October 12, 2008

A History of Stock Market Bottoms

Recent market turmoil has many wondering when the freefall will cease, and whether we are on the brink of a new Great Depression, which is supposed to happen every 70-80 years according to Kondratieff Wave theory. I don’t believe we are on the brink of a depression, even though the present recession is already in its 10th month. But it would be instructive to compare the current situation with prior market corrections, and judge the present situation in a historical context.

We can first start with a chart of the S&P500, from 1950 to today. We can see that the deepest deviations from the trendline appear to be in 1950, 1970, 1974, 1982, 1987, 1990, and 2002. We shall term these instances as historical ‘bottoms’ for the stock market. All but the 1987 bottom were in the midst of economic recessions.

From this chart, we can see that the time period between bottoms can be irregular, with over a decade passing between them, in some cases. 1974 and 1982 appear to be the deepest corrections. These bottoms coincide with recessions, but interestingly do not coincide with other major crises. The Cuban Missile Crisis, Kennedy assassination, and 9/11/01 did not induce major market crashes beyond the first few days. Now, we can take the datapoints of each of these bottoms, and chart the exponential trendline that connects them. This is purely a chart of index valuation, with dividends not included.

From this chart. we can see that the equivalent value of the S&P500 in 2008, as designated by the red circle, would be around the 1000 level. As of October 10, 2008, the S&P500 is at 899, or 10% below the level of the bottoms trendline. However, we can see that both the 1974 and 1982 bottoms are substantially below the trendline.

The S&P500, since 1950, has delivered an 11.4% average return, with 7.7% of that in the form of a rise in the index itself, and 3.7% of the return being in the form of dividends. If the long-term underlying growth rate of the index is 7.7%, we can chart a 7.7% compounded projection trend from each of these bottoms as another method to compare them to an approximate 2008 equivalent. We shall start this chart from 1970.

It is apparent that 4 of the 6 bottoms cluster around a 2008 projection of 1100-1200, but the two deepest bottoms of 1974 and 1982 project to a 2008 equivalent of only 700-750. These should be considered the two ‘mega-bottoms’ that happen a couple times per half-century, with the other 4 being only smaller bottoms that happen every 7-10 years, whenever there is a recession.

Since we are presently at 900 for the S&P500, we are about half-way between a smaller bottom and a mega-bottom. Therefore, do not be surprised if the S&P500 does, in fact, dip into the low 700s in 2009, merely to match this correction to 1974/1982 levels. This would be a further 20% correction from the 900 close of October 10, 2008. It may not happen, but it certainly could in terms of historical precedent. This also means that the Dow Jones Industrial Average would simultaneously decline to as low as 6500. Indeed, there is no guarantee that it could not go even lower, but that would he historically unprecedented. Even the 1932 bottom in the Great Depression was not deeper than the 1974 and 1982 bottoms, by these measures.

The Good News :

If the thought of a further 20% decline in the S&P500 or DJIA is depressing, also consider the following :

1) After both the 1974 and 1982 mega-bottoms, the stock market promptly returned at least 60% in the next 9 months. This also happened after the 1932 bottom within the Great Depression.

2) Never forget about dividend reinvestment. Dividend yields are highest when the stock market is at the depths of a bottom, and reinvestment ensures that new shares are purchased at the lower prices. This enables the investor to enhance his returns when the recovery finally commences. Even in the 1970s, the major indices were stuck within a flat range for a decade, but dividend yields as high as 5% enabled total returns that were substantially better.

Considering points 1) and 2), make sure that you are in a position to capture the recovery, and are not forced to sell at the unfavorable prices of the bottom. This means that you must a) never hold any substantial margin debt, b) be positioned across a diversifed set of securities, preferably ETFs ahead of individual stocks, and c) watch as little financial news as possible, thereby reducing your chances of panic that could lead you to take ill-considered actions.

Tremendous profits will be made by those who can steel themselves through this purging of the weak, and are subsequently prepared for the post-bottom recovery. Put daily volatility aside, and enjoy the historical times that we are experiencing first-hand.