4/28/09
S&P 500: 855
Nasdaq: 1674
10 Year Treasury: 3.0%
David R. Snyder, CFA
Most investors are not impressed with the 29% gain in the Standard & Poor’s 500 Index (S&P 500) from the March 9 low. The consensus is that the sharp rebound in the stock market is just another bear market rally. After all since this bear market began 18 months ago, we have had no fewer than five 10% or more rallies that failed. Two of these rallies did reach 20% but burned out soon thereafter. So why should this rally be any different?
The logical answer is based on the law of probabilities. The economy and the stock market have a long term trend of rising. Therefore, the more the economy and the stock market fall below their respective long term trend lines, the more likely they are to reverse their short term declines. There are no valid arguments that the economy and the stock market are not well below their long term means. Capacity utilization is at 77 year lows (70%), while the S&P 500 at its March low was trading near all-time lows of seven times normalized earnings. A priori, each succeeding rally that starts from a lower value during this bear market has a better chance of becoming a new bull market than the prior rally.
There are a myriad of specific reasons why the most recent stock market rally is more likely to be the start of a new bull market than prior rallies. The analysis is divided into technical and fundamental factors. We will begin with a discussion of the technical factors.
The most significant technical event that occurred was a cumulative advance/decline ratio over the 10 day trading period of March 10 to March 24 of more than two to one combined with 90% upside volume on five of the 10 days. No prior bear market rally has even come close to reaching these ratios. Each of these events by itself is very positive but when achieved simultaneously it is even more powerful. Stock market guru Marty Zweig receives credit for publicizing the advance/decline and the upside volume indicators. His research reveals that whenever the cumulative advance/decline ratio exceeds two over a 10 day period, the stock market has always been higher three, six and 12 months later with an average six month gain of 22% for the S&P 500. It is a rare event occurring once every three years on average.
The five 90% upside volume days within 10 days is a NYSE record going back to 1940. The up/down volume ratio was an astonishing 42 on March 24. Historically when there are two or more 90% upside volume days within a three month period without any intervening 90% downside volume days, the S&P 500 was higher three, six, and twelve months later with an average gain of 27% over the next 12 months. Even adjusting for the increased volatility of the stock market in recent years, the five days of 90% upside volume are so strong that they still should have the same influence as in the past.
Another positive technical event that occurred for the first time in this bear market was three straight days of up issue ratio above 60% on the NYSE (March 10-12) after the stock market hit a new 52 week low (March 9). This was followed by a strong rally over the next four days (March13-18). According to Jason Goepfert of Sundai Capital Research, this sequence of events has only occurred six times in the last 70 years and five out of six marked the end of bear markets with two signaling the end of secular bear markets (1949, 1982). The lone exception was 10/18/46 when the stock market reached an intermediate term bottom but retraced much of the gain one year later. However, the stock market never made more than a marginal new low over the next couple of years. All dates are listed below with their three month gains. The average gain for 12 months was 28%.
Date 3 months later
10/18/46 3.1%
03/05/49 0.0%
10/18/66 9.1%
06/04/70 4.7%
03/15/78 11.6%
08/23/82 18.0%
Average 7.7%
Why are these short time periods of seven to 10 days so predictive of major turns in the stock market for the next year or longer? The reason is that in bear markets investors are so nervous that they use any rallies to sell, especially big short term rebounds of a few days, which are a hallmark of bear market rallies. To sustain a very strong rally for seven to 10 trading days without any bouts of selling is not possible during a bear market.
When the stock market made its recent bottom on March 9th, it marked the 40th consecutive day that less than 1% of all stocks traded on the NYSE hit new highs. According to Jason Goepfert, since 1965 there have been five other times when the streak reached 40 days or longer. All five occurred near the end of bear markets, either days before or days after the ultimate bottom was in place. The dates and 12 month returns are shown below.
Date 12 months later
10/11/66 28.6%
06/11/70 35.2%
08/09/74 6.4%
12/04/87 21.4%
10/02/90 23.5%
Average: 23.0%
The recent stock market bottom on March 9 was the 288th consecutive day without a rally of more than 80 days, the fourth longest since 1928 according to Jason Goepfert. Because the stock market made a new low on March 9, this streak of consecutive days without an 80 day rally will have to extend to at least 368 days. This will make it the second longest streak since 1928, exceeded only by the 429 day streak ending January 1975. The three other dates that reached 288 consecutive days were 8/27/32, 7/8/74 and 5/19/78. The stock market bottomed a month before the 288th day in 1932. In 1974, the stock market declined another three months before bottoming while in 1978 the stock market had reached a bottom two months before the 288th day.
The S&P 500’s intra-day low of 666 on March 9 happens to be very close to coinciding with a Fibonacci 61.8% retracement of the bottoms formed in 1974 and 1982, which would be in the 640-660 range. This is a very important technical level because it extends the trend line support through both a secular bull and bear market.
