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What Can the 73/74 Bear Market Teach Us?

A question on many investors' minds is did the market bottom last month at 7,449 on the Dow and 741 on the S&P 500? No one can hope to provide the answer to that question today as lows are only determined well after the fact. Both the Dow and S&P rallied off those lows, advancing by 17% and 19% respectively by the end of the month. The indices then promptly gave back about half those gains in the first trading day of December. Bear markets frequently stage short-term rallies that only serve to set investors up for the next fall. Forming a bottom is an unnerving process. It is not an event.

The current downturn in stock prices is every bit as bad as the 1973-1974 bear market. Historians will recall how it followed the OPEC Oil Embargo that caused oil prices to double and the U.S. economy to shrink. Higher oil prices caused input prices to rise all along the supply chain, even in the face of falling demand. Nixon's ill-advised wage and price controls only exasperated the situation. In addition, the 1970's saw baby boomers entering a job market that was declining. As a result, inflation took hold of our economy even while unemployment rose. Stagflation became a part of our economic vocabulary.

From the stock market's peak in December 1972 to its low on October 10, 1974, the Dow dropped a total of 46.2%. The future of the U.S. looked pretty dismal in October 1974. From the resignation of the disgraced President, to high inflation and long lines to buy gasoline, there were no easy answers as to how we could get out of the mess in which we found ourselves. Consequently, the October 1974 low did not light the fuse for a sustainable market rally, as the Dow rose and then tested that low again in December. Finally, over the ensuing 7 months, the Dow rallied 55%, almost in a straight line. By April 9, 1976, sixteen months after the December 1974 low, the Dow almost reached its prior high of 1,067.

By comparison, from October 12, 2007 to its low on November 21, 2008, the Dow dropped a total of 47.5%. What lessons from the 73/74 bear market can we apply this time around? First, if we allow ourselves to suffer the pain of reorienting our economy to the new environment, we will recover. Second, there will be false starts along the way that make it hard to know when the worst has passed. And third, the initial recovery in the stock market will be sharp and quick. It will take most investors by surprise. Many of the stockholders who decided to duck out of the market for awhile will wait for a retest that will not come on their timelines. They most likely will miss the first 30% of a sustained market advance. As we've heard and said many times, it is hard to time the stock market - sell before it goes down and buy before it goes up.

So, what's an investor to do?

FOR INVESTORS WHO HAVEN'T SOLD: our advice is to maintain their present allocation to the market, but re-evaluate the holdings in their portfolios. What worked the best in the last bull market may not do so well in the next one. Therefore, we'd use the near-term volatility as an opportunity to reposition some investments - sell low and buy low. We believe the global recession will change the trajectory of the rates of growth for the emerging economies, but not derail them. The deeply cyclical, capital-intensive metals, mining and industrial companies whose customers require bank-financing may not come back as quickly as the "average" stock. Companies with significant exposure to Europe's economies may lag U.S.-oriented enterprises. We should see a re-emergence in the demand by new laborers in the emerging markets to strive to improve their standards of living with better food, shelter and clothing.

FOR STOCK INVESTORS WHO HAVE SOLD (and are looking for an opportunity to reinvest their cash): our advice is to invest their cash in several stages and understand that the purchases will not be at the bottom. The market bottoms about 5-6 months ahead of the economy. However, bad news will persist even after we've touched the bottom, so waiting for positive news to confirm the bottom may too costly in terms of lost opportunity.

A good, first confirming-sign the market has probably discounted the worst is that stocks stop responding negatively to bad news. A healthy credit market will serve as a second indicator of firmer footing in the stock market. Have the credit markets improved enough to allow high quality corporate borrowers to float new bond issues? Third, how the market responds to developments coming from the new Obama administration will provide a flavor for the market's acceptance of the change in policy direction. Does the market's reaction confirm support for the new legislative or regulatory initiatives promulgated during the early weeks and months of the new administration?

We expect 2009's economic news to be as ugly as 2008's financial market news. Yet, there's reason to believe the worst is behind us. We hope the New Year brings everyone better news and bigger portfolios.