The Bear's Back

The Bear's Back

By Bespoke.Com, Barrons | 8 July 2008

It's official: the bear has arrived. The Dow Jones Industrial Average last week qualified for the widely accepted definition of a bear market of a 20% drop from the highs. The good news is that once the decline reaches that arbitrary 20% mark, based on history, the market has suffered most of its losses. The bad news is that the decline typically drags on for some time, and time may be the worst enemy. Investors may initially try to grab erstwhile highfliers that have crashed and burned but rarely regain their former status. And as the decline wears down investors' psyches, they tend to bail out at the market's nadir, when things look bleakest— and when the greatest opportunities present themselves.

The post-1940 average bear market (as defined by the Standard & Poor's 500 index) produced a decline of 30.4% from a peak that took 386 days to reach its trough, according to data compiled by Bespoke Investment Group. By the time the market was down the requisite 20%, the average bear market was 74% completed. Based on those averages, the bear market would have another 118 days to run and would face losses of another 14% from current levels. Rarely does the market get a short, sharp shock, as in 1987, when the bear market lasted just 101 days— with most of the total damage of 22.51% done on Black Monday, Oct. 19. The longest march downward was the 1973-74 decline, which took 630 days and sliced 48.2% off the S&P.

But Bespoke defines two separate bear markets following the bursting of the technology bubble— an initial 36.77% drop from March 2000 to September 2001, punctuated by a brief, post-9/11 recovery until the next decline of January-July 2002 of 31.97%. In the minds of most investors who suffered through that period, it was three long years of false starts and frustration until the recovery really got under way, in March 2003. Signs of bear-market fatigue already are becoming evident. Investors have yanked more than $80.4 billion from domestic equity funds in the past 12 months, according to Investment Company Institute data parsed by Bianco Research. Overseas funds drew $75.7 billion from American mutual-fund investors, leaving a net equity fund outflow of $4.7 billion.

What's more, there have been few hiding places other than commodities, observes Jack A. Ablin, chief investment officer at Harris Private Bank. Even Warren Buffett isn't immune, with Berkshire (ticker: BRKA) off 21% from its peak. The foreign stocks Americans have been flocking to lost nearly as much as U.S. equities, despite help from the falling dollar.

The MSCI EAFE, the benchmark for developed markets outside the U.S., suffered a negative 10.58% total return in the first half, according to Bianco Research, compared with a negative 11.91% for the S&P. Emerging markets were slightly worse than the EAFE, with a negative 11.64% return, according to MSCI's measure. Even the once hotter-than-hot China market has gone into a deep-freeze; the FXI exchange-traded fund, a popular way for Americans to play that market, is down 43% from its high last October. Bonds other than Treasuries lost money in the first half, especially corporates, junk bonds and municipals. Meanwhile, the Dow Jones-AIG Commodity Index returned 27.23% in the first six months of 2008.

Yet there's little prospect for relief in the near term, especially as the second-quarter earnings reporting season is about to kick off. Despite its near 20% retreat, the S&P 500 remains too high relative to prospective earnings, says Ablin. Even though analysts have slashed their 2008 earnings forecasts to just 5.8% gains from 15% at the beginning of the year, he thinks they're still too optimistic. Based on his estimated profit gains this year of 3%, and an earnings yield (the inverse of the price-earnings multiple) equal to triple-B corporate bonds' 6.8%, Ablin's model indicates the S&P should shed another 5%.

But others see the current decline as another phase in a longer-term secular bear market. "We are still in the super bear of 2000," asserts Jeremy Grantham, chairman of money manager GMO. In a bear market, stocks fall back to, or below, their long-term trend line. But after the great bull market from 1982 to 2000, equities never flushed out their excesses "because of the Greenspan-inspired chain of bubbles, from growth stocks to real estate to commodities," referring to former Federal Reserve Chairman Alan Greenspan.

"Great bear markets always take their time, and the most likely end is 2010," Grantham continues. If the S&P 500 were to fall to 1100 in 2010, that would be about a 13% decline from here, about 1263, and would put the index back on its long-term trend line. He adds: "Chances are we will overshoot on the downside. We always do. We will be lucky if it is 1100."

Like Tolstoy's unhappy families, every bear market is different, observes John De-Gulis, a portfolio manager at the Sound Shore Fund. Citing data from Ned Davis Research, he notes that the S&P has been down an average of 4.83% six months after the start of a recession and up 3.15% 12 months on. "Of course, we haven't entered the recession officially yet," he adds, which may happen late this year or early 2009. But, he adds, "the two recessions where the market was down big time 12 months after the recession started were '73, minus 27%, and '81, down 18%— both periods when oil prices spiked."