Another very significant technical threshold was reached in the third week of April when the S&P 500 closed 25% higher than its low close in early March. Since World War II, there has never been a bear market rally of 25% or more within a three month time period. There have been numerous bear market rallies of between 20 and 25% including three of them during the 2000-2002 bear market and one during the recent bear market. Whenever the stock market has rallied 25% or more within a three month period, it has always signaled that a new bull market was underway. Also every new bull market has begun with at least a 25% gain within a three and one-half month period from the bottom. In fact the safest nine month period to invest is after the stock market has increased more than 25% within a three and one-half month time period. The average nine month gain after this event has been 21% with none under 10% since World War II.
The stock market advanced six consecutive weeks after falling to a new 52 week low. When this has happened in the past the average 12 month return is 22% with over 90% of the data points yielding positive 12 month returns.
One of my favorite technical indicators is the simplified Rydex ratio, which simply compares the assets in the bullish Nova fund to the total assets of the bullish and bearish (Ursa) funds. This is not just a sentiment indicator, because it measures actual cash investments in bullish and bearish funds. This ratio dropped below 10% in early March to match the lowest reading since the funds began in 1994. According to Don Hays, when this ratio has dropped to 10% or below in the past, the forward 12 month return average is 27% and the forward 24 month period average is a 22% annual compound rate of return. Out of over 20 data points there was never a negative 12 or 24 month return.
My favorite sentiment indicator is the American Association of Individual Investors (AAII) sentiment survey. It has the best correlation with stock market bottoms and tops. On March 5 the bearish sentiment reached 70.3%, and the bullish sentiment dropped to only 18.9%. This is a record reading on this indicator, the most bearish ever before in its 21 year history, well below the reading when the stock market made its bottom last November 20. The previous low week was a 67% bearish reading on 10/19/90, which marked the bottom of that bear market. Similar to today, the 1990 bear market was caused by a financial crisis that took extreme sentiment readings to end the panic.
Individual investors are backing up their record negative sentiment with their actions. According to the AAII survey in early March, individual investors for the first time ever have more money allocated to cash (45%) than stocks (41%),
In synch with the AAII data, the Conference Board Consumer Confidence survey fell to record low levels in March, significantly below the readings of last November when the stock market bounced off its prior low.
Not to be out done, Wall Street strategists recommended asset allocation in early March was only 51% equities and an amazing 45% bonds at the likely peak of the bond bubble. At he end of March 80% of traders believed the recent bounce in the stock market was a bear market rally. Over 50% of hedge fund managers predict that the stock market is either going to retest the March lows or decline to new lows.
Money market funds now exceed eight trillion dollars up from five trillion dollars in 2005, while savings accounts and money market funds now are at a record 110% of the S&P 500 stock market capitalization. Stock mutual funds at the recent stock market bottom were holding 1.1% more cash than is normal to meet redemptions, substantially higher than at the November lows. According to Jason Goepfert, when the mutual fund surplus has exceeded 1.1% in the past, the S&P 500 has averaged a 17% gain over the next 12 months with 16 out of 18 instances resulting in positive returns. The equity market has the potential to explode if all this money sitting on the sidelines earning less than one or two percent comes back into the stock market.
During the last financial crisis in 1990, the financial stocks lost over two-thirds of their value. They had their biggest percentage decline in the last month of the bear market and were the last sector to bottom. The financials then became the leaders in the ensuing bull market. In the last down cycle of this bear market from early January through early March, the banking sector experienced its biggest two month percentage decline (60%) of the entire bear market and experienced its worst relative underperformance. The fact that the bank stocks are the last to bottom is only logical. They were the first to fall and were the cause of the financial crisis, so the stock market squeezed every last ounce of optimism out of the sector before finally capitulating in early March.
NYSE volume usually peaks at stock market bottoms. In the bear market from October of 2007 through March of 2009, NYSE volume actually peaked at the bottom of a stock market correction in August 2007, before the bear market actually began. Each succeeding bear market rally that fizzled proceeded to a new stock market low, but was accompanied by lower NYSE volume. These successive lower lows in NYSE volume reveal a long bottoming process and now the peaks in NYSE at short term bottoms are the same as in a normal stock market environment. Thus the healing process is complete.
The ratio of Nasdaq/NYSE volume is another sentiment indicator that is useful in pinpointing stock market bottoms. This ratio reveals how much risk investors are willing to bear. The higher the ratio the more speculation is in the market. As the end of the bear market approaches, bear market rallies should peak with lower Nasdaq/NYSE volume ratios as speculative juices are wrung out. The last bear market rally from late November through early January was the first bear market rally where the Nasdaq/NYSE volume ratio did not reach a sell signal of 1.9 before the rally ended (the peak was 1.6).
The dollar volume in pink sheets is another indicator of speculation in the stock market. In February the total dollar volume in pink sheet stocks reached at least a 15 year record low at only $511 million, down from $28 billion in March 2000 and over $10 billion in 2006. It is also about 25% lower than at the November stock market low. These numbers may be revealing not only a cyclical low but a secular low in the stock market.
