S&P's chief investment strategist says a bear-market bottom may already be in place—and tells why 2009 could be a better year for stocks
From Standard & Poor's Equity ResearchExcerpted from a report published by Standard & Poor's Equity Research Services on Dec. 22
Investors will remember 2008 as a year of change. Not just change in the White House, but also the pocket change that they used to call their portfolios.
Let's face it. This bear market started as the perfect storm of popping bubbles—commodities, emerging markets, hedge funds, and real estate. From Oct. 9, 2007 through Nov. 20, 2008, the S&P 500 declined 52%, making it the third-worst bear market since the 1929-32 crash. One of the more amazing characteristics of this decline was its speed. The average "mega-meltdown," or bear market decline of more than 40%, traditionally took 21 months to play out. This one took 13 months.
Not surprisingly, all 10 sectors within the "500" fell, from a 22% slump for Consumer Staples to a 74% thrashing for the Financials. Finally, 125 of the 128 subindustries in the S&P 500 declined.
Factors Backing a Bottom
Where do we go from here? Probably not lower, in our opinion. A few months ago, I wrote that 700 on the "500" might be a worst-case scenario for a decline, citing the trendline drawn off of the 1932 low, the average bear-market retracement of prior bull market advances, and the applying of a bear market P/E ratio on a conservative "top-down" EPS estimate. We got close to that level, as the S&P 500 closed at 752 on Nov. 20. Since then, it rose 21%—technically signaling the start of a new bull market. So I say why quibble? What's 50 points among friends? Besides, we believe there are several reasons that a bear-market bottom may already be in place.
The magnitude of the decline is one of the reasons I believe a bear-market low may have been put in place. The 52% decline is within earshot of the 54% falloff recorded in the 1937-38 bear market—the second worst since 1929. Only if you believe the 89% decline recorded from 1929-32 will be challenged should you stop reading any further.
If the year had ended on Nov. 28, when the S&P 500 had recorded a 40% year-to-date decline, it would have been the second-worst calendar year since 1900; 1931 was worse at minus 47%. What's more, the S&P 500 fell by more than 20% eight times since 1900. It rose in six of the subsequent years, posting an average advance of 10.4% in all occasions. You have to look to 1931 and 1932 for the exceptions.
This bear market retraced 103% of the advance during the 2002-07 bull market. Traditionally, bear markets retrace an average 73% of prior bull-market gains. And those that retrace more than 60% of the prior bull run have taken back an average 110%. The current 103% retracement is close enough, in my opinion, to call it a wrap.
At the 752 level, the S&P 500 was trading at a P/E ratio on trailing operating earnings per share (EPS) of 11.5 times, equal to the lowest operating P/E ratio in the 20 years that S&P has been tracking operating results. It is also a 40% discount to the average operating P/E ratio of 19.3 times since 1988. (In prior years, the Street looked only at GAAP or "as reported" EPS).
Finally, on Dec. 8, the S&P 500 closed at 909.70, or 20.9% above the Nov. 20 closing low of 752.44. Technically, that's a new bull market. Even though I would prefer to see this level successfully retested before admitting that we are in the beginning of a new bull market, history indicates that only once since World War II (September 2001-January 2002) did the S&P 500 experience a bear-market rise in excess of 20% that was subsequently followed by an even lower low. All other 20% advances were eventually proven to have been the ultimate bear-market low. Again, you have to go back to the 1930s to find exceptions to this rule.
Of course, these are unprecedented times and the rules are being rewritten every day. In all, however, I believe the abundance of positive precedents will likely serve as a healthy dose of virtual Valium.
A New Bull Historically Charges Out
S&P's Investment Policy Committee has a yearend 2008 target of 850 for the S&P 500, indicating a full-year projected decline of 42%. Our 2009 target of 1025, however, anticipates a 20% gain. Why such an optimistic advance? Actually, by historical standards, it's fairly conservative.
This is the 16th bear market since 1929. Its more-than-50% decline makes it the worst bear since 1945, and the third worst since 1929. But when this bear market finally ends, history says be prepared for a fast and furious partial recovery. In the first 40 days after establishing a bear-market bottom, the S&P 500 has traditionally recovered an average 33% of the point loss experienced during the just-ended bear market. In this case, that would point to an initial rally from the 752 level on the "500" to around 1020 before the market gives us a second chance to get back in. Historically, in the 20 days following the initial bounce off of the bear-market low, the S&P 500 has retested the prior low by falling 7% from the recovery high. An average retest would imply a decline to the 950 level. Be prepared for an even deeper retest, however, as declines from recovery highs following mega-meltdowns (bear markets of -45%+) have averaged 13%, which would imply 888 on the "500."
Should Nov. 20 end up being the low for this bear market, we believe 2009 may end up being a fairly good year for stock returns, if history is any guide. During the first year of a new bull market since 1932, the S&P 500 rose an average 46%. What's more, the "500" recovered more than 82% of the prior bear market's loss, on average, in that first year. I can't guarantee that the market will respond the same way this time around, but successful investors look at history—and history points to a sharp advance in the first year of a new bull market.