A Bear Market of Historic Proportions

T. Rowe Price Report
By Steven Norwitz

        At the recent low on March 9, 2009, the S&P 500 Stock Index had fallen almost 57% from its peak, making this the second-worst bear market of all time, behind only the 1929-1932 collapse of 86.2% that ushered in the Great Depression, according to the The Leuthold Group, a market research firm. (This excludes the World War II-related years from March 1937 to April 1942 when the index lost 60%).
       Moreover, this marks the second bear market in this decade to set post-Depression records in terms of losses, with the S&P 500 falling 49% in the 2000-2002 bear market. The gains achieved after that steep slide have been wiped out in the current debacle.

        As of early March, the S&P 500 had lost more than half of its market capitalization, representing almost an $8 trillion loss, led by devastating losses in the financials sector, according to ISI, another market research firm. Not only has the U.S. market collapse been steep and broad-based, but it has unfolded at an almost unprecedented pace compared with other mega-bear markets.
       While investors are naturally despondent over the startling declines, history does provide some reason for hope. As seen in the chart, markets have always recovered, and investors may get back to even faster than expected it they are reinvesting dividends to take advantage of the lower equity prices.
        Even the worst 10-year periods historically have been followed by strong stock market performance.
        After this year's terrible start, investors were hopeful that the powerful market rally in March signaled a more positive environment for equity investing in the months ahead.
        Still, this bear market has been accompanied by probably the worst recession and financial crisis since the Depression. The current contraction has lasted 15 months through March, just a month shy of the previous postwar records set in 1973-1975 and 1981-1982.
        With both housing and equity values falling precipitously, household net worth last year plunged $11.2 trillion (a postwar record) or 17.9%, with over half the decline coming in the fourth quarter, according to Federal reserve data. (Stocks collapsed 41.2%, while real estate fell 10.5%). However, this of course followed extraordinary gains in household wealth achieved since 1990.

Earnings Carnage

        The global recession also has taken a heavy toll on corporate earnings. S&P 500 operating earnings imploded in the fourth quarter of 2008, marking the first negative quarterly earnings in history. Reported earnings, which reflect corporate write-offs, were even worse, showing a negative $23.25 per share in the fourth quarter - the sixth straight quarterly decline.
        "The ripple whammy of slowing demand, weak pricing, and margin pressure did a number on Q4 [fourth quarter] earnings," Leuthold says. "With or without financials it was a dismal Q4 performance."
        Overall, last year marked the second down earnings year in a row. Operating earnings in 2008 were 46% below the 12-month earnings peak in this cycle, and reported earnings were 82% below their peak 12-month earnings.
        While analysts have been slashing earnings projections, most see an improving trend. Based on its analysis of recessions since 1959, UBS Securities says the typical recovery from a fourth-quarter earnings low was a 15% gain over the next four quarters and 30% rise over the two years.
        "The sudden and massive corporate profit deterioration that has come since the crisis ballooned last autumn has caused many investors to fixate on how bad things can get short-term and disregard the earnings power of the S&P 500 during more normal times," UBS commented recently.
        "While the current earnings environment is rather grim, the worst should be nearly over," Leuthold says. "Earnings on a 12-month basis will begin to stabilize by Q3 or Q4 [third or fourth quarter] 2009."
        Ned Davis Research (NDR), another market research firm, notes that while recent estimates point to "the most negative earnings growth we have ever seen," the firm also considers this a positive because "the estimates are setting the bar very low for future earnings" comparisons.
        Earnings are likely to show a modestly improving trend, but it could take many years before S&P 500 earnings regain their recent 12-month peak level, reached in the second quarter of 2007.
        In the shorter term, however, stocks also may be poised to benefit from attractive valuations. Leuthold calculates that the normalized price/earnings (P/E) ratio (based on trailing five-year earnings) on the S&P 500 as of March 31, 2009, was 12.8x - 26% below the median of 17.3x since 1940.
        "Buying stocks anywhere near this valuation zone has always resulted in higher-than-average long term returns," the firm says. Of course, past performance cannot guarantee future results.
        As indicated in the chart, the S&P 500 P/E ratio at the March 9, 2009, low based on 12-month trailing earnings, was about average for bear market bottoms, but interest rates and inflation now are considerably lower. However, rising interest rates and inflation from these low levels as the economy recovers could dampen a stock market recovery.
        Whatever the current valuation, it's worth noting that stock prices have historically bottomed well before the economy and earnings. Based on 10 bear markets since 1949, NDR says bear markets on average ended 4.8 months before the end of a recession and 5.9 months before the trough in earnings that typically comes after a recession end.