The total put/call ratio and the equity put/call ratios are two of the best technical indicators because they are more than just sentiment indicators. They measure actual put and call option buying by investors. These are contrary indicators with stock market bottoms coinciding with high put/call ratios. The 15 day moving average total put/call ratio required to form a short term bottom in the stock market reached its highest reading of 130 in February of 2007, just over two years before the likely ultimate bear market bottom in early March 2009. This ratio since February 2007 then peaked at lower highs for each succeeding short term stock market bottom. A reading of only 95 (versus 130 in February of 2007) on this ratio was required for the stock market to form a bottom in early March. The total put/call ratio was likely predicting an intermediate term stock market bottom two years in advance. Symmetrically, the 15 day moving average total put /call ratio required to make a short term top in the stock market bottomed at its highest level in July of 2007 at 90, almost two years before the intermediate term stock market likely bottomed in March of 2009. Since July of 2007, this ratio has bottomed at lower lows with each succeeding short term stock market top (bigger declines needed in the total put/call ratio). The January top required a bigger decline to 83. It appears that the total put /call ratio was forecasting an intermediate stock market bottom two years before it occurred.
The equity put/call ratio has formed a pattern similar to the total put/call ratio. The 15 day moving average equity put/call ratio needed to make a short term stock market bottom reached its highest level of 95 in March of 2008, one year before the likely intermediate term stock market bottom. Since March of 2008, this ratio peaked at lower highs for each succeeding short term stock market bottom. The rally that began in March only required a reading of 80 to make a short term bottom in the stock market. This ratio appears to have forecast an intermediate term stock market bottom a year in advance. Symmetrically, the 15 day moving average equity put/call ratio needed to form a short term stock market top bottomed at its highest level of 70 in September of 2008, six months before the likely intermediate term bottom in the stock market. Since September of 2008 this ratio has bottomed at lower levels (bigger declines needed in the equity put/call ratio) with each succeeding short term stock market top. The January top required a decline to 67.
Historically, peaks and troughs in the total put/call and the equity put/call ratios correlate inversely with intermediate stock market bottoms and tops. However in the current stock market cycle, these ratios appear to have peaked and bottomed one to two years before the intermediate stock market top and bottom.
There are some put/call ratios that are following historical patterns. The OEX put/call ratio is known as the smart money ratio because these professional traders are usually on the right side of a trade. Therefore this ratio is actually positively correlated with the future direction of the stock market. Thus high call option buying and low equity put/call ratios are bullish for the stock market. As the stock market bottomed in early March this ratio reached a record low, well below the reading at the November lows. The open interest OEX put/call ratio has also been near record levels recently.
The volatility index (VIX) measures volatility in the stock market which correlates highly with fear in the stock market. Intermediate stock market bottoms usually occur when the VIX reaches its highest levels. However in this bear market the VIX reached its highest levels of 92 last October but the stock market declined to significant new lows last November and March of this year with lower VIX readings. The good news is that since the October high, the VIX has been setting lower highs and lower lows with each succeeding short term stock market cycle. If this pattern continues it is very unlikely the stock market would continue to make new lows in the future.
Since the early October low, the stock market has made two new significant lows in November and in March but the number of new 52 week lows on the NYSE has declined sequentially at each of these lows. This is certainly a net positive because it reflects that market breadth is no longer deteriorating at successive new lows. However it is not quite as good an indicator as the consensus believes. For example, there were fewer new 52 week lows when the stock market reached a significant new low in March of 2008 than at the short term bottom in late January 2008. The stock market then declined to a much lower level later in the year accompanied by substantially higher new 52 week lows.
The lack of deteriorating breadth is also evident in the world stock markets. At the early March stock market low in the US, only one out of three stock markets worldwide declined to new lows. At the November low, more than three out of four stock markets worldwide fell to new lows. Because world stock markets are highly correlated in bear markets, the recent lack of correlation is a significant positive development.
The S&P 500 at its March low of 666 was at a lower level than 13 years ago in 1996. Since the early 1930’s this has happened only two other times. In December of 1974 the S&P 500 was lower than it had been 13 years earlier in December 1961. In June of 1949, the S&P 500 was at a lower level than in June of 1936. The good news is that in each of these time frames it did not extend beyond 13 years and the stock market began a roaring bull market soon thereafter.
The S&P 500 has declined for six consecutive quarters which has only occurred one other time since World War II. That was the period ending in the second quarter of 1970. The S&P 500 then advanced 15.9% in the third quarter of 1970 and gained 62% over the next ten quarters.
Many pundits are comparing the 2007-2009 bear market with the 1937-38 bear market. Both had nearly 50% declines within a six month period after the first year of their respective bear markets. The technical pattern of the final six months of the 1937-38 bear market looks very similar to the October 2008 through March of 2009 chart. The 1938 stock market bottom was followed by a 19% 12 day rally, similar to the 22% 12 day rally after the March 9, 2009 stock market bottom. If the 1938 pattern continues, the stock market should consolidate for the following 60 days before rallying an additional 30% this summer. I don’t put much credence in the similar chart patterns except that the 1938 chart proves that a similar technical pattern can form a bottom.
