Issue 24 • May 13, 2009

Apocalypse-Deferred:
Will Green Shoots Get Trampled by a Resurgent Bear?

Stock markets globally have enjoyed a nice “spring fling” with the S&P 500 Index jumping +34% higher since its most recent bear market low on March 9.¹

The nine-week rally since then has been both powerful and frustrating for many investors. That’s because there hasn’t been much of a pause along the way to allow side-lined investors to jump in.

In the end, they may be very happy to have remained on the sidelines.

Talk of “green shoots” — economic data that is “less bad” than before — has us scratching our heads here at Weiss, wondering what investors are thinking. While some of the economic data may have slightly improved in recent weeks, the stark reality is that it’s still pretty bleak … at best!

So, why are investors buying into this optimistic scenario — is there more to the “numbers” than meets the eye?  Is the “economic apocalypse scenario” off the table for now?

Don’t let Wall Street pundits brainwash you into believing the economy is on track for a swift and robust rebound … or that markets are reacting in anticipation by forming the much anticipated “V-shaped” recovery pattern.

True, the stock market often leads the way, but let’s look at the facts. After such a significant sell off, it’s not at all surprising to see the S&P up by one-third in just over two months time.

After all, this rally came on the heels of a -38% wipe-out in 2008 — the worst year for stocks since the Great Depression.²

Keep in mind that during America’s first Depression, stocks rallied +25% to +30% in a short period of time on four different occasions, with each rally attempt coming from a lower level, while the overall market trend continued downward.³

Be Careful Not to Mix Perception with Reality

How quickly we forget that the sum of all fears in the first quarter of 2009 was exactly that: Depression ... a doomsday scenario for the economy. Back in January and February of this year, investors were all but convinced that the global economy would continue to tumble off a sheer cliff.

When Citigroup traded down to a buck-and-change in March, investors were convinced that all banks might be sucked into a black hole of never-ending losses. Today, investors are acting as if stocks will go nowhere but up — indefinitely. It’s as if the need to raise another $75 billion in extra capital (as prescribed by the so-called “stress tests”) is just pocket-change.⁴

It’s all a matter of perception … “misplaced perception” to be exact.

Investor perceptions have changed from an “apocalypse-NOW” scenario to an “apocalypse-postponed” scenario, which they apparently consider as good a reason as any to bid up share prices once again.

Let’s not get carried away though. We have no reason to believe that markets and the economy will be back to “business as usual” by the end of this year.

And who knows when the apocalypse-NOW perception may take hold again?

Longest and Deepest Recession You’ve Ever Experienced

Rather than dealing in perceptions, let’s look at some cold-hard facts:

First, this recession is currently in its 17th month — already the longest recession since WWII. The previous record holders were the severe slumps of 1973-75 and 1981-82 — each lasting 16-months in duration.⁵ This is also likely to be the worst contraction in terms of magnitude that anyone (under the age of 80) has ever experienced, with real GDP estimated to fall -3.5% this year (first-quarter GDP already plunged at an annual rate of -6.1%)! The previous record decline was just -1.9% annualized in 1982.⁶

Second, the reality is that, after asset bubbles (housing & stocks) burst, and in the wake of a credit crunch as severe as we witnessed last year ... recovery and rehabilitation take time. This time period is likely to be measured in years, not months or weeks.

In fact, the economy is so depressed right now, precisely because we built too many houses, too many shopping centers and too many office parks ... paid for with too much borrowed money ... lent by banks with too much leverage … and securitized by too many investment banks with too little “skin” in the game.

The ‘Stuff’ of Bear Market Bounces

American investors have lost nearly $20 trillion dollars in wealth since this debacle began. We have also lost 5.6 million jobs so far in this recession, and just since last August, $266 billion of consumers’ incomes have vanished as layoffs surged.⁷

To fully recover from such a traumatic loss of wealth and spending power will take a considerable amount of time. American consumers account for 70% of our economy, and small business owners provide most of the new jobs created. Neither one is in the mood to spend or invest right now. And bankers are in NO condition to lend either.

