Nearing a Bear Market Bottom?

09/29/2008 12:00 am EST

Focus: MARKETS

James Stack

President, Stack Financial Management

James Stack, editor of InvesTech Research, says history suggests we could be approaching the low of this bear market.

Today’s concern is whether [recent] “events” are piling up to create a systemic risk to entire US market and economy. In the depths of a bear market—after all major indexes have lost 20% or more—investor emotions start to take over. Fear begets more fear.

Our historical knowledge of bear market psychology prevents us from overreacting to current headlines. Today, in the current recession, all bearish extremes are again in place for one of those “best buy” opportunities that typically comes around every three to seven years.

With oil prices having fallen over $40 from their high, the price of gas at the pump also has come down. The Future Inflation Gauge from ECRI (Economic Cycle Research Institute) has fallen to a new six-year low. And a University of Michigan survey on consumer expectations about inflation shows declining inflation concerns in four of the past five months, from 5.2% down to 3.6%.

As a result, consumers are starting to feel less gloomy about the future. In the past, these rising expectations have been a key component to any path leading out of recession. If consumer expectations are rising, relative to their current gloom, can improving economic fundamentals be far behind?

We don’t want to be overly anxious or aggressive. But to us, this turmoil in the financial stocks still looks and feels like an “event” risk rather than a “systemic” risk that might send the US economy into a deep, prolonged recession. If the Fed and Treasury are successful in restoring confidence, it could be surprising how quickly the market finds firm technical footing.

We have not built the extreme cash defenses that we had during the 2000-02 bear market for three reasons:

1. We successfully anticipated this bear market, built our defenses early, and avoided the high-risk sectors and stocks that have now dropped into bottomless free falls.
 
2. Individual stock valuations are not as extreme as [they were] in the late 1990s. In fact, we are finding an increasing number of compelling bargains to consider adding to our portfolio.

3. The bearish conditions that typically precede the “best buy” opportunities on Wall Street have already fallen into place.

From a psychological and market-historian standpoint, I believe the lows in this bear market may be at hand or not far off. Thus far, we have survived a 26.2% loss in the major indexes with only a small single-digit loss in our portfolio. That allows us to accept a little higher risk in preparing for a potential market bottom, as long as we keep a close eye on our indicators and move quickly if storm clouds worsen.

It’s always difficult to fight media headlines and investor emotions at the depths of a bear market. Yet the final market bottom is defined as the point of maximum pessimism on Wall Street. In other words, it’s always gloomiest before the bull market dawn.

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