Another positive development is the pending changes in short selling rules. Short sellers have used illegal naked short selling to help depress financial stocks. Also, allowing stocks to be sold short on a downtick has created unprecedented fear in the marketplace. When short selling of financials was abolished last summer, financial stocks performed well. Fear is a much stronger emotion than greed, and when investors panic, the short selling rules exacerbate this fear.
The technical price pattern of gold is also indicating the bear market has ended. Gold has been considered a safe haven throughout the recent bear market but it has been losing its shine recently. In fact, the chart of gold is just plain ugly. After a long increase well above its long term trend line from 2001 through 2008, gold has made a triple top at $1000 per ounce over the last year. From 1800 through 2000 the price of gold has appreciated at the rate of inflation with spikes above and collapses below this trend line. Since then it has increased for eight straight years and is well above its mean. Adjusting for inflation the price of gold should be around $480 per ounce. Reversion to the mean is one of the only principles that has always prevailed in the long term. The recent topping formation in the price of gold simultaneous with the rally in the stock and high yield markets is very bullish for the financial markets. Gold has been an anti-stock market play over the last 18 months, but that trade is over.
Many skeptics will not be impressed with the above technical analysis. They argue that many of these contrary technical indicators should be at record levels because the stock market declined at record percentage rates (with the exception of the Depression). And if the stock market continues to decline these technical indicators will continue to fall to new record levels. While this argument has some merit for a few of the contrary technical indicators, remember that many of these did not reach record levels until the last stock market downturn earlier this year. Also, many of these technical indicators are at such extreme levels, it would be difficult to become any more extreme. Finally, the high upside volume and advance/decline ratios within a 10 day period are historically bullish for the stock market regardless of the steepness of the prior decline in the stock market.
The stock market surged so dramatically over the last six weeks (29%) that many short term technical indicators have flashed sell signals. In fact many of these technical indicators are now at the high end of the range where bear market rallies have fizzled out. Some have even broken out from their downward sloping channels, creating even more concern.
The problem with technical analysis is that bull and bear markets have different ranges for certain technical indicators. In a bear market a contrary technical indicator can trade in a certain short term range with the high end signaling a sell signal and the low end signaling a buy signal. However this short term range could be still at the low end of the long term range. If the stock market is shifting from a bear to a bull market then the high end of the short term range will no longer be a sell signal and a breakout of that range on the upside would actually be a positive for the stock market. This is what is likely happening now. For example, during the recent bear market whenever the NYSE overbought/oversold indicator reached an overbought level of 40, the bear market rally ended. However historically extreme short term overbought levels above 80 have been very bullish for stocks over the next three, six, and 12 months. Last week this indicator had been above 80 for three days in a row.
Investors have been conditioned to sell over the last 18 months when many of these technical indicators reach current levels. However based on other technical indicators discussed earlier, investors are making the wrong decision because we are undergoing a transformation from a bear to a bull market. Any sell-off should be mild and short term.
Despite record insider buying in February and March, recent insider selling has increased dramatically in April and the bears are publicizing this statistic. This is exactly what happened in the first two months of the 2003 bull market rally. With stocks this depressed it is only logical that insiders would sell on the first big run-up in their stock prices. It didn’t prevent the stock market in 2003 from climbing for 10 more months and it won’t prevent the current new bull market from advancing sharply over the next year.
Fundamentally there are also many factors that make the recent stock market rally more likely the start of a new bull market than prior bear market rallies. The most obvious are the stock market’s valuation and the percentage decline from the top. The S&P 500 bottomed on March 9 at a level 10% lower than the bottom on November 20, near record low valuations. The total percentage decline since October 2007 reached 54% with dividends reinvested which is a record since the Depression of 1929-32. Stocks at their low in early March were cheaper than at any time in the last 27 years. According to my calculations, the S&P 500 was trading at only seven times normalized earnings of $92 per share. This matches the valuations of June 1949, October 1974 and August 1982, the lowest of the last century other than the Depression. Normalized earnings are calculated by taking an earnings base in 1947 and then growing earnings in line with nominal GDP growth. An extra one percent per year growth was compounded since the early 1990’s because of the substitution of corporate stock buybacks for dividends since the early 1990’s. One-half of one percent growth was added to earnings over the last 10 years due to the increasing percentage of earnings from foreign countries (now 48%) where nominal GDP grows one percentage point faster than the US.
Many investors argue that corporate profits as a percentage of GDP were unsustainably high at the peak in 2007. My calculations adjust for this anomaly and just because this percentage was near its peak doesn’t mean it can’t stay in a high range as it did between 1950 and 1965. Even if earnings were to grow less than normal over the next ten years it would not prevent a major bull market. The 1950’s was one of the best decades for stock returns even though earnings growth was subpar.
