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Last week brought about an interesting turn of events; the Russell 2000 Value Index dropped below 20% from its recent peak set in May of 2007. Typically, a 20% drop in an index is one definition of a “Bear Market”. I guess this should be no surprise since Value Indexes as a whole tend to have a proportionately higher percentage of financial stocks than Core Indexes such as the Russell 2000 or the S&P500.

With the Financial and Consumer Discretionary sectors down over 30% from their highs, and together comprising close to 50% of the Russell 2000 Value Index, the relative decline of the Value Indexes is easily understood and amplified in small caps. But now that the Bear has officially arrived, the bigger question is how long it will be here.

To answer this question I took a look at the past two economic cycles to see if there were any similarities. The last two Bear Markets in the Russell 2000 Value occurred in 1998 and 2002. The duration from peak to trough was four months and six months, respectively. In each cycle the Russell 2000 lost just over 30% before rebounding. In 1998, the less severe and shorter of the two cycles, the gain one year after the bottom was about 18%. In 2002, the slightly deeper and longer of the downturns, the gain one year after the bottom was about 55%. Currently, the Russell 2000 Value has dropped approximately 23%. We are in the eighth month of the decline, longer than either of the two recent declines, yet still less severe than either of them.

The hardest part, of course, is interpreting historical information and its relationship to where we are today. To do this we most look at each of the situations in their relative context. In broad terms, 1998 was caused by a financial shock that was corrected in relatively short order via aggressive action by the Fed and positive prevailing market conditions (the internet, Y2K…). In 2002, the problems were more systemic and had to do with overvaluation and excesses that had been built up in the system, which explains why it was longer and more severe. What we are experiencing in 2008 is again systemic, as shown by the longer duration of our downturn. We have not had as severe of a downturn, which may suggest there is still some potential downside, but as in any case it will be difficult to pick the bottom. The upside is, when we do hit the bottom, and based on recent cycles this may be soon, one year out the Russell 2000 Value will probably be significantly higher.

Of course the wall of worry folks out there are going to say, "yes, but what if we enter an extended Bear Market because of the mess the financial markets are in?" This is a legitimate concern when the markets are in free fall. The problem is, it is probably emotionally driven. Let’s look at the facts. Most Bear Markets where steep declines are persistent have a few things in common: excessive valuations, hawkish Fed policy, and excessive bullish sentiment. Currently, market valuations are at a 10 year low. Earnings yields on stocks versus bonds are pointing investors to equity exposure. The Fed is not hawkish, but they are not dovish either; this will probably have to change.

Up until recently, Fed action has been focused on unlocking the credit markets and providing assurance to investors that they are watching economic growth numbers, while still concerned about inflation. I predict that in the next month the Fed will begin to shift policy towards focusing on improving economic conditions rather than unlocking credit markets. This will be a major shift in mindset that will welcomed by the markets.

The hardest part will be letting go of inflationary fears, but this will have to come for a fewreasons. One, most recessionary environments are accompanied by deflation, not inflation.Two, inflation is being driven by commodity prices, which the Fed cannot influence by rate policy. And finally investor sentiment. Unfortunately, most investors’ emotions tend to be a good contra-indicator. Right now the AAII, the largest retail investor network, and the Hulbert Stock Newsletter Stock Sentiment Index, both indicate that investors are excessively bearish, both having bullish sentiment of less than 30%. Sure, the economic numbers that are rolling in every day look bleak, but keep in mind when looking at ISM or Unemployment that many of these are lagging indicators and may be indicating a market bottom. They will probably continue to show weakness and drive sentiment downward until we get significant shift in policy from the Fed.

This commentary wouldn’t be complete without brief discussion on the U.S dollar. This may be another driving factor in a small cap recovery in the coming months. Currently, Europe is slowing faster than we are, but the ECB continues to be hawkish. This will probably change in 2008, and when it does so will the slide in the U.S dollar. At the point when the ECB turns its stance and the U.S dollar begins to gain on the euro, money will begin to flow out of large cap multinationals, who will no longer be receiving the advantage of global growth and currency exposure, back into small caps. I don’t expect this will play out until mid-year, but it is another reason to keep an eye on the Russell 2000 Value as a place to rotate allocations into soon.

Source: The Markets Have Spoken: They Say 'Bear'