Over the past several months I have spent most of my time maintaining that tough times lay ahead and to become defensive. I have also been emphatic on ignoring Wall Street pundits who have been incredibly wrong in calling for a bottom in housing over the last several years, then in financials and the broad market, saying that subprime real estate was contained, maintaining the whole “decoupling” mantra, and denying that we are in a recession. The pundits have capitulated in calling a bottom in housing, some have capitulated in calling a bottom in financials, though many are still trying to call a bottom in the stock market.

I too have capitulated! I was so sickened but the bottom calls that I finally turned off CNBC in my office in utter disgust by anchors and guest appearances and the “Goldilocks” foolish espoused by Larry Kudlow and his guests. Most of the July and August WrapUps were devoted to keeping readers from believing the nonsense that July marked a bottom, and to keep readers from jumping headlong into the markets. To get a sense of how wrong the pundits have been, take a look at the article headlines from Don Luskin who appears frequently on Larry Kudlow’s show and their timeline with the S&P 500 over the last year and a half (Click for Luskin article archive ). I don’t mean to pick on any one individual in particular; it’s just that Mr. Luskin’s calls are easily researched and reflective of financial pundits in general.

I still maintain that the markets will not bottom until next year and that the current recession we are in will likely not end until the second half of 2009. A brief explanation of these views from last week’s article is given below:

So there you have it. Credit markets remain frozen, the Federal Reserve is dropping B-52 dollar bombs (devaluing our currency), household net worth is declining, incomes are falling, and jobs are being lost to the tune of over a half million year-to-date. The economic tanker is clearly in recessionary waters that will not be calming until at least next year. What the Federal Reserve and government do from here will decide the depth and duration of the current recession but make no mistake, an economic recovery will not take place until next year as the economy will not turn on a dime.

As such, any market bounce produced from reaction to the bailout legislation passing or some other government action will fade as quarterly earnings misses (losses), job losses, rising unemployment, and falling consumption reports come in. SELL STRENGTH!

I have had a very pessimistic tone over the last few months and have likely depressed many readers. The chief reason was to help protect reader’s capital by staying out of the markets and using rallies to exit if one was still invested. Today’s WrapUp will be a bit more balanced as I will show that we are still not at “THE” bottom but rather at or near “A” bottom, as well as show the light at the end of the tunnel. Central banks are now acting in a coordinated fashion by lowering interest rates globally, and the markets crashing over the past two weeks means that we are likely at or near an intermediate-term bottom in the markets. Nothing goes down or up indefinitely as the 2000-2003 bear market showed us with several double-digit counter trend rallies, and we are due for one now as the current sell off is long in the tooth.

While we are overdue for a corrective bounce we still have not seen the end to the current bear market. Valuations are still not near lows seen in previous bear markets, and historical intermarket timelines and relationships show that a bottom in the markets in the here and now is far too early relative to the state of the economy to be signaling “THE” bottom. Market participants would be looking past a very long and dark valley indeed if this is to be the bottom.

Valuations Still Too High

In a late August WrapUp (The Worst is Yet to Come ) I showed how analyst estimates for the S&P 500 were far too high and likely to fall significantly as corporate profit margins still remain near historical highs and with analyst accuracy near 16 year lows (Analysts’ Accuracy on U.S. Profits Worst in 16 Years ). As such, I have looked at previous bear market bottoms (using 15%+ to define a bear market) and used the trailing price-to-earnings ratio (PE) using the previous twelve months of earnings rather than the leading PE ratio that uses suspect forward analyst earnings estimates. A table of the bear market (15%+) corrections and the PE lows are given below.

*Average excludes 2002 market PE low, which bottomed in 2007 at 17.12

As the table above illustrates, with a current PE ratio of 18.83 we can hardly be close to a bottom where the average excluding the 2002 bear market lows is 11.87, hence why I say we are not yet at “THE” bottom in the S&P 500. We are currently at the long term average PE ratio for the S&P 500 though markets tend to shoot on the underside of averages during corrections. Graphically as shown below, the S&P 500 PE ratio using either the long term average or long term trend shows we still have a ways to go before the carnage is truly over.

Source: Standard & Poor’s

Source: Standard & Poor’s

Another way to show that we are still in overvalued territory is to look at the dividend yield of the S&P 500. The long term average dividend yield for the S&P 500 is 3.59%, with September’s end of month yield of 2.45% much closer relative to the paltry 1.8% yield seen at the market’s peak last year. Again, while we are currently closer to the long term average dividend yield, markets typically over and undershoot averages and so we are likely to see a dividend yield north of 4% before the final bottom is in.