The S&P 500 was valued at 1.2 times book value at its low on March 9. Although this was at the low end of the historical range, it was still above the levels of 1949, 1974, and 1982 when the S&P500 traded just below one times book value. Many believe that the S&P 500 will not bottom until it falls below book value which equates to the S&P 500 falling to the low 500’s. However, there are two main reasons why the stock market will likely not decline to below book value. First, the service sector of the economy has grown from 30% in the late 1970’s to 45% today while the manufactured goods sector has decreased from 35% to 25% of the economy during the same time period. Service companies trade at higher price/book value ratios because they have less volatility in earnings (due to lower fixed costs) than manufacturing companies. Second, since the late 1980’s stock buybacks by public companies have increased sharply. When corporations buy their own stock above book value it dilutes their book value. However, theoretically it doesn’t lower the value of the company if the stock is fairly valued at the time of the buyback. After adjusting for these factors, the price/book value ratio of the S&P 500 is very similar to the levels that prevailed at previous lows in 1974 and 1982.
The U.S. stock market at its March 9 low was valued at just over 50% of GDP, well below the 200% level reached in 2000 but still above the 30% level at the secular stock market bottom in 1982. However again American companies get a much bigger share of their profits from abroad than they did in 1982. Also the corporate sector’s share of GDP has increased sharply over the last 30 years and public companies have been gaining market share at the expense of private companies. Adjusting for these factors and the stock market capitalization is as low as a percentage of GDP as in 1982
The secular low in the current stock market should be at a higher valuation than the secular lows of 1949 and 1982 because tax rates and transaction costs are much lower. Even with the proposed higher taxes, tax rates are still well below the rates that prevailed 30 years ago. Because 50% of all money invested in the stock market is taxable, the lower taxes on capital gains and dividends should increase the valuation of the stock market since returns are measured on an after tax basis. The lower transaction costs lower trading costs which again enhances returns, increasing the value of equities. Also the unprecedented number of free markets throughout the world should increase long term global earnings growth, increasing the underlying value of global stock markets.
At the end of February the prior 10 year annual real rate of return for the S&P 500 was -6%, the worst on record. The worst 20 year real rate of return in the last 200 years was an annual gain of 1.1% per year. Therefore, for the 20 year period March 1999 through March 2019 to just match the worst 20 year record for real returns, the S&P 500 would have to return 7% annualized after inflation for the next 10 years. This would be above the long term average of 6 1/2% annualized real returns.
Not only was the 10 year period ending February 2009 the worst ever, but the 40 year period ending February 2009 (March 1969 through February 2009) was the second worst out of 545 rolling 40 year periods since 1900. Only the 40 year period ending December 1941 was worse, earning just 3.8% annualized real returns vs. 3.9% for the 40 year period ending in February 2009. The only other 40 year period that had annualized real returns of less than 4% ended in December 1942.
The good news is that in the past well above average 10 year annualized real returns have followed below average 10 year annualized real returns. According to Jeremy Siegel, the bottom quartile of rolling 10 year periods since 1870 was followed by 10 year periods of average annualized real returns of 8.2%. Similar 10 year superior returns have followed subpar 40 year periods. Below 4% annual compound real returns for 40 year periods were followed by 10 year periods of average annual compound real returns of 11.1%.
Value–Line has a well respected publication service that analyzes and rates over 2000 stocks. It also projects the average three to five year appreciation potential for all of the stocks it covers. Over the last 40 years these longer term projections have been extremely accurate. At the March 9 low in the stock market the Value Line service was projecting three to five year annual appreciation potential of 24%, the highest appreciation potential in its 42 year history other than August 1982 (25%) and the second half of 1974 (25 to 28%). Don Hays has adjusted the Value Line appreciation potential formula by subtracting core inflation from Value-Line’s appreciation potential. This formula attempts to measure real (adjusted for inflation) appreciation potential. At the March 9 bottom this adjusted three to five year annual appreciation potential reached a record level of 22%, eclipsing the previous record of 19% in 1974.
Long term government bonds have outperformed stocks over the last 20 years, but that has only happened in 5% of all the 20 year periods since 1870. There has never been a 30 year period when long term government bonds have outperformed stocks. Thus it is highly probable that stocks will outperform bonds over the next 10 years. Both T-bills and long term government bonds have recorded negative 40 year real returns (32% of the time for long term government bonds) while stocks have never had negative 40 year real returns.
Many pundits argue that the secular bear market for equities that began in March 2000 can’t be over nine years later in March 2009. According to these skeptics, secular bear markets last 15 to 20 years. The last two secular bear markets were 1965-1982 (17 years) and 1929-1949 (20 years). However this theory is not necessarily correct. The broader stock market actually recorded well above average real returns from the low of 1974 to the low of 1982. Even the S&P 500 averaged only slightly below historic average real returns during that period. Therefore a very good argument can be made that the secular bear market lasted only nine years from 1965 to 1974.
A similar argument can be made concerning the declared 1929-1949 secular bear market. The best time ever to invest in the stock market was July 1932, not July 1949. Real returns bottomed in 1932 but if an investor missed the first year or two of the new bull market, he experienced subpar real returns for the next six to 10 years. My own opinion is that the secular bear market ended in 1942, as above average real returns began a much steadier upward trend. Thus the secular bear market could easily be defined as from 1929 to 1932 (three years) or from 1929 to 1942 (13 years).
