Finding the Bottom

Wanted to get this in before the market opens Wednesday. Unlike yesterday's session, which ended with a pull-back from the day's lows in the final hour of trading, today we closed on the lows. The technical guys would predict, on that basis, that we'll get a rally tomorrow.

Could be. But it'll be a dead-cat bounce. This thing isn't over yet.

And if Bernanke follows through on his hint today and cuts the funds target, we will most certainly get a rally. But that, too, will be a dead-cat bounce. It should already be priced into stocks - after all, it's fully priced into bonds and Fed funds futures: the three-month T-bill yield is 76 basis points, down almost a point from a month ago, and the implied probability from the funds futures market calls for a two-thirds chance of a 50 basis point cut in the funds target by the next FOMC meeting, at the end of this month, and a one-third chance of a 75 basis point cut.

(A quick pat on the back - the funds futures bet looks dramatically different from that of a month ago, when there was a 98% implied chance of no change and a 2% chance of a hike; the chances of a hike were even higher a few weeks before that. Astute readers will recall that on Thursday, August 7, I made a post in this space arguing that the Fed would not raise rates to fight inflation, as was widely expected at the time, and that its next move would be a cut.)

Well, with the heavy selling we have everybody on CNBC (another blogger calls it "Bubblevision" - I like that) and all over the finance websites like Yahoo Finance saying we're near the bottom.

Balderdash.

For one thing, this market has yet to price in a recession. But it is coming. It will hit manufacturing and retailing particularly hard in the fourth quarter. And it will last well into next year, at least. The market may be in the initial stages of pricing one in, but it hasn't gone deep enough yet.

For another thing, it hasn't priced in the likelihood of a big hike in the capital gains tax if Obama wins, which appears increasingly likely. (Note to Obama supporters: stand down. I am not insulting your candidate. He said he'd raise the tax himself, I'm just quoting him. And for the record, I am equally disgusted with both candidates, and with Joe Biden, after last week's Senate bailout vote. Palin gets a pass, since she's not a Senator. But she'd earn more respect from me if she came out and said she strongly disagrees with her running mate on this one.)

And it hasn't priced in a lot of other stuff that could, and likely will, happen, like the potential inflationary Armageddon that the bailout and a rate cut will produce (did anyone notice the dollar tanked today?).

In May 2007, I wrote an article noting the strong correlation between the NAHB Housing Market Index - based on a survey of homebuilders - and the S&P 500, lagged 18 months. I also noted that, at the time, the index suggested the S&P would bottom out around 600, and that this would happen around the second quarter of 2009.

I based the timing of this prediction on the fact that the NAHB index had hit its then-low of the cycle in September 2006, after peaking in June of 2005. Since it took 15 months to bottom out, my argument was that the S&P would take about the same amount of time to hit bottom, and it had just begun to fall slightly at the time of that writing.

Meanwhile, the NAHB index appeared to be on the rebound; it had risen from the low mark of 30 in September 2006 to 39 by February of 2007. (That's a reasonably significant move; to put it in perspective, the peak in mid-2005 was 72.)

Well, we know what happened to the S&P: it continued to rise until October, when the bear trend began. So what happened to the NAHB index?

In March of 2007, it resumed dropping. Like a rock. It bounced around 20 from September 2007 until about April, then fell some more. It bottomed out at 16 in June, and stayed there in July. Then it went up two points in August.

So the bottom for the S&P could be below 600 (it closed below 1,000 today), and it could come later than mid-2009.

We can know this: stocks won't recover meaningfully until housing recovers, and that won't happen until 2010. Also, during most recessions since 1970, stocks have bottomed out one-half to two-thirds of the way through the recession, defined using the NBER definition, by which we have not yet entered a recession. So, assuming the third quarter saw the first quarter of GDP contraction, and that it lasts as long as the last two recessions (I think it'll last longer, but let's just set the bar somewhere for now), the halfway point will be somewhere around year-end. So we could see a bottom then.

But don't count on it. (Slight detour: stocks bottomed about a year after the last recession ended, but that makes sense, as the stock market itself - specifically, the tech sector - largely brought about the recession. This is not a stock market-driven recession. The market is the victim this time, not the perp.)

Again, I believe this recession will last longer than the last two, something on the order of a year to a year and a half, at least. So the halfway point would likely come no sooner than next summer or fall.

As for where the bottom is level-wise, I'll just say this. Stocks grew at a nice, normal, healthy, sustainable pace throughout the '80s. Then, around 1994, things got frothy. Then downright bubbly. We got a correction in 2000-2002, then another pretty frothy run-up through the housing heyday, and now we're in another correction.

If you plot that nice, long-term-sustainable trendline through to the end of this year, you find the Dow should be at about 8,000 and the S&P at 800. Now, that ain't exactly rocket science, but it's a nice, stable, logical, rational approach to valuation. We are not in a "new economy" or a "new environment," as I've said more times than I can count since the mid-90s. And most of the talking heads on Bubblevision that say we are haven't even been in or studied the markets long enough to know better.