It's lonely at the bottom

Now that the major global market indices are all near or below their November lows, we’re hearing the pundits predicting ever lower market bottoms. Calls for “Dow 5,000” have become common, and there was even an article in today’s Wall St. Journal talking about this possibility. Jim Cramer, the chair-throwing investment guru on CNBC, did his own calculation and estimated that a “worst-case scenario” could bring the Dow down to 5320 (got to admire his precision).

Obviously, all of these numbers are total guesses, as there’s just no way to know where the market will go in the near term. But investors continue to sell nonetheless, concerned that stocks may still be far away from a bottom. The bulk of these sellers during the current downturn, as opposed to last fall, appear to be individual investors, who redeemed $71.2 billion from mutual funds in the 4 weeks ended March 4. While this is down from the record $137.9 billion withdrawn last October, it represents an historically huge number and a marked increase from December and January.

Meanwhile, institutional investors, including hedge funds, have dramatically curtailed their selling of equities since the fall. And many institutions and professional investors are buying stocks. Warren Buffett, the wealthiest man in the world (earned entirely through a lifetime of investing) went “all-in” to stocks with his personal fortune last October, and has been putting Berkshire Hathaway’s huge cash hoard to work recently. Peter Lynch, legendary manager of the Magellan Fund during its heyday, remains fully invested in equities. Marty Whitman of Third Avenue Value Fund is buying the deep value stocks that he loves (and that have been getting especially creamed recently). Even George Soros, one of the granddaddies of hedge fund management who publicly remains quite negative, has been seen recently buying $billions in stocks for his Quantum Fund.

All the the investors mentioned above have stellar track records going back 30 years or more. Why would these people, and others like them, be buying, while the general public is selling? Do they know something the average investor does not? History tells us that they do, as the bottom of every prior bear market has been accompanied by heavy individual selling, while insiders and pros start buying or at least stand pat. I know that this one will be no different, but knowing this does not help me identify the date or the level of the market’s bottom.

At the risk of wasting my time and yours, I will take my own stab at where the bottom of this bear might be. Although many analysts have tried to use valuations to do so, bear markets at this stage are driven primarily by sentiment (i.e., fear) and the need (or desire) for cash, not by a cold analysis of stocks’ value. Valuation analysis is, however, useful in determining whether one is at a propitious long-term entry point; we will examine this in a subsequent email.

One might, however, be able to look at prior bear markets to get an idea of where the bottom might be. At its current level, the Dow Jones Industrial average is 13.8% below its low of the previous bear market in 2002. It turns out there have been only 2 prior bear markets in the past 120 years when this has happened, that a bear market low is below the level set in the previous bear market: 1974 and 1932. In 1974, after that brutal 2-year bear market, the Dow was 8.5% below the price reached at the bottom of the bear market in 1970. At the market’s historic bottom in 1932, the Dow was 35% below the low reached in the prior bear market in 1921.

Using this particular metric, the Dow could bottom during the current bear market anywhere between 4,935 and 6,628. The index is now slightly below the higher number. So on a very simplistic level, if you think things now are about as bad as they were during the darkest days of the 1970’s, then the bottom should be right around here. If you think the economy will get as bad as it did during the Great Depression, then we’re talking about another 24.6% drop. Or maybe somewhere in between.

But the above analysis is actually severely lacking in at least one respect, as it looks at price only, and does not take dividends or inflation into account. Including both of these factors, and going beyond the Dow to the more inclusive S&P 500 index, the US stock market actually returned 57.6% from June 1921 until June 1932 (11 years). This is obviously very different from a –35% drop. In the 4.3 years from June 1970 to October 1974, stocks actually lost –22.8%, showing the effects of high and rising inflation. Today, on this basis, stocks have returned –16.9% since October 2002. Using this approach, then, it seems that the worst-case bottom should be another 7.1% below today’s close.

