10 reasons to suggest that the stock market has bottomed

By Lex Kerkovius
Globeinvestor Magazine Online, July 28, 2008

Lex Kerkovius, CFA, is a portfolio manager and senior research analyst with McLean & Partners Wealth Management Ltd. specializing in global dividend growth stocks. Based in Calgary, McLean & Partners provides investment counsel to individuals, family trusts and foundations.

In our view, the recent sell-off has many characteristics marking the probable culmination of the recent protracted bear market for global stock markets. To come to this conclusion, we have reviewed a wide range of indicators that have been historically useful in gauging the potential for a market bottom, and have come up with a Top 10 list. These indicators lead us to believe that we are close to a market bottom.

1. Time.

A typical bear market lasts approximately 10 to 11 months with a range of three to 21 months, and a pullback of 21-24 per cent. The U.S. bear market, which has led the world, has now lasted 10 months and the pullback to its low was just over 22 per cent, in-line with normal expectations and the United States has not even entered a recession yet. This latter point should not be dismissed because it suggests to us that a recession scenario could very well be built into the market already.

2. Extreme pessimism.

The current bear market was precipitated by the collapse of the U.S. housing market (the worst since the Great Depression) and has now reached an extreme as the "bubble" burst. It is at such levels of extreme pessimism that we can often expect stabilization and a possible recovery. Most importantly, this is supported by some early anecdotal evidence that suggests we are getting close to a bottom. Some of the anecdotal evidence we have seen includes:

• A slowing in the rate of decline of U.S. housing starts (in July they reached the trough levels of earlier cycles).



• A slowdown in the U.S. Home Builders Housing Market Index.



• Traffic to view U.S. real estate is increasing.



• Declines in U.S. construction spending have levelled out for residential construction.



• In May we saw evidence that pending home sales had begun to rise.



• June retail sales on housing related items have turned upward.

While we do not believe that we will see normal housing markets for some time (probably beyond the beginning of 2009) we are seeing the initial signs of a possible inflection point.

3. Commodity sell-off.

Because oil has been a major headwind to world economic growth, we needed to experience the recent sell-off in oil, energy and metal stocks that we recently received. However, the significant sell-off we have seen in oil prices over the past week is very important because it means we may have seen a near-term peak in oil prices induced in large part by OECD demand destruction. Although the world is still facing tight oil supplies over the longer term, a sell-off in oil, as painful as it is to an energy investor, is also bullish for the overall stock market. Oil and stock markets are rarely positively correlated, especially when we reach the recent record oil prices that can only be termed an oil shock.

4. Improved earnings.

We have seen a number of significant U.S. rescue packages showing that the regulators will not allow the financial system to fail. Most recently, this occurred with the Fannie Mae and Freddie Mac bailouts and followed the bailout of Bear Stearns and the creation of the Term Auction Facility. Just as important are the second-quarter earnings per share reports of key financial stocks such as State Street, Wells Fargo, JP Morgan and Bank of America that clearly indicate that analyst expectations for EPS are likely too negative. Remember that EPS expectations are coincident to lagging indicators. In short, with EPS deterioration coming to an end, the financials may have stopped being the market loss leaders. The recent rally in financial stocks is supported by strong anecdotal evidence - we have been told that trading floor buying of financial exchange-traded funds is very high; in the first round of a recovery market, people typically move into ETFs before becoming more discriminating. Technically, the U.S. Banking Oscillator and U.S. BKX banking index recently hit extreme lows, indicating that a recovery for financials was likely only a matter of time.

5. Interest rates.

There is an old market saying that you should not "fight the Fed." Real interest rates are negative. In addition, borrowing spreads are far above normal. This suggests that reversion to more normal levels is more likely than further significant upward expansions. Low interest rates and borrowing costs are highly supportive of equity valuations over time and this means that the current interest rate environment is becoming far more supportive of the market.

6. U.S. employment.

Even though U.S. employment has weakened, it has not reached the poor levels normally associated with serious U.S. recessions. Initial claims have levelled off in the United States, portraying an employment cycle that has stabilized at higher levels than would normally be expected in a more serious recession - typically, this means claims of at least 425,000 weekly. This suggests that even though the consumer is poorer because of housing, they have not lost jobs to the same degree as in prior recessions. It is the loss of jobs that has a deeper and more lasting impact on personal consumption.

7. Capitulation of the market.

Bottoms are typically reached when investors "throw in the towel" and indiscriminately sell everything with little regard for value; this is referred to as capitulation. We measure this with a capitulation index. When the index is below -1.5 as it is today, the stock market is typically positioned for a recovery.

8. Extreme volatility.

Market bottoms are also characterized by extreme levels of market volatility, measured by what is known as the VIX index. When this index reaches very high readings of 30 and above, as it did last Tuesday, the market is typically well positioned for a recovery. The index has not hit prior extremes due to some large hedge programs or it may very well have reached far more extreme levels.

9. Adviser sentiment low.

U.S. advisory sentiment recently hit the extremely low levels reached in March 2008, October 2002, October 2001 and October 1998. This measure of market sentiment is a contrarian indicator. Levels as low as these illustrate when the markets are typically oversold conditions and typically precede a market recovery.

10. Presidential election.

Markets tend to perform well in U.S. presidential election years. The U.S. markets have increased a little over 6 per cent on average over the past 104 years of U.S. presidential elections.

In our view, recent events are likely to mark the early stages of a market recovery, but it is likely to be quite volatile and try investors' patience.

Special to The Globe and Mail