Historical Lessons

        If past is prologue, the future should be brighter. The 10-year annualized return (including reinvestment of dividends) of the S&P 500 through the March 9, 2009, market low was 4.5% - the worst 10-year performance in U.S. stock market history, including the great Depression, according to Leuthold.
        The firm examined the total return of the index following the worst 10-year periods since 1929. In those rebound decades, the worst recorded a gain of 101% from fourth quarter 1938 to fourth quarter 1948 (7.2% annualized), and the best recovery decade returned 325% from third quarter 1974 to third quarter 1984 (a 15.6% annualized return).
        After the horrendous performance of 1929-1939 (a -3.65% annualized return), the index gained 128% (an 8.6% annualized return) over the next 10 years. When the annualized return for a 10-year period was 1% or less, the firm found that the subsequent decade produced an average cumulative return of 183%.
        "The most meaningful lesson to be learned from this exercise is the investment opportunities that 10 years of terrible performance present for those with the courage and discipline to then act," Leuthold concludes.
        Leuthold also examined how returns unfolded historically after stocks had reached similar levels of market valuation compared with the recent March low. From such a low level of valuation, the median 10-year annualized return was 15.4% (or about 319% on a cumulative basis).
       Steve Leuthold, the firm's president, compares the current "fear-driven" market environment with two others that suffered comparable 53% to 60% declines. One is the market collapse in 1974, when interest rates and inflation were rising at double-digit levels, and the other is 1937-1942 as World War II got underway.
        Each represented a "far more dangerous risk environment where investor fears were justified and far greater than today's financial and economic crisis environment," Mr. Leuthold observes. The stock market, of course, surged after both of these periods.

Stocks vs. Bonds

        Another anomaly created by stocks' abysmal performance in the current decade that may bode well for their recovery is the unusual disparity between stock and bond returns.
       Although stocks involve much more risk than bonds, their returns are well below historical averages and Treasury bond returns are well above their norms, due to the recent flight to quality as the financial crisis intensified.
        Leuthold calculates that the median 10-year annualized return for long Treasury bonds since World War II is 3.4%, compared with 7.9% for bonds and -2.2% for the S&P 500 over the decade ended march 31, 2009.
        Even more astonishing, Leuthold notes, is that stocks have significantly lagged bonds since the 1987 stock market low. NDR analysis shows that there have only been four periods since 1926 when bonds significantly outperformed stocks, including the current one.
        "While there is room for further bond outperformance," NDR concludes, "the longer your time horizon, the worse your chances of this trend continuing based on history...Assuming continued bond outperformance is a risky long-run proposition." Indeed, stocks trounced bonds from the March 9 stock market low into early April.
        In addition to a possible "reversion to the mean" for stock and bond returns, NDR cites several other positive factors, including the massive amount of stimulus, both monetary and fiscal, in the U.S. and globally; the huge reservoir of cash on the sideline available for investment; various cyclical influences now turning positive; the global recession that the firm believes is nearing a bottom; and the potential for favorable earnings surprises compared with extremely negative expectations.
        Editor's Note: (c) 2009 T. Rowe Price Report, a quarterly publication of T. Rowe Price Associates, www.troweprice.com