So what does this economic scenario mean for stocks, specifically the 34% spring-fling rally we have now? At Weiss, we believe this rally has been based more on relief rather than any tangible evidence of true recovery.

Investors were happy to think that apocalypse was deferred, and so they stopped selling ... some even bought on the “less bad” news. Institutional investors fueled the rally by covering some short-sales, and closing out some of their hedge positions.

This is the stuff of bear-market bounces — not the stuff of sustainable bull market advances.

The Key to Surviving a Secular Bear

Take a step back and look at the big picture. The S&P 500 Index has been locked in a secular bear market since it peaked in 2000. Adjusted for inflation, the index has plunged 58% in real terms since then. Secular bear markets take a long time to play out — longer than many investors think possible. We are now in the 9th year of the current secular bear market.⁸

The last secular bear for U.S. stocks began in 1966 and didn’t finally bottom (in real terms) until 1982 — 18 years later. Before that, the secular bear market that began in 1929 didn’t finally end until 1942, and it wasn’t until 1954 that stocks finally made new highs. In Japan, a secular bear market began in 1989 ... and it continues today … 20 years later.⁹

The truth is, this secular bear may be only half-over. That’s especially true when you consider valuation. At the recent lows, stocks began to look interesting.

Based on projected earnings over the next 12-months, the S&P 500 Index looked very cheap in October and November with a price-to-earnings ratio (P/E) of just 11 — well below the average P/E of 15 during the past 25 years.¹⁰

But then the “E” in the P/E ratio collapsed, as corporate profits plunged. Stocks, of course, tumbled much lower too. But after the recent rally, the market’s forward P/E was back up to about 14.5 last week — pretty much average — but certainly not cheap.¹¹

Perhaps the best way to measure stock valuations is over a longer period, to smooth out the inevitable ups and downs of the business cycle.

One approach, which we favor, was made popular by Yale’s Robert Shiller. He measures the “normalized” earnings, after adjusting for inflation, over a 10-year period.

In March, this normalized P/E ratio fell to 13 — its lowest level since 1986!¹²

But wait, that still isn’t dirt-cheap either. At the end of previous secular bear markets in the 1940s, 1970s, and early 1980s (see graph below), the normalized P/E ratio frequently fell into the single digits.

Today, after the market’s nine-week relief rally, the normalized P/E is back up to almost 16 ... close to its historical average, but certainly not cheap. According to Shiller, today’s valuation indicates only “average returns” for stocks.

Perhaps the real key to surviving a secular bear market in stocks is to have the patience to wait for the true bargains to emerge.

At Weiss, a number of our professionally managed strategies have attempted to take advantage of the recent rally in two ways: aiming for short-term gains in certain attractive sectors and repositioning other strategies for the difficult market conditions we still expect. A word of caution: If you aren’t a short term speculative trader, then risks are still running high, and these markets are very difficult to navigate on your own.

Bottom line — Don’t settle for “average” valuations. After an epic crisis like this, you’ll need a much bigger “margin of safety.”

Good investing,

Mike Burnick
Director of Research & Client Communications
Weiss Capital Management, Inc.

* You must be a U.S. citizen or legal resident to qualify for a complimentary portfolio review.

¹ Bloomberg: “Paul Krugman Says Rapid Recovery ‘Extremely Unlikely’,” 5/12/09
² Ibid.
³ Bloomberg market data: 5/7/09
⁴ Black Rock Investment Commentary: 5/11/09
⁵ Northern Trust: U.S. Economic & Interest Rate Outlook, 4/21/09
⁶ Northern Trust: Daily Global Commentary. 4/29/09
⁷ Merrill Lynch: “Shooting the shoots,” 5/1/09
⁸ Merrill Lynch: “Closing the book with an open mind,” 5/4/09
⁹ Ibid.
¹⁰ Wall Street Journal: “By Most Measures, Stocks No longer Look Cheap,” 5/11/09
¹¹ Ibid.
¹² Ibid.