The determining factor for secular bull and bear markets should not be the length of years but valuations. If it only takes nine years to go from the top of the valuation range to the bottom, then the secular bear market is only nine years. The same is true of bull markets. For example the stock market increased over sixfold from 1921 to 1929 while rising from the bottom to the top end of the historic valuation range. This is more evidence against the theory that secular bull and bear markets are supposed to last 15 to 20 years.
In my opinion the secular bear market lasted nine years from March of 2000 to March of 2009 as valuations fell from extreme highs to extreme lows. The S&P 500 peaked in March 2000 at 30 times normalized earnings and then bottomed in March 2009 at seven times normalized earnings. Likewise, the price/book value ratio declined from over three in March 2000 to 1.2 in March 2009.
The most important fundamental reason behind my thesis that the bear market is over is the improvement in the credit markets since late November. Both the credit and stock markets bottomed in late November and surged through the first week of January. Then the stock market began a descent to new lows while the credit markets held on to half of their gains. In the past, the credit markets have been smarter than the equity market and often lead the stock market. After a 50% decline in the stock market, both the equity market and the credit markets bottomed in October of 2002 and advanced sharply into December. The stock market then declined into March of 2003 as we waited for the Iraq war to begin while the credit markets held their gains. The stock market then exploded in early March and increased over 45% in the next year simultaneous with strong credit market returns.
Technically the credit markets have never made an intermediate term bottom without the stock market making an intermediate term bottom within the next few months. It is difficult to believe that the credit markets did not make an intermediate term bottom in November because the high yield markets were discounting default rates of over 15% per year or a cumulative default rate of over 75% for the next ten years. These are preposterous levels of default. The worst one year default rate for high yield bonds was 13% and the long term average is around four or five percent. The same is true of the high grade bond market which at the November low was discounting a cumulative default rate of over 45% over the next 10 years. The worst ever 10 year default rate was 5%.
Fundamentally the recession needs to be over by July or August of this year in order for the March stock market low to hold. The stock market usually bottoms three to six months before the end of a recession. Is it possible for the recession to end by this summer? There are many indicators that are revealing that the worst may be over. The most significant indicator is the improvement in the credit markets which is highly correlated with subsequent improvements in the economy. Therefore if the gains in the credit markets since November continue to hold then the economy should start to show some improvements by the second quarter.
The biggest surprise so far this year has been the pickup in consumer spending. Real personal consumption expenditures are likely to increase at a one percent annual real rate in the first quarter after declining at a four percent annual real rate for each of the last two quarters. In turn final sales are likely to be only slightly negative for the first quarter. Business inventories have fallen sharply in the first two months of the year as sales increased, resulting in a dramatic decrease in the inventory/ sales ratio. The economy usually bottoms when the inventory/sales ratio peaks which likely occurred in December. Another big positive surprise has been the dramatic reduction in the trade deficit in the first quarter which will add to GDP growth. The aggregate hours worked index has not decreased much faster than the decline in payrolls since last September as the average workweek has remained stable. Productivity is likely to be positive this quarter as businesses adjust to the sudden decline in sales in the fourth quarter. All of these factors point to a decline in GDP that is less than the consensus estimates. However the make-up of the GDP report will be much better than the headline number as final sales likely decreased less than expected.
The big improvement in the underlying numbers in the economy in the first quarter is before any of the stimulus bill effects, which should begin impacting the economy in the second quarter. Despite the criticism of the stimulus bill, it will definitely have a positive effect on the economy. It is a good mix of tax cuts and spending. Independent surveys have revealed that the government has quickly awarded contracts. The total dollar amount represents over 2% of GDP per year over the next two years and a little less than that in the third year. Without a multiplier effect this should add almost 2.3% per year to GDP growth for each of the next two years. Therefore GDP should improve with each quarter, turning positive by the third quarter and gaining close to 3% in 2010.
There are other subtle signs of an improvement in the economy such as the decline in the number of banks tightening their lending standards over the last couple of months. New orders for the Institute for Supply Management Index (ISM Index) have risen sharply for the first three months of this year. And surveys of business plans for hiring reveal that businesses have completed most of their layoffs in the first part of this year. Although unemployment will likely continue to increase after the recession is over, the rate of increase should decline markedly.
Although the leading indicators have not turned positive, the rate of decline has slowed over the last four months. The year over year decline has bottomed while the year over year decline in the coincident indicators has continued to decrease. In the past this has been a better signal of the turn in the economy than the economic leading indicators by themselves.
There is also the theory that the economy is so bad that it can’t get any worse. For example, new home sales have declined 78% from their peak in 2005 and are now tracking at an annualized rate of just over 300,000 units. It is difficult to conceive how they can decline much more from current levels. Car sales have been running at a nine million annual rate this year, well below the annual scrap rate of 13 million.
The two main requisites for the economy to bottom are for oil and commodity prices to return to their long term trend lines and for mortgage rates to drop below 5%. Both objectives have been met.
After studying the data, it is my opinion that housing prices have no more than 10% downside risk. California home prices may have already reached their bottom while Florida has a little bit more downside.
The housing affordability index is at multi-decade highs. Existing home and new home sales appear to have stabilized at very low levels over the last couple of months.
