The consensus among many talking heads today is that this is just a suckers’ rally, that the market will soon resume its plunge, that you should get out while you still can. So is it time to buy?
For long-term investors, yes. With the exception of a few months in 2002-2003, Friday was likely the best time to add money to the stock market since the early 1990s. Even today, with a 500 point DOW rally, the S&P 500 is only just above fair value, so you’re less likely to get a crappy long-term return than you have for most of the past decade.
In support of this thesis, Goldman provides two encouraging charts. The first maps 10-year rolling returns and shows awful decades like the one we’ve just had are usually followed by much better ones. The second shows that the market finally dipped below fair value for the first time since the early 1990s.
But isn’t it possible that the market will crater from here?
Yes. The most likely scenario, in our opinion, is that the market falls another 10%-20% or so from Friday’s low, for an overall decline of 50%+. And, yes, it’s possible that it could be much worse than that. Specifically, here are two examples that shouldn’t be ignored.
- Great Depression: S&P 500 down 86% peak to trough, about 2X the current decline
- Japan: NIKKEI trading at about 1/5th of peak value 18 years ago.
Either of those scenarios is possible, so don’t delude yourself. Fortunately, in our opinion, they are also unlikely.
The difference between now and those disasters, in our opinion, is the massive government response. Yes, the response has been ad hoc, and yes, it has been far from perfect, but it has also been vastly better than the response in the first years of the Great Depression (tightening) and the Japanese meltdown (denial, no bank writedowns).
In fact, when you look at several recent examples of banking crises, you find that the stock market often bottoms about a year after the crisis starts–which would be about now. Again, Goldman Sachs:
It’s also possible, therefore, that Friday was the bottom and that you just missed your best buying opportunity of this bear market. It’s always darkest before dawn, and, boy, was Friday dark.
But we think the most likely scenario is that this is, in fact, a short-term rally and that the market will set a modestly lower low (down 50% or so from the peak) over the next 3-6 months.
Despite all that has happened over the last couple of months, analysts are still hallucinating about a v-shaped recovery. Specifically, after violent declines in earnings for the last four quarters, analysts are estimating that Q3 S&P 500 operating earnings will be essentially flat (-3%) and that they’ll rocket higher from here. Based on the behaviour of earnings in the past recession, this seems highly unlikely.
Here’s some recent history and what analysts are expecting (in blue):
03/31/2007: $22.39 8%
06/30/2007: $24.06 10%
09/30/2007: $20.87 -9%
12/31/2007: $15.22 -31%
3/31/2008: $16.62 -26%
6/30/2008: $17.02 -29%
9/30/2008: $20.32 -3%
12/31/2008: $22.77 50%
03/31/2009: $23.73 43%
06/30/2009: $25.44 49%
09/30/2008: $26.24 29%
12/30/2008: $27.94 23%
And here’s what happened last time. Note that the earnings recession lasted longer and was deeper than analysts are currently expecting (despite a shallow recession from 2001-2002). Also note the absence of the v-bottom today’s analysts are projecting:
09/30/2000 $14.17 9%
12/31/2000 $13.11 -5%
03/31/2001 $10.73 -23%
06/30/2001 $9.02 -39%
09/30/2001 $9.16 -35%
12/31/2001 $9.94 -24%
03/31/2002 $10.85 1%
06/30/2002 $11.64 29%
09/30/2002 $11.61 27%
12/31/2002 $11.94 20%
Do you really think today’s analysts have it right, especially with credit conditions so tight? We doubt it. We therefore expect to see considerable estimate cuts over the next few months. We have a hard time imagining that the stock market will power higher through that.
Conclusion? We think we’re a lot closer to the bottom than the top. You can drive yourself crazy trying to perfectly time the bottom, or you can focus on the implied long term return (first chart above) and take heart that, at this level, it’s a lot better than it has been for most of the last two decades.
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