Only with the benefit of clear hindsight can we be certain of market bottoms or the troughs of economic cycles (or market highs and the peaks of economic cycles, for that matter). Most financial advisors try to take broad market and economic cycles into consideration but do not try to pick peaks and bottoms, knowing that it nearly impossible and can actually lower returns and increase risk. With the Dow Jones Industrial Average rising over 30% from its March low, however, some investors are asking whether we have seen the bottom and must now buy stocks to participate in the recovery. (Just three months ago, some of these same investors were willing to swear off stocks forever in fear of losing everything.)

Several factors have contributed to this investor enthusiasm. First, the panic that the sky was falling has been replaced by a sort of calm acceptance that we will survive and an acknowledgement that there will eventually be a recovery. This feeling is rooted in the idea that some time has passed and the sky has not actually fallen. Second, since much of the pain was inflicted so quickly there is now a sense that, if not getting better, at least things are declining at a slower and more manageable pace. The stock market has lately been grasping at every bit of good news and discounting the bad, the exact opposite reaction of the year prior. Finally, the government has announced program after program and has committed trillions of dollars in bailouts and economic support, creating an assumption that eventually it all has to work.

The sobering fact is that markets rarely move in smooth, uninterrupted cycles. As Blair Reinkensmeyer observed on stocktradingtogo.com, “Bearish sentiment causes violent sell-offs that eventually turn into rallies. These rallies always seem to be just large enough to trick some investors into believing the bull is back. And like a roller coaster before its next drop they are surprised to see the drama start all over again.”

While we are far from repeating the slide of the Great Depression, Reinkensmeyer compared the bear market rallies of 1929 to 1932 to today’s situation. The Depression decline occurred over three years, while we are only one and a half years from the market peak. In its first one and a half years, the 1929 crash had four major downswings of 30% or more, each followed by a rally of 20% or more. The decline continued until 1932, with the final sell-off being the most severe at 55%.

We have had five declines of 18% or more, each followed by a market bounce of 10% or more. Our last decline of 29% from December 2008 to this March was not the largest or steepest; the market fell farther and faster in September and October 2008. These swings create enticing opportunities for short term traders, but long term investors can still exercise patience and successfully participate in the eventual recovery.

The market pattern around the prior bottom in 2002 is also similar to today. After dropping 15% very quickly and hitting 8,000, the Dow rallied 11%. It then dropped a new 15% to its low, only to rally 17% to 8,800. Its last drop of 12% did not test the lows, but it did present another buying opportunity before resuming its advance.

But what about the state of the economy? Federal Reserve Chairman Bernanke has referred to improved economic data as “green shoots” which will eventually bloom into a full recovery. But the news is still mixed and optimism can quickly be snuffed out by any signs the economy is continuing to slip. Likewise, recovery means different things to different people; growth in GDP may cheer economists but will mean little to the worker who still can’t find a job.

From the Wall Street Journal, here is the current reading of some popular indicators, all of which have had precipitous drops.

• University of Michigan consumer expectations – This index is based on how households feel about the future and has bounced off its low readings to an 8-month high. It remains to be seen whether this will translate into increased spending. (The Conference Board, another measure of consumer confidence, showed a huge jump in May.)
• Retail sales – Sales have stabilized in the last few months, but at 70% of the economy, consumer spending will have to pick up to fuel a recovery. Coupled with a corresponding increase in the savings rate, lower sales reflect the “new austerity” gripping the consumer.
• Single family housing starts – An increase in housing starts is often a sign that a recession is ending, as lower interest rates spur more building. Unfortunately, housing starts are still on a long slide (despite a slight increase in May) and inventories of unsold homes remains high.
• Spread between corporate and Treasury bonds – This spread spiked rapidly as investors were unwilling to extend credit to companies for fear of default. The spread has declined, indicating that investors are willing to take reasonable risk and allowing companies to borrow and expand.
• Purchasing Managers’ Index – This survey has rebounded the last two months, perhaps indicating that the manufacturing sector is about to improve.
• Orders for nondefense capital goods, exc. aircraft – In a possible sign that businesses are becoming expansion-minded, orders for equipment items rose in February and March – but they also rose briefly about six months ago, halfway down their long decline.
• Initial jobless claims – This four-week average seems to have leveled off, but is still at very high levels. The number of workers with continuing unemployment claims is at all-time highs.

The challenge for an investor is to balance current data with an overall plan and objectives. It remains true that the best way to fully participate in a market’s opportunities is to stay invested in that market, at least to some degree. And given the market’s overall decline, there will be plenty of time to benefit from a recovery even if we have seen the bottom and things continue to improve from here. As every parent of an impatient child has said, we’ll get there when we get there.

June 2009