Stock Markets: When Will the Bull Return?

This bear market is unusually hard to read, but signs point to more pain to come. Still, opportunities are emerging for the very long-term investor

The stock market is crashing—slowly, and in plain view of the people who count on it most. The 53% plunge in the Dow Jones industrials since October 2007 has wrecked the college- and retirement-savings plans of millions of investors. It has permanently lowered the long-term investment projections of private endowments and pension funds. It has sent corporate compensation experts scrambling to figure out how to reward top employees. All told, more than $10 trillion of stock market wealth has vanished, and with it the confidence that springs from financial security.

While 17 months may feel like an eternity, it could turn out merely to be a prequel. The questions on the minds of investors, money managers, and corporate executives are threefold: How much longer will the bear market last? How low will the averages go? And when might investors get their money back?

As Warren E. Buffett has said: "Beware of geeks bearing formulas." It's especially difficult to predict the direction of the markets these days because the most popular gauges, from price-earnings ratios to measures of investor "capitulation," have stopped working. The peculiar nature of this bear market limits the kit of useful tools to just a handful of bond market and business confidence indicators.

Those signals, along with interviews with financial historians, market strategists, and economists, point mostly to painful scenarios. Stocks don't seem likely to fall much more from here—but market turmoil could continue for months or even years. Worse, by the time the market revisits its highs, so many years are likely to have passed that many older people will have gotten out of stocks, missing out on the rebound. The flip side is that new money put into the stock market now will likely do comparatively well over the long term. That's welcome news for twentysomethings and executive compensation consultants, but perhaps not for soon-to-be retirees.


History can't provide as many clues to the market's direction as usual. That's because while most bear markets more or less track the business cycle, this one began with a broken financial system. That makes the current bear more like the one that snarled from 1929-32 than others of the past 100 years. But that analogy doesn't fit perfectly, either. "We have no good precedents to help us," says Peter L. Bernstein, a 90-year-old market essayist and financial historian who was a teenager during the Great Depression. "What's breathtaking is the rapidity of the decline and its breadth."

The market anxiety is especially high now because of the raging fire in the economy. "The next six to nine months are going to be awful," says Desmond Lachman of the American Enterprise Institute. Waves of corporate defaults, home foreclosures, bank failures, and job losses are still to come.

Of course, the stock market already knows that for the rest of 2009 the economy will be a "shambles," to use Buffett's recent description. Today's low share prices may well reflect that. The Dow Jones industrial average has already fallen through the 7,000 level predicted earlier this year by Nouriel Roubini, the New York University economist nicknamed Dr. Doom for daring in 2006 to foretell the credit calamity. That's right, even Dr. Doom was too optimistic.

If recent history were a reliable guide, it would be just about time for the bear to retreat to his den, which nowadays might include a flat-panel TV and leather chair bought at a foreclosure sale. The market's average decline during bear markets since the 1929 market crash is just 30%. What's more, those past bears lasted an average of 13 months, making this one look not just mean but old.

But this is no ordinary slump. Even the most basic market gauge, the price-earnings ratio, which measures a company's share price relative to the earnings it generates, is unreliable. Historically, the overall market has traded at prices that average 15 times earnings, ranging from roughly 8 during the worst bear markets to 25 or greater during bull runs.

At the start of the year, the market's p-e ratio was about 11, suggesting that stocks were already cheap and wouldn't drop much more. Instead, the Standard & Poor's (MHP)500-stock index fell 19% in January and February, the worst opening months on record.

Why did the p-e ratio get it so wrong? The "e" is plunging—by 18% in January and February alone, according to Thomson Reuters (TRI). As a result, even though the stock market has dropped, it hasn't gotten any cheaper relative to earnings. Sure, a lot of earnings vanished amid a fog of one-time charges that may say nothing about companies' future profit power. But analysts still aren't seeing through that fog; their earnings projections are more scattered than they've been in two decades. "You don't know what the 'e' is because the economy is in free fall," says Charles Biderman, CEO of TrimTabs Investment Research.