What seems consistent among bear markets is the tendency of investors to despair in their later stages, dumping everything indiscriminately. For instance, Bespoke Investment found that in the early stages of a decline, from the peak to the down 20% bear print, the traditional defensive redoubts— consumer staples and health care— hold up relatively well, shedding about 4% each. But after the bear market becomes "official" at minus 20%, the two actually do slightly worse through the rest of the decline— down 11.6% for consumer staples and down 13.9% for health care, versus minus 10% for the S&P at that stage, as investors tend to dump anything and everything.

There's no surprise about what did best during past bear markets tracked by Bespoke. During the first phase on the way to the minus 20% mark, gold prices were virtually unchanged while oil was up 18.7%. Bond yields, as measured by the 10-year Treasury, actually were up by about 7% in the early phase, which would result in negative returns. But after the S&P was down 20%, gold gained an average of 6.6%, oil was up 19%, and bond yields were down 0.5% for a positive return.

What's less clear is what will be the signal leader when a new bull phase starts. Rarely, however, is it the group that led the previous advance. Energy stocks, for instance, did not return to the lead position until the recent bull run, about a quarter century after their last heyday. After the dot-com bust, technology stocks did not take the lead in the subsequent bull market; indeed, the Nasdaq recovered only a bit more than half its decline from its bubble peak of 5048.

The late bull market was, of course, led by financial stocks— on the way up as well as down. Critics charge that was because the Fed slashed rates too far, to 1% at their low, and kept them too low for too long. This effectively free money fueled the subprime mortgage bubble and burst, which reverberated throughout the credit markets and eventually led to the emergency rescue of Bear Stearns in March. [[Even less than free! With inflation at ~2% (government figures), Fed was essentially paying borrowers 1% to come and take that hot money off their hands! : normxxx]]

But after all too many declarations that the worst of the credit crisis is over, and with the latest round of "kitchen sink" write-downs of bad assets by banks and brokers, few pros at this point want to bottom-pick in financials. "I know what I don't want to own," says David Sowerby, portfolio manager of Loomis Sayles— "'toxic subprimes', which one day will be "great trades," but not yet.

Bank stocks are nowhere near as cheap as in the early '90s, contends Frederic Marks, president of Cheviot Value Management, which manages $236 million in separate accounts. For instance, WFC had been cut in half by the fall of 1990 to just 75% of its book value. Today, Wells' shares trade for closer to 1.75 times book, and book values are far less than certain, given the potential for write-downs. Wells traded in 1990 at about six to seven times its long-term earnings power (not that year's published earnings), compared with 12 times long-term earnings today.

Despite the ongoing housing woes and credit strains, inflation has moved to the top of the Fed's worry list. So, too, with the stock market. "The critical variable lies with the [consumer-price index]. It's the biggest driver of the market multiple for the S&P 500," says Francois Trahan, strategist with ISI Group.

He adds that if gains in the CPI slacken in the second half, "then multiples start to expand. Some 80% of the CPI items looks great, like rents and wages, but 20%— oil and food and import prices— looks horrible. If commodities just level off, then the CPI will come down." On that score, the Economic Cycle Research Institute's Future Inflation Gauge, a leading indicator for the CPI, fell to a four-year low in June.

With crude soaring past $145 a barrel and prices at the gas pump well past $4 a gallon, investor and consumer psychology is the glummest in decades. So much so, in fact, that the market might be setting itself up for a short-term trading bounce, says Woody Dorsey, proprietor of Market Semiotics. It would be akin to the short-lived rebound from the March lows following the passing of the Bear Stearns phase of the credit crisis.

Marks of Cheviot, who says his composite portfolio of client accounts is up 4% in the past 12 months against the 13% slide in the S&P, has had one-third in precious metals and other vehicles that benefit when the dollar or the market declines, one-third in cash, and one-third in strong U.S. companies not tied to the domestic economy. Two exceptions are WMT, "which is one of our largest holdings a couple of years running because of our thesis that buyers will be more price conscious and will be more attracted than ever to this store."

And, another retailer Cheviot has been buying recently is WAG, says Marks, because "two-thirds of its revenues are from pharmacy sales, the company is enormously profitable with zero debt, and its shares are as cheap as they've been in well over a decade." BCA Research's Global Investment Strategy Weekly Bulletin advises subscribers to batten down the hatches to ride out the "perfect storm" resulting from spiking oil prices by reducing equities and boosting bonds, especially European securities. (The BWX provides exposure to foreign government bonds.) "This latest oil surge is canceling out the impact of the Federal Reserve's policy easing, crippling economic growth and causing share prices to relapse," writes Chen Zhao, BCA's managing editor. It is no time for heroics, he adds.

The key to surviving bear markets is capital preservation, concludes GMO's Grantham. You want to "live to fight another day." You may see amazingly cheap asset opportunities in the next couple of years as distressed pricing might become more commonplace. "It would be nice to have the money to take advantage."

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Normxxx    
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