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Stocks continued their downward slide through the end of February and into March, reaching a new low for this bear market. In February, the S&P 500 Index declined 10.7% - the worst February since 1933. Stocks have fallen 43% in the last six months – the worst six month stretch since 1932. The S&P 500 Index is now at the same level that it was in October 1996.

The Great Recession

As can be noted from the previous statistics, most of the comparisons for recent stock market performance are from the Great Depression. This might lead many investors to believe that the current economic state is also similar to the Great Depression. However, while the economy is weak and further deterioration is likely, it is worthwhile to note that current economic conditions bear little resemblance to the Great Depression.

Gross domestic product (GDP) is considered to be the broadest measure of economic activity. During the Depression, GDP fell by 8.6% in 1930, 6.4% in 1931, and 13.0% in 1932. At the end of 1932, GDP was 26.5% below the 1929 level. Last week, the government reported that GDP contracted in the fourth quarter of 2008 by 1.6%, (6.2% annualized). While the current decline in GDP is steep, most economists expect the economy to hit bottom within the next two quarters. Of 52 economists surveyed by the Wall Street Journal in February, all but five are forecasting that GDP will turn positive by the fourth quarter of 2009.

During the Depression unemployment peaked in 1932 at 25.2%. Unemployment currently stands at 7.6% and is likely to rise further; however, most economists are predicting a peak unemployment rate of less than 10%.

There are many other differences between now and then. The existence of social security and unemployment benefits makes the current economy much more stable than that of the 1930’s. In addition, governments around the world are currently making a coordinated effort to stimulate the global economy through monetary and fiscal actions.

It seems that the stock market is behaving as if we are in another Great Depression, considering the steep fall in stock prices. At least for now, it appears that the current downturn will be severe, but nowhere near the magnitude of the Depression. As this fear subsides, stocks should begin to recover.

Are we looking at the Inverse of the Tech Bubble?

The following chart shows the performance of the S&P 500 Index since January 1981. The straight line on the chart depicts long-term equity performance of approximately 10% annualized returns. As can be noted, many times when the market moved significantly above the trend line, a correction followed.

The period from 1995 to 2000 included one of the strongest bull markets in history. It was propelled by a mania for technology stocks, the end of the cold war and the global spread of capitalism. In hindsight, it is apparent that the market became overvalued as investors overestimated earnings growth and underestimated risk.

In the same way that greed dominated investors’ attitudes in 2000, fear has been the overwhelming emotion over the past six months. Concern over a collapse of the global financial system and the possibility of another Great Depression has resulted in the worst stock market performance since the 1930’s. Considering the psychology of markets, it is quite possible that the pricing of stocks is as irrational today as it was in 2000.

S&P 500

click to enlarge

courtesy of Fidelity.com

Market Timing

The recent economic news has been overwhelmingly negative. Citicorp (NYSE:C) and AIG have required multiple bailouts. The big three auto makers are on the verge of collapse. In this environment, it might seem unlikely that stocks will recover anytime soon. With the market hitting new lows, investor sentiment is extremely negative.

Interestingly, the stock market will typically reach a bottom and turn higher before the economy turns upward. In other words, the market will begin to advance, while economic conditions are still declining. This is because investors will anticipate a recovery before economic improvement is clearly visible. S&P Equity Research noted that the market bottomed before the recession ended in nine of the last ten recessions. On average, a new bull market began four months before the end of a recession.

While it is likely that the market will begin its recovery before the economy does, it remains impossible to determine when this upturn will occur. Long-term investors that attempt to call a bottom must be right twice – getting out and getting back in. If someone decides to exit, does he get back in if the market falls another 5%, 10% or 20%? And what if it doesn’t fall further? Does he get back in after it rises 10% or 20%? If the investor waits for news to improve, the market will surely be higher at that point.

Warren Buffett is generally regarded as the world’s most successful investor. In Buffett’s current letter to Berkshire Hathaway shareholders, he notes that the S&P 500 has risen in 75% of the 44 years that he has been running Berkshire. He estimates that the market will be up by a similar percentage over the next 44 years, however, he acknowledges that he won’t be able to predict the winning and losing years in advance. Buffett also forecasted that “the economy will be in shambles throughout 2009 … but that conclusion does not tell us whether the stock market will rise or fall.” The truth regarding market timing is that no one can consistently predict the market’s short-term movements.

Although it is certainly painful to watch as the stock market makes new lows, I continue to believe that the economy and market will ultimately improve, and that the most probable way to fully participate in the eventual recovery is to stay invested.

Source: Searching for the Bottom