Besides the stimulus bill, other government programs are having a positive effect on the credit markets and the economy. The government guarantee of short term debt issued by higher rated companies such as GE has saved billions of dollars of interest expense. The expansion of the Fed credit facility to riskier assets has increased liquidity in the credit markets. The most important program though is the recently created Term Asset Loan Facility (TALF). This trillion dollar program extends low interest loans from the government to investors of securitizations of assets ranging from auto to credit card loans. Contrary to conventional wisdom, the asset securitization market provides about 50% of the financing of corporate America while banks only provide 20%. While banks have only decreased their lending by a small percentage, the securitization market came to a complete halt last Fall.
The reversal of the mark to market accounting rules announced earlier this month is also extremely important for saving the financial system despite the vague nature of the rules change. The depth of the financial crisis would have been much less if the mark to market accounting rules had not been changed at the peak of the market in 2007.
The new program involving the government buying toxic assets from banks is not going to have any effect. Major banks have already commented that they have no interest in selling depressed assets with strong cash flow to the government at the bottom of the market without retaining upside in the asset. The massive buying of mortgage agency notes and 10 year Treasury bonds is a major positive for the housing market.
Comparisons of the current recession to the Depression of 1929-1932 or Japan in the 1990’s is way off the mark. Since the recession began in December of 2007, cumulative GDP decline has been positive compared with a 33% decline from 1929-1932. At the same length of time from when the respective recessions began, GDP cumulative decline was 14% in 1931 versus close to zero percent cumulative growth over the last 17 months. Policy decisions to increase interest rates and taxes as well as limiting free trade accelerated the deterioration in the economy in 1929-1932. Government spending as a percentage of GDP did not significantly increase until the latter half of 1932. The lack of government guarantee of bank deposits helped cause the failure of over 5000 banks. In 2008 only 25 banks failed. In fact the US government has only lost $40 billion in 2007-08 versus over $700 billion from the banking crisis in the late 1980’s (over $1 trillion adjusted for inflation).
Japan also made policy mistakes of raising interest rates at the initial stages of the decline and not spending the fiscal stimulus plans that were eventually passed. But most important, Japanese stocks were trading at over 100 times earnings and most companies (including banks) had substantial interlocking stock interests, compounding the decline in the stock market.
The better comparison is with the financial panic of 1907. Speculation was rampant as investors were able to bet on stocks that they didn’t own. The term “bucket shops” has its origins from that era. As these newly created financial instruments began to decline, the financial system collapsed and the stock market declined 45% over six months. New financial regulations were implemented to prevent recurrences (does this sound familiar). The stock market bottomed at the end of 1907 and then more than doubled over the next two years.
Financial panics are by definition short term and severe (remember the Asian financial crisis of 1998 and the US financial crisis of 1990). Financial panics become long term events only if policies are implemented that are counterproductive such as during the Depression. Panic created distorted valuations and as panic subsides and liquidity improves, stocks should rise even if fundamentals don’t improve in the short term.
The concerns over excessive consumer debt in the US are overblown. There is a strong correlation between interest rates and consumer debt. The lower the interest rate the more debt the consumer can service. There is also a correlation between consumer debt and assets. The more assets the consumer owns, the more debt he can afford. Therefore as interest rates declined dramatically over the last 28 years simultaneous with very strong asset appreciation, it is logical to expect increased debt levels. Granted consumers went overboard especially with housing. But the media has distorted the facts. Despite a significant increase in consumer debt, debt service payments as a percentage of disposable income has only increased to 14% from 12.5% in 1986. Everyone knows the savings rate formula understates savings by a significant amount, but its supporters omit this fact. Another myth is that credit card debt has ballooned over the last 10 years when it has only grown at a 3% annual compound rate. Most of the increase in debt over the last decade is mortgage related debt. Although many consumers overextended, the vast majority of this debt was a long term investment in their homes.
Consumer spending in the US is a cultural phenomenon, and it will not die. No doubt it will be more measured going forward, but it will persist.
Once again there is a consensus that when the economy recovers, it will grow much more slowly for many years ahead. This same consensus prevailed at the end of the 1990-91 and 2001 recessions. Yet the US economy grew at above average GDP rates in the 1990’s and the world economy grew at its fastest rate ever for five years after the 2001 recession. Other sectors such as capital spending may pick up the slack from slower consumer spending over the next few years. The US should have a strong rebound with above average growth in 2010.
The other consensus is that the inflation rate will accelerate over the next few years as a result of the massive expansion of money by the Fed and the big government spending programs. However past history reveals that after long disinflationary periods, it takes many years before inflation becomes a problem. Even under the most optimistic assumptions, the output gap will not close for several years. Until this gap is closed there will be very little inflationary pressure.
Much of the Fed’s balance sheet expansion is in the form of investments. As the economy recovers these investments will be liquidated, taking money out of the system. Also despite the Fed increasing reserves in the banking system, there has been no velocity of money. The economy will only recover when velocity picks up and then the Fed can drain the reserves.
