Tuesday, 26 May 2009

How Long Till the Stock Market Recovers?

From time immemorial astrologers have been foretelling the future. They are still at it. Back in January, Vedic Astrologer said the stock market will be good in March (correct), bad in April (wrong), good in May (correct) and June but "A New Moon Solar Eclipse in July 2009 will not be good for Stock Market; there may be some crisis in Stock Market."

Those with a more rationalist bent may discount such prognostications but the question of how long it will take before the stock market regains former highs or even begins rising is an important and valid issue. Various methods propose an answer.

The History of Past Downturns and Recoveries
There have been dramatic stock market downturns associated with severe economic slumps similar to the current episode in the past. The most extreme example is the the 1929 crash and depression that followed. Crestmont Research's Stock Matrix Options chart shows that a taxable US investor who had invested at the peak in 1929 would have had to wait 22 years to break even after inflation with an investment in the S&P 500. Will it be as bad this time?

Fund provider IFA's Probability of Portfolio Recovery page graphs in figure 9-B the chances that portfolios with various mixes of stocks and bonds will recover within a certain number of years. The graph says two significant things:
  • full recovery will probably take a long time - e.g. a portfolio of 50% stocks and 50% bonds is 90% sure to fully recover in 14 years, though there is a 50% chance it could be only 7 years
  • portfolios with a lower proportion of stocks will likely recover more quickly than one with just stocks since they will not have fallen so much in the first place
Secular Market Cycles
This approach maintains that stocks markets go through long term cycles in which stock prices rise unduly compared to earnings and thus the Price to Earnings Ratio (P/E) goes above the normal long term average of about 15x. John Mauldin in While Rome Burns graphs the excessive rise in P/E in recent years and shows that in past cycles, the inevitable correction drove prices and the P/E down below the average. The suggestion is that the correct market downturn may not be over yet and a new bull market probably won't start till the middle of the next decade, after which returns climb strongly again.

Robert Schiller, the author of investing book Irrational Exuberance, expounds a similar view in this Yahoo Finance article and video clip, saying that the S&P 500 P/E is likely to go down to 10x from its current 14x before climbing again.

Credit Crises, Real Estate Slumps and Market Crashes
A third method of trying to figure out when bad times might end and good times return comes from economic studies. International Monetary Fund researchers posted Global Financial Crisis: How Long? How Deep? over at Vox EU in which they summarized past episodes of such crises - yes, they have happened before, though not on a global scale - and found that recessions could last up to four years with stock market declines of up to 50%.

Lessons for an Investor:
  • stock / equity investing is for the long term, at least ten years, better 15 years;
  • reasonable expectations will increase patience in the downturn, avoiding the error of selling after the downturn; cautious expectations will also improve investment planning
  • a portfolio approach is the way to go: mixed portfolios of stocks and bonds cope better with market cycles
  • portfolio composition needs to be aligned with investment objective time frames
  • markets do recover, even extreme downturns are eventually followed by upward cycles

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