A New World Record

As a brief aside before resuming the portfolio email series, I would like to answer a query I’ve received from more than a few people. In the midst of the most powerful stock market rally since 1933, many are still wondering, “How low can it go?” In other words, if March 9 was not the ultimate low for this bear market, what’s the worst that could happen if the bottom is ahead of us rather than behind?

As you know, I’ve often used history as a guide. In that context, I’ve said that 2008–2009 has been the second worst bear market ever, exceeded only by the one in 1929–1932. Using that massive decline as the model, if the economy today were to become as awful as it was in 1932 (highly unlikely), we could be looking at another drop of more than –50%. Scary, yes. But there are two big problems with this comparison.

The first is that the 1929–1932 bear market was unique in taking stocks from extremely overvalued to extremely undervalued in a single 3-year decline. Normally, this process takes 10 years or more. For example, during the “lost decade” prior to this one, stock valuations peaked in 1968 and did not bottom until 1982, a period of 14 years.

The most recent valuation peak was in March 2000. If March 2009 marked the valuation low for this cycle, then the process took a total of 9 years, faster than average but far less than in the 1930s. The 1929–1932 debacle was really 2 powerful bear markets combined into one, and thus should have been roughly twice as severe as this one or the recent 2000–2003 decline. On the basis of this analysis, the current decline could already be over.

There’s yet a second flaw in using the US market decline in 1929–1932 as a model. Like today, the financial and economic crisis of the 1930s was worldwide, starting in the US and subsequently spreading overseas. But the US suffered disproportionately back then, both in the scale of its stock market decline and in the depth of its depression. This time, the pain is spread relatively evenly, with economic and market declines of roughly similar magnitude in a large number of countries. Thus, a better comparison to today’s market would be a global stock index, specifically the MSCI World index of 23 developed countries.

A global comparison also makes sense because the US represents a much smaller proportion of worldwide GDP and stock market capitalization today than in the 1930s (even without counting the emerging markets that aren’t included in the MSCI World index). So on a global basis, how does today’s bear market compare with others?

Until February 27 of this year, the 1929–1932 bear market was still the worst in world history, with a –54% decline in the MSCI World index after inflation. But on that day, the world record was officially broken. By the time the decline hit bottom on March 9, 2009, the MSCI World index had dropped a stunning –57.8% from its peak on October 31, 2007. Those of us alive today can now say that we’ve lived through the most severe bear market in world history!

Based on this analysis, what does history tell us about the ultimate low? It at least suggests that we’ve already been there, having exceeded the previous record drop. There is no reason (at least on the basis of history) to believe that global stock markets need drop any more from here. The knowledge that we made market history in 2009 is simultaneously sobering and encouraging.

In sum, history supports the notion that we have seen the lows. Valuation analysis comes to the same conclusion (see my email of March 10, “Are stocks cheap yet?”), as does investor sentiment. So even though the bad news is far from over, and the market will continue to behave badly from time to time, the worst may finally be behind us. I’m actually starting to think 2009 will be the best year for stocks since 2003. We’ll know for sure in less than 9 months.