Remember, Markets Rebound Before Economic Data Improves

As we head into 2009, the economic backdrop looks gloomy. Two important measures in particular, employment and corporate earnings, are set to deteriorate further throughout next year. The unemployment rate has risen from 4.4% to 6.5%, but many are now predicting a peak of 8%-9% sometime in 2009. Corporate earnings will fall for the second straight year in 2008, but many top-down forecasters expect a third year of declines. Does that mean stock prices have a lot further to fall still? Not necessarily.

Remember, the stock market is a discounting mechanism. It reflects future events ahead of time, as the 50% decline over the last year or so reflects. At some point, stock prices reach levels where they already are reflecting the assumptions of continued weakness in unemployment and corporate earnings. Bill Hester, of Hussman Funds, helps to shed light on this concept. He writes:

“The four-week moving average of the jobless claims data breached 500,000, which has happened only 4 other times. It occurred in December of 1974, in April of 1980, in November of 1981, and in March of 1991. During the 12-month period following these periods, the S&P rose 32 percent, 30 percent, 20 percent, and 9 percent, respectively. These periods also shared attractive valuation. Over the four periods the price-to-peak earnings ratio averaged 8.75, which is about right where the market’s current valuation is. Although it’s a small sample, low valuation, coupled with economic data confirming a substantial contraction in the labor market, has offered longer-term investors very strong average returns.

Those returns aren’t restricted to bull markets that follow the worst recessions. Returns following all of the recession-induced bear markets have been quite strong. First-year returns following a recession have averaged 37 percent with surprisingly little variation. Not including the out-sized gains following the 1982 bottom, all of these first-year bull markets gained between 29 and 44 percent.”

Even if we assume, as the market has already begun to grasp, that both employment and earnings don’t trough until mid or late 2009, we should not assume that the market will not hit bottom until those numbers stabilize or improve. Examining market history shows that the market rebounds before the economic data signal the recession has ended. As always, the market is a discounting mechanism.

Now, I don’t know if the economy will bottom in early 2009, mid 2009, late 2009, or during 2009 at all. As a long term investor, I don’t find it very helpful to try and guess between outcomes that are only a quarter or two away from each other. Even Nouriel Roubini, the biggest proponent around of a doomsday economic scenario, thinks the recession will end by the end of 2009. Even if you believe in his forecast, the market would start a new bull market in Q3 or Q4 of 2009 (3-6 months before the recession ends, as history suggests). If he is proved a bit pessimistic, it could be even sooner than that. As a result, long term investors should be buying, not selling at this point. Equity market valuations are too low to make the case that the market has not yet discounted most of the bad news we are likely to get in coming quarters.