Source: Standard & Poor’s

Source: Standard & Poor’s

Historical Cycles

Not only do valuations point to a final bottom months out, so too does the historical precedent of the stock market’s bottom in relation to economic variables. I believe the economy is entering deeper into a recession that is not likely to end until next year as multiple economic variables show below. For instance, the year-over-year (YOY) rate of change in nonfarm employment typically peaks 15 months prior to the onset of a recession and bottoms two months AFTER a recession has ended. With the employment YOY rate of change still plunging it is not likely that the recession is to end any time soon.

Source: BLS/ U.S. Census Bureau

Another major leading economic indicator is housing. Housing (residential fixed investment) peaks on average 44 months ahead of a recession and bottoms four months prior to the end of a recession. With residential fixed investment still falling we have at least another four months before the recession ends.

Note: Assumed the 1980 and 1981 double dip recessions as one long continuous recession to calculate the average.

Another housing indicator that is great in gauging the end to a recession is to see an improvement of the internals for housing, specifically the ratio of home sales relative to commercial bank real estate delinquency rates. This ratio measures both housing demand and market credit conditions in terms of delinquency rates. In the previous two recessions the ratio has bottomed two months prior to the end of the recession and the YOY rate of change in the ratio bottoms 2-4 months prior to the end of a recession. The consistency in this metric over the last two recessions makes it a great leading indicator as to the end of the current recession. A “V-Spike” in the YOY rate of change in this ratio will likely signal the end of the recession. As of yet there is no spike in the ratio with the current YOY rate close to -80%.

If the recession is not likely to end until next year, looking at the relationship between stock market bottoms and recession conclusions will show that it is too soon for a current bottom in the stock market. It is common knowledge that the markets serve as discounting mechanisms and so stock markets typically peak prior to the onset of a recession and bottom prior to a recession’s end. Over the last forty years, the S&P 500 has peaked six months prior to the onset of a recession and bottoms five months prior to a recession’s end. The market has followed the historical average by peaking six months prior to the current unofficial recession that is likely to have started in January of this year.

As seen in the table above, the stock market typically bottoms five months in advance of the end of a recession. A market bottom in October would be discounting an end to the current unofficial recession in March of 2009, which I believe is highly unlikely. Fiscal policy typically has a significant lag (1-4 quarters) as does monetary policy, though monetary policy typically has a smaller lag before the effects are felt in the economy. The current Shock-and-Awe policy by the Fed and Whitehouse will take time to play out in the current environment as the credit excesses built up over the last three decades unwind. All of which leads me to believe the recession won’t end until the 3rd or 4th quarter of 2009, and based on the relationships above would signal a stock market bottom some time in the 1st or 2nd quarter of next year, likely at much lower prices.

The Light at the End of the Tunnel

If I am correct that we are near an intermediate bottom in the stock market, and that the stock market is not likely to bottom until the first half of next year, then all is not lost. Bear market counter-trend rallies typically lead to double-digit advances that can allow investors to sell into to regain some of their capital that has been lost over the prior months. Raising cash and sitting tight until next year should allow one to enter into the market at much discounted prices and experience a rally off the conclusion to a bear market, which are typically explosive.

I’ve compared the current environment to the 1973-1974 recession in a previous WrapUp (Déjà vu? Let’s Hope Not! ), using it as my working model. The 1973-1974 bear market in the S&P 500 saw a 42% correction, not far off to our current 37.5% correction which appears accelerated relative to the 73-74 example. The S&P 500 advanced 24% in twelve months after the September 1974 bottom and 55% after two years. Using the average monthly price, the S&P 500 was up 37% in twelve months off the February 2003 lows.

Source: Standard & Poor’s

Figure 10

Source: Standard & Poor’s

Selling into an intermediate corrective bounce should help investors regain some of the capital that has been lost recently. I believe sitting tight until reinvesting in an eventual market bottom next year will go a long way in returning an investor’s capital back to pre 2008 levels, more so if one invests in tomorrow’s best bargains. Going forward, the above mentioned economic indicators that typically herald an end to recessions will be monitored closely. New developments over the course of the remainder of the year will help fine tune my forward estimates for the likely outcome in 2009. Stay tuned.