such countries. They can blow up at any moment. Most Asian SE Asian managed economies regularly experience over 50% downturns even in mild cyclical downturns. As the US moves toward a government controlled economy, it too risks a multitude of catastrophic occurrences.

Feb 12 09:18 PM

[Yohei:]

Agree.

This one will be at least as bad as 1980-82, where we saw several quarters of S&P 500 12 month trailing earnings/price ratio in the 8's.


On Feb 12 09:11 AM 1werd wrote:

> I believe the bear market will be over when the following occurs:

>
> = the dividend yield on blue chip companies is over 7.5%
> = P/E ratio of less than 10
> = current debt level of individuals, businesses and governments is
> decreased dramatically.
>
> most investors will have given up on stocks and most investments
> in general. It took several decades to get to this point and it
> does not seem realistic that it would be over after one year. The
> main reason being investor confidence has been shattered and it seems
> apparent that it will take a lot longer than one year to rebuild
> that confidence.

Feb 13 12:27 AM

[johngonole:]

I agree with Larry House above. The markets could bottom and trade sideways for a long time. For one the demographics over the next 10 years suggest boomers will begin to shift monies out of stocks and into income investments such as municipals bonds, I-bonds, etc...

This same demographic also means the housing boom is gone forever. Its back to buying houses only to live in. Those who do buy them for investments will have to actually look to see if the income they produce from the properties yields a reasonable dividend. So housing for sure will bottom and then move sideways.

Feb 13 01:35 AM

[Sean Sloan:]

Larry House and Johngonole are absolutely accurate is what they are saying. The boom time in real estate is gone. The buyers of homes are not the younger versions of the sellers of homes in the G7 as it was since WW2 ended. The new home users are generally illegal aliens and young Americans who will not or can not work hard or smart enough to buy homes in the same numbers as their 30-50 year older counterparts. Similarly, the stock market will trade sideways until the dollar devalues to a laughable level (maybe 1/3 of it's current value) against non g7 currencies. The "reichmark dollar" will buy 1/2 a cup of gasoline and 4 slices of bread rather than a half gallon and a loaf like today. This will happen by 2012 when the American economic system implodes yet again. Buy Brazilian reals and Indian Rupees in a non American bank.

Feb 13 07:32 PM

[Dean M:]

Yes you are so much smarter and harder working than the younger generations. Shouldn't you be doing something productive like selling apples on a street corner.


On Feb 13 07:32 PM Sean Sloan wrote:

> Larry House and Johngonole are absolutely accurate is what they are
> saying. The boom time in real estate is gone. The buyers of homes
> are not the younger versions of the sellers of homes in the G7 as
> it was since WW2 ended. The new home users are generally illegal
> aliens and young Americans who will not or can not work hard or smart
> enough to buy homes in the same numbers as their 30-50 year older
> counterparts. Similarly, the stock market will trade sideways until
> the dollar devalues to a laughable level (maybe 1/3 of it's current
> value) against non g7 currencies. The "reichmark dollar" will buy
> 1/2 a cup of gasoline and 4 slices of bread rather than a half gallon
> and a loaf like today. This will happen by 2012 when the American
> economic system implodes yet again. Buy Brazilian reals and Indian
> Rupees in a non American bank.

Feb 14 04:03 AM

[thatguy57z:]

OK the depression was bad for all coming people. Now the 70's and the 80's where there any home foreclosure like it has been know, as far as I can remember there was no news of anyone losing there homes like to day.
So you know where headed down hill real fast to the wrist depression that man kind has ever seen, and there nothing the government can do to stop it other then keep blowing smoke up are a**.
Look at the stock market cant stables, the more the government prints more money the less the dollar is worth, its like the more you make of one thing the price drops,it kinda like coming sense, or open your eyes or smile the roses.

Feb 15 11:42 PM