In reality, the numbers above are just guesses as well, and not supported by financial theory. But it’s interesting that very different approaches yield a fairly narrow range of results. Either the bottom is right around where we are, or it’s between 7% and 24% lower. Either way, with the S&P 500 already –57.1% below its 2007 high, the lion’s share of the drop certainly seems to be behind us.

I don’t know whether the above is encouraging or discouraging. But either way, it’s really the wrong question to ask (after all that, you say!). The near-term market bottom is not only unknowable, it’s irrelevant to a long-term investor (at least from a rational point of view; emotions are an entirely different thing). What counts is where stocks will be in 5, 10, 20, even 30 years. That’s because stocks are a long-term investment by definition. Even an 85-year-old couple has a joint life expectancy of over 10 years, and a 65-year-old retired couple could easily see one spouse live for over 30 years. So don’t say you’re too old to look that far into the future.

So let’s look into the future by looking at the past. Review the graph below, which shows total return after inflation for the S&P 500 from 1871 through today. (Don’t worry about reading the dates.)



The squiggly blue line is the actual return from stocks, while the straight black one is a trend line that shows the average return over a period of nearly 140 years, including the recent bear market. Note that while actual stock returns have strayed both above and below the trend line at various times, they never stray that far before “reverting to the mean.” The greatest drops below the line were in 1920 and 1932. Stock returns remained moderately below the line from 1974 to 1987, as well as for most of the period from 1932 until 1954. But the reversion to the mean during these periods resulted in some fabulous bull markets.

Note where we are today: about the same distance below the line as we were in 1982. Unlike 1982, it took only months, not years, to get there. In 2000, we were well above the line, but the 2000–2003 bear market took us back to trend. The current bear market started with stocks only a little above trend, far less so than in 2000, the 1960’s or 1929.

Could we go further below the line, either in the short term or sometime down the road? Of course we could, and there’s no way to know. But the more important point is that sometime in the next decade or so, we should get back to trend, and possibly rise above it again, at least temporarily. This would result in abnormally high returns for stocks during that period.

To get an idea of what that future return might actually be, I extended the trend line for 13 years past June 2008, when the market most recently dipped below trend. I used 13 years because that’s how long it took the market to recover to trend after first falling below it at the end of 1973. If the market recovers more quickly that that, returns will be higher; if more slowly, returns would be lower.

The trend line return, by the way, is +6.61% per year (remember, this is after inflation). Real purchasing power doubles in about 11 years at this rate. Now, if we return to trend from here over the next 12 1/4 years, that implies an average annual return, after inflation, of +12.23%. At this rate, real purchasing power doubles in less than 7 years; after 12 1/4 years, your purchasing power would have increased over 4 times.

Could such an optimistic scenario come true? We obviously won’t know for sure until more than 12 years have passed. But total real returns of this magnitude are not out of line with prior bear market bottoms: comparable period returns were +12.31% after 1932, and +9.72% after 1974. As you can see, inflation was a great drag on returns during the latter period, even though during and after the Depression it took much longer (22 years vs. 13) for stock returns to revert to trend.

Although I don’t know for sure whether +12.23% will be close to the actual return experienced over the next decade or so, I am sure that the path will be anything but smooth. There will be great rallies and bull markets, as well as scary corrections and probably at least one bear market during this period. But the overall trend should be decisively up, and at a rate that is both historically high and better than most other investments (cash, bonds, commodities, real estate, etc.). The price one pays for this higher rate of return is more volatility, which on rare occasions reaches the crisis proportions we see today. But no crisis lasts forever.

One other thing I know by looking at the graph above is that the bear market of 2007–2009 will go down in history alongside the great bear market of 1929–1932 as one of the 2 worst ones in US history. We’ve had other severe bear markets, but none as sharp and brisk (or as scary) as these two. But a further examination of the graph might give one hope: the sharpest bear markets have historically been followed by the strongest rallies. This one should, too. Now if only I knew exactly when it will start!