The credit bust has rendered other trusted market indicators useless—most notably monetary policy, or the Federal Reserve's raising or lowering of its benchmark interest rate. Before the current slump, the federal funds rate was a reliable indicator in all but one bear market since World War II, says James B. Stack, president of InvesTech Research and Stack Financial Management. When the economy slowed, the Fed began cutting rates to turn the business cycle back up. After the second cut came, investors stepped in to buy, anticipating higher corporate earnings. But the Fed has cut rates 10 times since August 2007, to essentially zero, and yet the economy and stock market keep sliding. "The Depression is the only parallel for the lack of effectiveness in monetary policy," says Stack. It is failing because too many borrowers don't want to borrow and too many lenders don't have the capital or courage to lend.

Measures of capitulation, Wall Street's term for the final moment of a sell-off when the last weak investors give up on stocks, aren't working, either. The idea is that once the wobbly players are out, the ones left are strong enough to bid up stocks. Bull runs begin during those moments. Market mavens try to track capitulation by parsing statistics from days of heavy selling and comparing the intensity of past routs. Many thought they saw capitulation last September, says Eric C. Bjorgen, senior analyst with the Leuthold Group in Minneapolis. "But then the market kept going down," says Bjorgen. "Extreme fear was not a good indicator." The gauges became even more bullish with the selling in November, after which the market rallied 24%. Then it fell again. Biderman of TrimTabs says that's because much of the selling was by hedge funds that had been using borrowed money, not a major factor in previous bear markets.

Another signal that's turned out to be misleading is "cash on the sidelines," or the funds in money market and bank savings accounts. In normal times, strategists could look with some confidence to money in these accounts as buying power that investors were holding back from the stock market. The greater the cash compared with the value of the overall market, the more impact it could make on stocks. In January the reading reached its highest levels since 1984, says Bjorgen. Even so, he's dubious. As long as investors are worried about their own incomes, he says, the money seems most likely to stay right where it is. TrimTabs' Biderman, who tracks how investors move their money among asset classes, says he doesn't see much chance of this cash flowing into stocks with the job and housing markets so weak. He figures investors have been taking more money out of stocks than they've been putting into their cash accounts. "Some people are being forced to sell stocks to eat," Biderman says. "They are certainly not going to buy Google (GOOG) here."

With the ordinary historical measures failing, experts are looking further back for clues.

During the Great Depression, the Dow plunged 89% from the 1929 crash to July 1932. Then it went through some big swings before losing 49% in 1937-38 as the economy tanked again. World War II, which grew in part out of financial stress around the globe, followed. The Dow didn't get back to its 1929 high until 1954.

Much, of course, has changed in the U.S. since the Great Crash. Back then Washington made major policy mistakes, such as erecting trade barriers and letting too many banks fail without protecting depositors. This time, with a couple of exceptions, the government hasn't blundered so, even though it hasn't yet solved the economy's many problems.

So this bear market likely won't rival that of the Great Depression. But the bear markets during other banking crises have been brutal in their own right. In a recent study of 21 such episodes from around the world, including ones from Spain in 1977, Sweden in 1991, and Thailand in 1997, professors Carmen M. Reinhart of the University of Maryland and Kenneth S. Rogoff of Harvard University found that stocks fell an average of 56%—the same loss the S&P 500 had suffered through Mar. 3. Those bear markets also tended to be agonizingly slow, taking an average of 3.4 years to reach bottom. "Everything is protracted," says Reinhart. "In the best-case scenario, you are looking at six years or longer" to return to past highs. Bad as that sounds, it would compare favorably with Japan, whose Nikkei index reached 38,900 in 1989 and now trades at around 7,200.

Of course, just because investors have lost money in stocks doesn't mean equities are a bad choice from this point onward. "Stocks can't make up for the past 10 years, but they can do extremely well from our current position," says Jeremy J. Siegel, author of Stocks for the Long Run and professor at the Wharton School of the University of Pennsylvania. Siegel says that while stock returns have fallen behind government bond returns over the past 20 years, history says that's almost certain to reverse. He's found only one 30-year period when stocks returned less than bonds, and that one ended in 1861. "That tells us that once you are down 50%, those who are in stock markets for 10 to 15 years will get much better returns," he says. Lately, government bond prices have run up, boosting the odds that stocks will be the better play in the future.

