Lessons From Past Bear Market Bottoms

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The S&P 500 Index (NYSEARCA:SPY) tumbled 18 percent last week and closed at 899.22 Friday. The S&P 500 has fallen 42.5 percent since October 9, 2007. While the brutal one-year slide has some market watchers drawing comparisons to the bear market of 1973-74, the 1987 plunge, and even the 1929 crash that paved the way for the Great Depression, a larger percentage decline occurred much more recently. From March 24, 2000 to October 9, 2002, the S&P 500 fell 49 percent.

There are important differences between the market decline from 2000 to 2002 and the one today. The previous bear market occurred over two and a half years. It was more orderly and gradual. It was characterized as a painful grind lower. Although the media is reluctant to use the word, last week's action had all the characteristics of a crash.

Investor sentiment was different prior to the market top in 2000. At that time, a bubble in technology paved the way for the bear market. It had simply gotten out of hand. The higher prices rose, the louder the cheers.  The decline in shares prices that followed was an adjustment to the fundamentals in the equity market rather than a global macroeconomic problem.

The situation prior to the 2000 top is in many ways the polar opposite to what is happening today. At that time, many members of the financial media were providing fodder to the irrationality and speculative activity that led to the bubble. As share prices of America's leading technology sector surged, it was justified as the "new era" and the "new economy".  The collective euphoria pushed valuations to unsustainable levels.

When everything unraveled, Americans surely felt the impact in their 401Ks and other stock portfolios, but daily activity outside the stock market and the technology industry remained much the same. In fact, another bubble was developing in real estate and housing.

The latest bear has been global in nature and is now infecting equity markets everywhere. As contagion spreads like wildfire, equity markets in Asia and Europe are also reeling. Some are shutting down. To make matters worse, the trillions of lost wealth in retirement and college funds from falling stock prices comes after homeowners are also feeling the sting from declining real estate values.

Unlike previous years, borrowing is not an easy option. It's difficult to refinance or get home equity loan, which was a popular way to finance consumption in previous years. The unemployment rate in 2000 was near 4 percent. It has since moved up to 6.1 percent. There was a growing sense of despair due to the problems in housing, the credit markets, and economy before the recent stock market debacle, which was not the case when the tech bubble collapsed in 2000. At risk of stating the obvious, the problems facing the economy and investors seem much more daunting today than after the 49 percent drop in the S&P 500 during the previous bear market. 

On a brighter note, while the nature of the latest bear market is clearly like none other, it will end like all the others: i.e. when things seem the very darkest and investor sentiment has reached extreme levels of pessimism and negativity. At that time, the major publications will have headlines of gloom and doom. Even the bullish business talk show hosts, the ones that have been screaming "buy stocks!" throughout the entire market slide, turn bearish. Traders and brokers call in sick just to avoid seeing another day of red on their computer screens. The ordinary investor is dismayed and liquidating everything that has the slightest hint of risk.

Are we there yet? Has risk aversion reached such an extreme that investors have fully capitulated?

The 1,000-point intraday swing in the Dow Jones Industrial Average Friday capped off one of the most dramatic week's in stock market history. There is simply no precedent to last week's amazing market action. As a result, there are few guides as to what the future holds for the stock market because nobody has seen anything like it before.

Yet, if one holds a contrary-view of the markets and believes that the stock market is more likely to recover just when things seem the absolute darkest, one might also find solace in the fact that, by most objective measures, bearish sentiment and pessimism is higher today than after the bear market of 2000-2002.

For example, Investors Intelligence reports that, according to its surveys of investor attitudes, only 25.3 percent of those polled are bullish and 53 percent bearish. The American Association of Individual Investors reports its latest survey shows 31.47 bullish and 60.84 percent bearish.

According to these two surveys, bearish sentiment is substantially higher than in October 2002.  As I wrote on October 11, 2002 "Investor's Intelligence... shows only 31% bullish, compared to 38% the week before. ....Meanwhile, bullish sentiment as measured by the American Association of Individual Investors [AAII] plummeted to 28.8% compared to 35.2% [the week before] and bears surged to a yearly high of 54.8% from 47.9% the week before."

The CBOE Volatility Index (.VIX) is substantially higher now than in October 2002. At that time, the market's so-called "Fear Gauge" hit a high of 56.74. By way of comparison, VIX hit an intraday high of 76.94 and closed at record highs of 69.95 Friday. In addition, the NASDAQ Volatility Index (.VXN) was 64.38 at its peak in October 2002. VXN hit a high of 82.42 Friday. New highs in VXN suggest that risk perceptions towards the NASDAQ are actually higher today than after the 2000-2002 bear market, which was led by the large cap technology stocks that dominate the NASDAQ.

Finally, recent activity in the options market confirms that bearish sentiment is at extremes. Volume has been heavy, with a new record of 30 million contracts traded on September 18, 2008. Put activity has dominated recent trade. For example, on the Chicago Board Options Exchange [CBOE], which is the largest exchange for trading index and equity options, 5.05 million puts and 4.12 million calls traded Friday. Consequently, the put-to-call ratio (daily puts divided by calls) finished the day at 1.22. The ratio hit a 9-month high Monday when it rose to 1.52 and the ten-day average of this ratio (plotted below) is now 1.255 and its fourth highest levels ever. 

Figure 1: CBOE Put-to-Call Ratio (10-day Average)

In conclusion, the reasons for the bear market in 2008 are clearly different than the factors that caused the stock market slide from 2000 to 2002. The recent crash was part of a global debacle led by the financials rather than a market decline caused by an exploding tech sector bubble. However, all bear markets share one thing in common: they end when the majority of investors or "the crowd" has jumped ship--when pessimism has reached an extreme. So, contrary-minded investors might find some reassurance from the fact that the VIX, the sentiment surveys, and the overall action in the options market suggest that bearishness and pessimism has reached levels considerably higher than at the market bottom following the 49 percent decline in the S&P 500 from March 24, 2000 to October 9, 2002. 

Stock position: None.

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