Thursday, May 29, 2008

Bear bottoms

One hears an awful lot about what bear market bottoms look like historically, and most of it tends to seem a bit silly to me. But the idea this Morgan Stanley analyst had to read all the WSJ copies surrounding a bear market bottom seems interesting. A couple of his points:
1. Valuations get very very low indeed. The cyclically-adjusted PE, aka the Shiller PE, represented by the latest price divided by the average earnings of the last 10 years, reaches 10 or even less at bear market bottoms, while Tobin’s Q, the price divided by the replacement value of assets (or price over net worth defined as assets minus liabilities), gets as low as 30% or less. These valuations are the biggest problem with today’s market, as the Shiller PE is more than twice that. Today’s message: Shiller PE is above 20 still, while true bear markets tend to end at less than 10 times. Equities are not cheap enough and need to decline by at least 50 percent.

2. Equities become cheap slowly. The average duration of bear markets has been 14 years, with the much more rapid 1929-32 episode, when equities went down 89%, the exception. Today’s message: we are in year 8 of a 14 year bear market.

3. Sentiment is not hugely negative at the bottom of the bear market. The popular myth that there are no bulls left at the bottom of the bear market is wrong. Many market commentators are correctly bullish right at the bottom of the bear market. Popular myth has it that talk of ‘equities are dead’ and ‘there is no future for equities’ should be widespread and are classic signals of the end of the bear market. This is far from the truth, it turns out. In related fashion, there is no climactic last and final sell-off on high volumes. Quite the contrary, the final slump is on lower and lower volumes. Subsequent higher volumes at higher levels confirm the bear market is over, with hindsight. Today’s message: do not take any ‘contrarian comfort’ from the fact that many people are quite bearish on the macro outlook, contrary to conventional wisdom, that is not a classical sign of a bear market trough.

4. Patience! Equities do trough during economic recessions, but they do not anticipate economic recovery by 6-9 months. The lead time is much shorter, and often equity and economic recoveries are coincident, and sometimes economies bottom before equities do so. Patience is key. Today’s message: indeed, this is consistent with our finding that one should be patient in bear markets as there is not much discounting of the upturn going on at the end of the bear market, after numerous failed rallies and false hopes.

7. There are some consistent early signs of economic improvement. The three best are the copper price bottoming out, auto sales improving (or at least getting less bad), and inventories being very low. Today’s message: the copper price has not even fallen yet, so we are far away from the bear market trough.

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