So where to look for signs of an incipient upturn? One logical place is the corporate debt market, which understands the economy's core problem firsthand. Eventually, the pace of new defaults on corporate bonds will slow, and bad debts will be reduced or erased in financial reorganizations and bankruptcies. When those things happen, the economy and stock market should breathe easier.

Some quants see little evidence of that happening yet. "We are looking at a 60% to 70% chance that this bear market is not over," says Robert D. Arnott, chairman of Research Affiliates, a Pasadena (Calif.) firm that manages $25 billion. Jeffrey E. Gundlach, chief investment officer of Los Angeles-based money manager TCW Group, says the junk-bond market, which often tracks the stock market, is headed for new lows.

Another critical factor is the health of the banking system. One measure to watch is banks' so-called net worth, or the difference between how much they owe and the value of their assets. Rebuilding the banking system's net worth will be monumentally difficult. "On average, this process takes about six years," says Joseph Mason, a banking professor at Louisiana State University who has studied past banking crises. So far, little has been accomplished—a big reason the stock market hasn't gotten up from its knees.


Government policy decisions could speed or slow the pace of rehabilitation for the banks and, in turn, the stock market. David A. Hendler, a New York-based bank analyst at CreditSights, says his job has shifted from financial analysis toward Washington analysis. Essentially, his task is to figure out how quickly the government will permit weak banks to consolidate. When investors believe they know which banks will survive, they'll buy their stocks.

The process is so critical to the stock market that Richard Bernstein, chief investment strategist at Merrill Lynch (BAC), is tracking six signposts for financial industry consolidation. Among them: the extent to which the government carves up and sells bad banks rather than buying into them to prop them up.

Other strategists are keeping a close eye on the people who really know what's happening in the economy: business leaders. Biderman says he'll know corporations are getting confident once they start buying back their own shares and acquiring other companies. Right now they show no such bravado. Announcements of share buybacks are down 90% from a year ago, leaving that market thermometer so cold the mercury is off the scale.

In the end, the timing of the bear's retreat will likely hinge on that great market imponderable: psychology. How investors feel has a lot to do with whether they start seeing mixed signals as proof of a glass half-full. "The [market] stress causes the analytical part of our brains to shut down, and that makes us hyperreactive to bad news," says Michael A. Ervolini, CEO of Cabot Research, a consultancy catering to institutional investors. People become convinced conditions are worse than rock-bottom bad, he says. Only after they see that they've overreacted can things improve: "We look for the market to start [saying] tomorrow will be brighter."

For now, pessimism is winning the day. In the worst-case scenario, bad debts will continue to weigh on borrowers and lenders, causing the economy to slow even more, which will erode incomes and push more borrowers over the edge. Economies and corporations around the globe will weaken and rattle investors and business executives even more. Such fears have prompted Ben McCoy, a 30-year-old software engineer, to swear off new stock investments. Instead, he's putting money into his own business ventures, such as writing software for real estate appraisers and a blog about personal finance called "With these investments, I feel like I have more control," he says.

More Ben McCoys could signal the stirrings of an upturn. A market bottom, says Merrill's Bernstein, "generally occurs when everyone thinks it will never happen. You want to hear people giving up on the stocks-for-the-long-run theme."

But something positive must draw investors back. George A. Akerlof, a Nobel prize-winning economist at the University of California at Berkeley and co-author of a new book, with Yale professor Robert J. Shiller, on the importance of sentiment in moving markets, says investors will have to be offered a new story they can believe to get them to buy again.

That new story likely involves corporate and consumer debts being reduced to what borrowers can pay, freeing them of past mistakes so that new money can be put to productive use. Banks resume lending, and the stock market bottoms, signaling that the recession will be over soon. Budding optimism reverses the vicious cycle of losses. A bull is born.

A more probable outcome is the one drawn from the narrow history of bear markets that grew out of financial crises. In it, the bear scenario continues to play out until the bull takes over, with more debt busts and government trial and error until things get set right again. That could mean two more years of bouncing around and then another six or so before the Dow is back above 14,000. Not long ago, such an outcome would have seemed unimaginably bleak. Given the other possibilities, it doesn't seem so bad now.

with Tara Kalwarski, Ben Levisohn, Amy Feldman, Peter Coy, and Mara Der Hovanesian in New York and Christopher Palmeri in Los Angeles

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