Successful investing is just a game of probabilities. Throughout this article there have been numerous analyses explaining why the probability of this recent stock market rally being different than other bear market rallies is extremely high on both technical and fundamental grounds. The odds clearly favor this rally being the beginning of a new bull market.
How will this recent stock market rally progress? Although two out of three bear markets end with a retest of the initial low, we are very unlikely to have a retest of our March 9 low. This is because the US stock market has been building a long base since last October. Also once the S&P 500 rallies over 25% within a three month time frame, history shows that there usually isn’t even a 50% retracement of the first big upward move. Thus don’t expect a big pullback until the S&P 500 reaches the 930-40 level within the next two months. 870 -75 on the S&P 500 is only a minor resistance area with 940 representing a major resistance area. The S&P 500 should reach 1300 by next March which would be over 90% appreciation within one year.
The biggest mistake investors are likely to make is thinking that it is too late to get back in the stock market. Some of the financials will appreciate by double digit multiples from their lows. The stock market is not much more than half of what it was nine years ago! You are not too late! The bull market that began in August of 1982 increased over 45% in three months and over 80% in 10 months with no more than five to eight percent corrections along the way. The best is most likely yet to come.
The recent outbreak of the swine flu is not likely to have any major effect on the stock market or the economy. It is analogous to 2003 at the beginning of that bull market when SARS was a major epidemic in Asia. The virus became less of a threat in May as the stock market continued to rally. It is unlikely that the swine flu virus will continue to spread during the summer months. Thus the health authorities will have until next Fall to work on a vaccine or take other measures to prevent the spread during next year’s flu season.
The absurd stress test due to be released next week will likely not be an impediment to the bull market. Right on queue, the government will require some banks to raise capital just as their fortunes are turning for the better. One year from now we will observe how the government once again succumbed to panic and came up with the wrong solution at the wrong time. They will attempt to redeem themselves by giving these banks more time and more options than the market expects. The end of the uncertainty will be a positive for the financial markets.
S&P 500 earnings declining to below $50 per share (some estimates are as low as $40 per share) in 2009 from a peak of over $90 per share in the second quarter of 2007 should not prevent a bull market. The stock market always has its eye on normalized earnings especially if it believes a recovery is right around the corner. Normalized earnings are close to $92 per share in 2009. My own opinion is that S&P 500 operating earnings will not drop below $50 per share this year. First quarter earnings are already revealing that companies have adjusted to the new environment as earnings are coming in better than expected despite lower than expected sales. There will be plenty of operating leverage on the way back up as companies cost structures have quickly been cut to the bone.
The initial stage of the new bull market has been led by the financials and consumer discretionary sectors as well as debt –laden companies in all sectors that are likely to survive. These are the sectors that should be the market leaders coming out of a recession induced bear market. There is still significant liquidity discounts in financials and overleveraged companies that will dissipate as the financial markets recover. Commodities will have a nice bounce but will not be the leaders of the next bull market. The commodity boom of the last decade was a once in a generation event Prior bull market leaders never lead the next bull market. Oil is now in a long term bear market and we should see lower highs and lower lows over the next few economic cycles. The most likely leader of the next bull market on a longer term basis is likely to be technology but it will be difficult for any sector to outperform the financials from the stock market bottom because they became so depressed. The US should be one of the best performing stock markets over the next cycle as the dollar continues to strengthen. My favorite emerging market over the last two months has been China as it is benefiting from the decline in commodity prices.
Small-capitalization and value stocks always outperform large capitalization and growth stocks in the first year of a new bull market following a recession induced bear market.
What could go wrong with my thesis? The biggest risk to my forecast is that the improvement in the credit markets was just a head fake and the economy remains in recession past the middle of the year. Housing prices could fall more than the additional maximum of 10% projected. If the S&P 500 falls below 770 then the stock market is likely to decline to new lows.
In November of 2007 when the S&P 500 was above 1500 I made a forecast for a deep world recession and a major bear market that would last three years. I didn’t expect the overall stock market to decline this quickly or this severely. What was expected to occur in three years in the stock market happened in 17 months. I also didn’t expect the credit markets to reach these insane levels. Thus the major change in my view on the equity and credit markets is that they have already discounted the worst case scenario.
In conclusion, the probabilities are very high that a new bull market began on March 10. Despite the media devoting all their time to the doom and gloom pundits and the perma-bears, the outlook for the financial markets has never been better. If investors want to wait until the economy improves before going back into the market then they will miss most of the bull market.
This financial crisis was so severe that it took the mark of the beast to end it. The S&P 500 intra-day low for the bear market was 666, which is the mark of the beast according to King James Bible.
“And that no man might buy or sell, save he that had the mark, or the name of the beast, or the number of his name. Here is wisdom. Let him that hath understanding count the number of the beast: for it is the number of a man, and his number is Six hundred threescore and six.”
Full Disclosure: This is not an analyst report and merely represents the opinion of the author and not that of any investment firm. The contents of this report are based on sources believed to be reliable. It is not intended for circulation. This is not a solicitation or recommendation to buy or sell any securities. Your decision to buy or sell a security should be based upon your personal investment objectives and should be made only after evaluating the stock’s expected performance and risk.