Chart 1: Eleven years of gains lost

Chart 2: Volatility peaking at market bottoms Prices are in USD Source: iFAST Compilations and Bloomberg

Chart 3: Cash on the sidelines Prices are in USD Source: iFAST Compilations and Bloomberg

Chart 4: Investors pulling out

Chart 5: investor pessimism

2008 has been a horrible year for equity investors. At the close of the market on 26 November 2008, the S&P 500 had lost 51.9% from its peak in 2007 (in USD terms), marking the worst annual decline since 1931. The performances of other markets have left investors with nothing to smile about; gains built up over the past few years have been wiped out in just a matter of months.

The US has been at the epicentre of the financial crisis which started in 2007. The high level of correlation between the US market and other regional markets in the current market downturn suggests that the US market may provide some leadership in shaping the future direction of global financial markets. Thus, we are focusing on the US equity market in this article.

While despair still prevails, there are finally certain hints to suggest that the US market may have bottomed, or at least, is in an advanced stage of bottoming.

1. Almost all the bad news is out

In an endless state of nausea, the bear has been regurgitating bad news for months on end. We have seen the bursting of the subprime bubble, the failure of Bear Stearns, high inflation, the failure of Lehman Brothers, the near collapse of AIG, the collapsing of commodity prices and now, slowing economic data from all around the world.

Instead of wallowing in misery in the wake of all these events, a more optimistic implication has arisen: The shocking nature of the events in 2008 has left the market jaded, and further bad news is unlikely to rival the severity of the historic events we have seen so far. With unprecedented levels of government intervention, the credit crisis is now playing out in the form of a global slowdown. Poor economic data will be reported in subsequent months to come, but knowledge of a slowdown is old news, and should have been discounted by the equity market already.

2. Current declines have surpassed most historical falls

We selected periods of declines in the S&P 500 since 1929 with a substantial fall of at least 19% or over a period of recession. There were 17 such periods prior to 2007, with an average decline of 34.7% from each peak. For periods with recessions, the S&P 500 fell by an average of 38.2%. The historical averages pale in comparison to the declines of 2008. At the intra-day low of 741.02 on 21 November 2008, the S&P 500 lost 52.7% from its peak, sending it to levels last seen in 1997 (See Chart 1).

This 52.7% decline is historically the worst decline since 1942, even surpassing the 48.2% fall during the oil crisis of 1973 and the 49.1% decline after the technology-led stock market bubble finally burst in 2000 (See Table 1). If history is anything to go by, we are surely near a market bottom given the extent of decline seen so far.

3. Fear and Volatility appear to have peaked

The often cited Chicago Board Options Exchange Index (VIX index) is a measure of the implied volatility of S&P 500 index options. A larger value indicates a more volatile market over the next 30 days, while a smaller value indicates less implied volatility. The index is extremely interesting to our discussion as historically, the index has spiked upwards around the period of a market bottom. This substantiates the view that markets are very volatile near the point of peak selling, or “maximum fear”. The huge recent intra-day swings of more than 10% reek of utter confusion on the part of investors, who do not know whether to be buying or selling, thus contributing to the immense volatility in the market.

The market bottom in October 2002 was marked by a spike in the VIX index to 42.13 points, as was the October 1990 bottom, marked by a spike in volatility to 31.47 points (Chart 2 shows the VIX index and the S&P 500). Fear and volatility may have peaked, as suggested by the VIX index. The index breached 80 points, more than 4 times the average of 19.54 since 1990. With volatility spiking to the highest on record, there is a high possibility that a bottom has been reached.

4. There is a huge amount of money on the Sidelines

Many investors are peculiar in the sense that they have most of their money in equities when markets are near tops but have little exposure when markets are at their lows. With the S&P 500 having declined substantially in 2008, there is currently a huge amount of money waiting on the sidelines. US Money Market Funds assets recently increased to US$3.7 trillion (as at 26 November 2008), which is 35% of the total US market capitalisation.

Historically, the US Money Market Assets to US Equity Market Capitalisation proportion has stood at 15%, intuitively increasing when equity markets suffer sharp losses (See Chart 3). This ratio recently reached a new historical high of 39.2% on 19 November 2008, not only due to the decline in the equity market but also due to new inflows of cash into money market instruments. In comparison, the ratio spiked to 26% at the last market bottom in October 2002.  

Investors have been fleeing to safer assets in 2008. The near-zero yields on 3-month US Treasuries serve as further evidence for a flight-to-safety and heightened risk-aversion. The fact that short-term money market instruments make up 35% of the total US equity capitalisation clearly indicates that there is sufficient fuel for the next asset bubble. A shift into equities is a likely possibility, which may result in a substantial rally in stocks going forward. Cash on the sidelines is always hungry for better returns, and it will only be a matter of time before it shifts into traditional higher-risk instruments like corporate bonds and equity.  
 
5. The market is overbearingly pessimistic

As much as we like to believe otherwise, history has shown us that investors are not the best at market timing. Many pull out from their investments when markets are low, and buy the most at a market top. It is such behaviour that allows contrary indicators to be meaningful. The majority of investors are familiar with the phrase “Buy Low Sell High”, but usually end up doing the exact opposite.

Chart 4 shows the net monthly cash flow of US equity funds. A positive figure means net buying by investors, while a negative figure indicates a net redemption. It is perhaps unfortunate that the most selling occurs near a market bottom, which is exactly when investors should be buying. There was a huge outflow around the market bottom in late 2002, exactly where the market made a bottom. There was a US$72.3 billion outflow in October 2008, the largest since data was first tracked. This spike in net cash outflow is a very clear sign of extreme bearishness, and is yet another indication that a bottom may be near.

Looking at the American Association of Individual Investors’ (AAII) weekly survey of its members, we find that investors tend to be extremely bearish when markets are near their lows and bullish when markets are at their peaks. The market bottom in 1990 corresponded to a period of extreme bearishness, as did the bottom in 2002. This survey has remained bearish for a large part of 2008, and is highly indicative of the extreme pessimism present in the current market.

Current Bottoming is a Process

Given the huge falls in the S&P 500 this year, it is not surprising that many experts are trying to call a bottom on the US equity market. However, investors should be aware that the bottom we are looking for now may not be such a clear-cut bottom, as was the bottom in 1990, or even 2002. Economic data improved quickly in both cases, but we are likely facing a longer period of economic decline. Investors may see little incentive to hold stocks, given the weak economic outlook, and it may take awhile for stocks to embark on a sustainable rally from a low. While we believe that a large amount of negativity has been priced in already, the market may be confused as it tries to digest new information and we may expect to see the lows made in October and November be tested several times.

This being said, market bottoms are definitely good times to invest, if one has a sufficiently long investment horizon. With the assistance provided by governments, credit fears have eased somewhat and the crisis now is being played out more like a traditional recessionary slowdown. Declines this year have already been the worst since the Great Depression, and it is difficult to fathom the situation getting much worse. Fear and bearishness are at extreme levels, and a historically high level of cash is sitting on the sidelines with a potential to enter the equity market, whose valuations are at the most attractive levels in years. Bull markets and bear markets are cyclical, and the current bear has definitely overstayed its welcome. Unless we enter a global depression like in the 1930s, we are definitely close to a bottom. Investors who stay strong in these trying times and ride out the bear cycle will undoubtedly be rewarded handsomely when the next bull cycle returns.

We now track some of these indicators feature here on a weekly basis; these include leading indicators and market earnings and estimated PE.