Is the Market at a Bottom? A Historical Basis for the Market's Value (October 2008)

Last week Alan Greenspan spoke publicly, stating his shock at what happened to the banking system.  “Let the free market self regulate” was his mantra just a couple of years ago.  Because of massive deregulation, corruption and leverage, the global financial system is in a state that hasn’t been seen since the Great Depression.  Yet all the pundits, experts, and economists are shouting that we are at or near a market bottom.  The greatest deleveraging since the Great Depression and we are being told the bottom is near.

Sir Winston Churchill once said, “Those that don’t study the past are doomed to repeat it.”  In 1929, the market started its downward slide on September 3rd due to deleveraging from margin calls.  In 2007, the market started to decline on October 17th due to deleveraging on subprime mortgages and credit default swaps, which were far more leveraged than the 90% margin in 1929.  The deleveraging of Wall Street in 1929 started the first leg of the bear market, which dropped 47% in 2 months.  When the market started sliding on October 17th, 2007, the market lost about the same in 12 months even though the Federal Reserve and the US Treasury used every measure in their power to prop up the markets.  By November of 1929, the cry from the “experts” was “the bottom is now, it’s a great buying opportunity, and the market is on sale.”

Over the past year we have seen the market lose half of its value and we hear the same cries go out, “the market is cheap, so buy, buy, buy.” The bulls on Wall Street use the analogy of going to the store and buying goods at half price.  But is the market cheap?

Wall Street values the market based on its overall price to earnings ratio (P/E). A variety of studies show that buying the S&P 500 when it is trading on average below 9 times its earnings is considered a good buying opportunity.  If you buy the market over 21 times earnings it is considered overvalued.

As the price of a market goes down it is thought that the market price to earning ratio improves—the numerator is smaller and the denominator is the same.  However, if the earnings drop as the prices drop, the market is not getting cheaper.  The price to earnings multiples are still according to some analysts at about 16 times earnings, with the prices off 50%.  If the financial problems rollover into the general economy, which the evidence shows is happening, then earnings will drop lower.  Simply put, everybody knows what the “P” is in P/E but nobody really knows what the “E” is going to be. If the earnings keep getting smaller it will expand the price to earning ratios, not contract them.

In 1929 the market dropped 47% in the first two months of the bear market then rallied 48% in seven months as people poured money back into the market.  By April 17th of 1930, investors were feeling pretty good about where the markets had been and where they were going. Then the market turned south again, and by June 1932 it had lost 68% of its value. When the bear market finally ended, the cumulative market loss was 89%.

Presently, a lot of so-called experts are crying “buy, buy, buy”. In every bear market there is a level of optimism called a “bear trap” that rallies the market, encouraging investors to jump in right before the market turns south again.

When the new administration is determined in November there could be a level of exuberating optimism.  If history is a guide, the market could rally for a number of months.  But over the longer term the markets tend to lead what’s happening on Main Street, and Main Street is going to get a lot worse before it gets a lot better.  So be very careful jumping back into the market if you’re currently out, or not taking the opportunity to sell when the market bounces.  I say this because from where I sit, the markets are in the first leg of a long-term bear, and any rally right now is a trap.  A big grizzly bear trap.

*This article is not a recommendation to buy or sell and should not be considered investment advice. Please consult IPS or another financial advisor before making any investment decisions.