Early in March this year, the broad stock market appeared to have bottomed, with the S&P 500 Index closing at 676. At this point, the Index had declined 56 percent from its all-time closing high of 1,549 in October 2007. The last time the S&P 500 traded below 700, Bill Clinton was campaigning for his second term as president.
In the 10 weeks since March 9, the markets have marched steadily upward at an exhilarating pace, the S&P 500 gaining 34 percent. This is an impressive rally by any measure, but it still leaves the overall market down 41 percent from its peak. The market remains down more than 27 percent since September 15, 2008, the day the collapse of Lehman Bros. shook the global financial system.
Every investor wants to know whether this market recovery is for real, or if we’re just witnessing a “bear market rally” that will lure investors back into stocks ahead of further steep market declines—a sucker punch, if you will.
I leave predicting what the stock market will do in the next week, month or year to those with greater pretensions than I. What is true, however, is that, based on evidence developed over the better part of the last century, over the long haul, stock prices closely follow trends in corporate profits. After all, unlike bonds, where the issuer makes specific promises of interest and principal payments, shares of stock in a publicly traded company represent no more than a call on a pro-rata share of the company’s earnings.
So whether the rally starting in March will prove to be the light at the end of the tunnel—or merely an oncoming train—will depend on what happens to corporate profits going forward. Profits, in turn, will depend on how soon and how rapidly the overall economy recovers.
While we’d all like to see the economy recover and start growing vigorously, cheerleading isn’t an economic policy—nor is it an investment policy, for that matter.
Over the past century, there have been two severe bear markets lasting a decade or more. The most severe, of course, occurred during the Great Depression, during which stocks fell more than 85 percent, and a severe economic recession lasted from early 1930 until World War II. The second long bear market occurred three decades ago. By October 1974, the S&P 500 had declined about 48 percent from its peak at the beginning of 1973. The bear market of the 1970s persisted until well into President Reagan’s first term.
So far, the present market and economic turmoil has been more severe than that of the 1970s, while remaining considerably less severe than that of the 1930s. But a key aspect of both earlier periods is present today, namely heightened policy risk—the potential that government actions to help the economy will instead make matters worse.
While there’s plenty of argument among economists and academics about why the Great Depression occurred and why it lasted more than a decade, it’s pretty clear that a significant contributing factor was inappropriate policy responses from the Federal Reserve, the Hoover and Roosevelt administrations and Congress. As the economy spiraled downward in 1930 and 1931, the Federal Reserve took a do-nothing approach, while Congress passed the notorious Smoot-Hawley Tariff Act, leading to retaliatory tariffs that shut down commerce worldwide.
Things improved little under the Roosevelt Administration, as the unemployment rate stubbornly remained in the high teens until 1942. No less an authority than FDR’s Treasury Secretary and close friend, Henry Morgenthau, conceded in May 1939:
“We’ve tried spending money. We’re spending more than we’ve ever spent before and it doesn’t work. And I have just one interest, and if I’m wrong…somebody else can have my job. I want to see this country prosperous. I want to see people get a job. I want to see people get enough to eat. We’ve never made good on our promises…I say, after eight years of this Administration, we have just as much unemployment as when we started…And an enormous debt to boot!”
In the 1970s, inflation became rampant as the Fed copiously printed money. Government wage and price controls in response proved counterproductive.
Back to bear market rallies, which aren’t atypical; they occurred during both the 1930s and 1970s. From July to September 1932 (eight weeks), the S&P rose 92 percent, only to see most of those gains evaporate within six months. An even stronger runup occurred between March and July of 1933, as the S&P gained 105 percent. However, following this short, sharp rally, the stock market treaded water well into World War II. A similar bear market rally in 1974 saw stock prices rise 52 percent in nine months. This rally was followed by seven years during which stock returns were barely positive.
Meanwhile, the stock market has remained highly volatile since last September. Volatility is the most commonly used proxy for market risk and is typically measured through an index called the “VIX.” In 2007, the VIX fluctuated between 10 and 15, lower than the typical range between 15 and 20, indicating high investor complacency as market and economic conditions were beginning to deteriorate. During the height of the panic last fall, the VIX crested at a new record level into the 80s. Only a few days before I wrote this column, the VIX dropped below 30, a level that’s still considerably higher than the long-term average.
As I write this, some economic data show hopeful signs of stabilization or a turnaround. Other indicators remain stubbornly negative. Only time will tell whether the actions of the Fed, Congress and the Obama Administration will right the economic ship or ultimately result in continued economic distress. The course of the stock market rests on those results.
