At the start of the year, there were reasons for optimism that stocks had put in an important low on November 20. Those hopes have been dashed in recent weeks amid unrelenting day-after-day declines. All but a handful of market indexes have plunged to new bear market lows. The central issue remains the banking system - specifically the fear that the large banks are insolvent (i.e. that they lack the capital to deal with the loan losses that may be coming).
Even allowing for the enormous scope and complexity of the task of repairing our broken financial system, further complicated by a change of power in Washington, surely this period will be remembered as an example of how not to manage a systemic banking crisis. With our financial system in flames, consuming asset values and risking a catastrophic debt deflation trap, it is utterly exasperating to witness policymaking bogged down by politics, populist confusion/outrage, and logistical details, and the attention of our financial officials diverted by less pressing matters such as the development of ten-year budgets.
One can’t help but be depressed by the partisan spectacle that has unfolded in Washington D.C. Democratic policies intended to lift confidence seem to be having more of the opposite effect, because they are seen by too many to involve more social engineering and pork barrel spending than legitimate and equitable stimulus. And the Republicans, who presided over the financial sector and real estate bubbles, have re-discovered their long lost virtue of fiscal responsibility at the worst possible time (if there was ever a need for government to run temporary deficits, surely it is now). As a result of the financial and economic meltdown, consumer confidence as measured by the Conference Board is the lowest in the history of the survey (going back to 1967). The last thing Americans need right now is for their political parties and their media mouthpieces to revert to tired, ideological battles, but that is the situation in which we find ourselves.
The closest historical analogues to the price pattern of the current bear market can be found in the bear markets of 1973-1974 and 1937-1938. The accompanying charts overlay the price movements of the S&P 500 in the current bear market (shown in orange) with the price movements from these two historical analogues. No two bear markets and recessions are alike, but these two potential “roadmaps” give us a sense of how this bear market could evolve.
The 1937-1938 scenario, which unfortunately has been tracking most closely, is the bleaker of the two scenarios in that it projects a further drop of approximately 15% in the weeks ahead. The “good news” is that such a drop, if it occurs, and the analogue continues, would be followed by a 50% rally over the ensuing four months.
Potential Roadmap: 1937-1938
Even for investors who are firmly in the “secular bear” camp, and wish to raise cash levels, this would be a rally worth waiting for to get more defensive.
According to the 1973-1974 scenario, stocks have already experienced a greater percentage decline in this bear market, but the bottoming process may extend for a few more months to match the duration of the 1973-1974 bear market. Again, the lesson from that experience is that patience is warranted at this advanced stage of the game. After stocks bottomed in 1974, they appreciated 80% over the subsequent 18 months.
Potential Roadmap: 1973-1974
We don’t want to overdo the comparisons with these historical bear markets. The differences in the economic environments, policy responses, monetary conditions, and political environments vastly outweigh the similarities. However, mass psychology, which is a dominant driver in epic bear markets such as these, does manifest itself through stock market price patterns. Moreover, the crises in the 1973-1974 and 1937-1938 periods were every bit as severe as the crisis we are in today. The 1973-1974 crisis featured soaring inflation, record high interest rates, gasoline shortages, a war in the Middle East, a recession, and forced resignations of both the President and Vice President. The 1937-1938 crisis was characterized by a looming world war with Japan and Germany and a relapse into a seemingly insurmountable economic depression.