Bear Market In Its Final Stages?

Bear markets exhibit a process of risk subsiding over time as excesses are corrected, valuations improve, and pessimism builds. This bear market is now roughly a year old, and signs are appearing that it may be in its final stages. September and October are historically the two most difficult months for the stock market, and the additional uncertainties surrounding the election may prevent stocks from gaining much traction in the near term, but evidence is accumulating that it is appropriate to begin to look forward to a healthier market environment. The damage inflicted during the 2007/2008 global equity bear market has been severe and typical of the extent of bear market losses historically.

On a peak-to-trough basis, the S&P 500 declined 22.4%. Broad-based foreign stock indexes, which outperformed during the preceding bull market, have declined over 30%. Formerly high flying markets such as China and India have suffered huge drops in excess of 50%. These declines have taken their usual toll on investor fortitude and behavior.

The latest asset allocation survey from the American Association of Individual Investors shows that the average investor is holding 32% cash, the second highest level since the depths of the 2002/2003 bear market. Assets in money market funds, expressed as a percentage of the market capitalization of the S&P 500, are at the highest level in 24 years. Net redemptions from U.S. focused equity mutual funds are on track to set a record in 2008.

These statistics reflect deep-seated pessimism, which is bullish from a contrary opinion standpoint, and reveal a great deal of potential buying power when investors eventually, and inevitably, begin allocating money back to stocks. In addition to the public’s exodus from stocks over the past year, equity valuations have fallen to a level that suggests the downside risk is not much below current levels.

Relative to longterm, trendline earnings (smoothed for the fluctuations of the business cycle), S&P 500 valuations are the most attractive since the bear market lows in early 2003. Another shorthand means of gauging the limited downside risk in the S&P 500 is to take the price low from the 2002/2003 bear market and grow it at a 6% annual rate, which approximates the long-term rate of growth in earnings. The S&P 500 bottomed at 800 in the last bear market. Six years of 6% compounded growth from this base yields a level of approximately 1150, 7% below current levels. Foreign stocks, which have fallen over 20% in just the past three months, and appear very “sold out,” are even cheaper. Based on an equally weighted average of price-to-book and price-to-cash flow multiples, foreign stocks (developed and emerging markets) are trading at a 25% discount to the broad U.S. stock market.

Despite the inability of the major indexes to sustain a dynamic rally since the mid-July panic lows, there have been significant and constructive sector rotations in recent weeks. Financial and consumer discretionary stocks, the groups that have been hardest hit in this bear market, have been among the best performing areas since the mid-July lows. Conversely, energy and materials stocks have been among the weakest groups, reflecting the sharp decline in commodity prices. The strong likelihood that the commodity inflation cycle has peaked for at least the balance of 2008 provides important relief for consumers, whose spending is under pressure from falling net worth and a weak employment market.

The principal risk confronting the stock market is that the recession could turn out to be deeper and more protracted than is currently discounted by the stock market. However, the stock market almost invariably turns up before the economy, on average about 60% into the timeline of a recession. So even if the economy does not begin to improve until the first or second quarter of 2009, we are now in the period where the stock market may be making its final bottom, given that the economic contraction started in the fourth quarter of 2007.

Alongside a firming in stock prices and an improvement in credit market conditions, we will be watching for an upturn in the Economic Cycle Research Institute’s [ECRI] leading economic index for confirmation that the stock market has decisively bottomed and can sustain a rally as it looks ahead to a business cycle recovery.  

Comments

[irondoor91:]

The stock market is the perfect reflection of the people's mood. When that changes, it will begin to show up in the averages. Check out mutual fund cash politions, dividend yield, a/d line, etc. The banks are loaded with under-performing real estate that is about to get even worse. We are just beginning to enter the worst phases of the economic downturn. The reasons for individuals and businesses accumulation of cash is obvious: They are going to need it.

2008 Sep 07 04:20 PM

[SW Richmond:]

One in ten mortgages is late or in foreclosure. We're in a bear market, but according to government statistics that use 1.9% as the annual inflation rate, the economy is still growing and we're not in a recession.

Good luck with your bottom call.

2008 Sep 07 04:42 PM

[TheRealBull:]

With all the government bailouts, the real headline should say, "Inflationary Market in Beginning Stages."

2008 Sep 07 07:25 PM

[FreddieBoy:]

The S & P was equal to 60% of US GDP in 1996 before this stock market madness started. It is now 88% of GDP. We could drop alot further before this market is a "value". I still see too much bullishness. The financials and Realestate shares are up BIG time in early pre-trade today on the US takeover of FNMA. This is NOT good news ! FNMA was $68 in the last 52 weeks and is now ZERO. We are in a sH$D storm. This is not good news.

2008 Sep 07 08:33 PM

[Canuck Econ...:]

No way Joseh! You have just gone through the stimulative government checks which your govt timed slightly ahead of the election. You have lost half a million jobs and there will be more to come now that the stimulative package has gone by. Your government cannot afford to keep spending and will be forced by financial markets to either cut expenditures or increase taxes.

Just like one would expect a stimulative package pre-election you should expect the tough medicine just after one. I think this is not the time to go buy stocks; it is time to be prudent. The mood does not look good from where I stand, investors will figure out that they need to crop their riskier bets. I don't know about you, but I will wait to see a solid panic sell-off.

2008 Sep 07 09:33 PM

[David Martin:]

Once the Framie debacle unwinds, and the realisation dawns that housing cannot recover with present earnings/price ratios but in the process the credit worthiness of the Treasury has been trashed, interest rates will rise, unemployment soar and house prices fall still further to go with a stock market crash.
A massive transfer of wealth to the banking sector has been carried out, and the cost is the financial stability of the US Treasury.

2008 Sep 08 09:35 AM

[Schweizer:]

The charts suggest a 600-800 SP500 is coming, based on a H&S topping pattern.

The fundamentals suggest a 600-800 SP500 is coming based on $50 in earnings and a "bottoming" 12 PE.

2008 Sep 08 09:46 AM

[Ricard:]

Great article and discussion. Must agree that the current mood certainly supports a contrarian bull call. However, strangely enough, I don't see that mood translated into deeply bearish territory for the S&P 500.

The foreign stocks you mention probably are ripe for the picking, but I'm not so sure about US stocks. If you can find a path to growth and profitability in the US markets, then great, but that path is full of thickets - oil, housing, debt. None of those look set to improve in the foreseeable future. I suppose that may lend credence to your argument that once that path is seen, it will be too late to invest, as the bandwagon would have already left the station. Tough call - good luck!

2008 Sep 08 10:16 PM

[Kunst:]

"The principal risk confronting the stock market is that the recession could turn out to be deeper and more protracted than is currently discounted by the stock market."

Ya think?

2008 Sep 13 06:57 PM