12. Big Market Bottoms (and Tops)

It is impossible to spot a big market bottom until after the fact, but as of November 2022, it was clear we are still down the path to a bottom. In October the market hit a low of about -25% below its previous peak. It has recovered a bit since then and is still above its long term mean. A mean reversion implies, the market has always eventually dropped below that mean after reaching the heights it did earlier in 2022. The odds are about even (~50/50) if we are close to bottom of no more than 5% to 10% further down) or a long way (20% to 30% further down). Comparing the big drops that have occurred over the past 50 years, this one does rhyme with the other big drops: the inflation of the 70's, the tech bubble bursting in the early 2000's and the financial crisis late in the first decade of the 2000's. Below is what each of those declines looked like from the peak to the trough. Unfortunately for those prior events it always took more than 4 years to reach another peak.

The periods of time over the past 50 years that shared some similarities to today (red) are: the high inflation 70’s (yellow), the tech bubble (blue), and the financial crisis (green). (The pandemic decline was a black swan event whose negative impact on the market was quickly extinguished with historic fiscal and monetary moves.) But none of these moments in time are identical to now.

In the mid 50’s valuations began oscillating above historical valuations and interest rates were rising from very low values. But in the 50’s and 60’s we rarely saw the kind of market extremes we have seen more recently. The tech bubble burst early in 2000 from ridiculously high valuations, even worse than today. The financial crisis became a systemic threat with the risk of wide spread contagion that crushed the market. Unfortunately the periods of time that most closely rhyme with today are the tech bubble and the financial crisis, which each bottomed out around 50% down from the previous peak. But even then, because interest rates were higher than they are now, there was room for monetary policy to provide some backstop.

We are coming off a valuation peak similar to, but slightly less than the tech bubble. The rate of decline and the time it took to get from a market peak to this level (about -22% from peak SP500) is roughly similar in both periods (roughly a year, more or less). But interest rates at the time began a lot higher and the FED had room to ease when the bubble began to burst. Today the FED is raising rates with historic speed to combat inflation (never fight the FED is still prudent advice). Rising rates from the near zero bound means the FED has no dry powder to stimulate the economy; equities and bonds are likely to both offer negative returns while rates rise (as they both already have in 2022). (The pandemic hit right at the wrong time triggering a needed, but massive fiscal injection from the government, just as the FED had over played its hand by keeping interest rates too low for too long, in its efforts to get inflation up to 2%.) Now, until inflation slows or the FED begins to soften its stance, it is not a time to be aggressive, unless you are confident in contrarian indicators. There is more on that later in this article.

Large market declines usually follow valuation bubbles bursting (e.g. tech bubble), market crises (e.g. financial crisis), or over stimulating monetary or fiscal policy. Black swan events, like the pandemic, are unpredictable and the negative impact can be fast and severe. The recovery can be fast as well if fiscal and monetary policies are appropriate. But it may take monetary and fiscal heroics that have unintended consequences going forward. A black swan event is an outlier that can be catastrophic to markets. (If Russia uses nukes in Ukraine or China invades Taiwan all bets are off).

But all hope is not lost as we enter here. There will be a positive opportunity at some point in the near future. In almost 100 years the market has never failed to eventually make a new high. But you will need patience (it can take years to return to a peak) and a strong stomach (a year bouncing around the bottom is possible and it’s not smooth ride up). So it is worth looking at the details that characterize market bottoms. And see what rhymes with the 4th quarter 2022.

Below is a plot of the SP500 over an almost 30 year span (1993-2022). The top plot (log scale) identifies the big declines and their primary cause. The mean (least mean squares exponential best fit) and peak lines are superimposed. The bottom plot shows how far down in percent the market declined from the previous peak. The time line ends in September 2022 with the SP down around 25% from its previous peak.

As you can see, peak to trough declines of 40% to 50% are quite possible. The great depression was far worse. It took about 4 years to hit bottom over 80% below the previous peak and then another 10 years to reach that peak again.) Below is the plot of how far below a previous peak the DOW dropped over almost 100 years.

The market mostly tends to drop much faster than it rises in these large swings. For market shocks that ratio tends to be higher and for bubbles correcting to the mean its lower.

It is easy to be pessimistic in late 2022. Reading the headlines can be a downer. But on any given day you can find expert headlines that scream opposites. It has been noted that the Leading Economic Indicator is a valuable contrarian metric. The indicator has recently fallen implying we are in a bottoming process. So I dove into the numbers. It appears to be a coarse indicator, but that does a fairly remarkable job of identifying market reversals. It often tends to be an early indicator.

To improve matters I created a "predictor" metric based on this indicator along with some other variables in a simple learning machine. The metric includes the FED rate and velocities of the FED rate and the Leading Economic Indicator. Below is the data for the past 62 years (December 1960 - October 2022). The combined metric (red) is shown superimposed on the 1 year future return of the DOW (blue). A reversal of the metric off a low does provide some hope that a bottoming or peaking period has occurred.

(Note: The Y axis values are normalized, so divide by 10 to get the 1 year actual average future return of the DOW in percent. The blue line of the DOW future actual returns ends 12 months before the indicator.) The red line is the predictor’s value at the beginning of the year’s window of time. It does a fairly good job except when it doesn’t. Over the past 60 years, the worst performance for the indicator were the following periods: the volatile high inflation 70’s, the post inflation recovery in the 80’s, and the tech bubble in the 90's. The indicator hit a low and began rising in October 2022. Of the 9 or so big market bottoms (1 year average return worse than -10%), the indicator got it right 6 times. Of the 15 big market tops (return over 10%), the indicator got it right 11 times. And when it got it right, it nailed it.

Another data point is the result of the short term analysis from an earlier InvestEngines article entitled “Climbing further out on a limb”, (this was a review of the short term cyclical performance of the learning machine’s portfolio). Below is an updated chart from that piece and it supports that we may be in a bottoming process, with the next portfolio peak sometime in 2024.

The light blue line is the actual annual return of the learning machine portfolio (updated every day). The dark blue line is the 1 year trailing average of that annual return. The light red line is the model predicted return. The dark red line is the 1 year trailing average of the model’s prediction. Training ended in early 2021.

The stop loss machines went back “IN” during June (for the learning machine managed portfolio) and September (for the SP500). If the peak to trough value for the SP, which hit -25% earlier in October 2022, stays above that in the near term, then a positive market response for the next 12 months is probable. If the peak to trough dips below -30%, then the probability shifts very negative with another -20% or more decline. For now, as goes inflation and the FED rate, so goes market expectations. A higher inflation reading will indicate the FED is not likely to ease. A stable or lower reading will give the FED room to slow rate increases or pause and would be a boost to market expectations.

There has not been a combination of market extremes (coming off near historic high valuations), interest rate extremes (coming off historic lows and rising at historic rates), and worldwide economic and Geo-political uncertainty in the past 30 years that match conditions at the end of 2022. The data indicate a bottoming process may be in play. The silver lining is what happens after the bottom is in. So all is never lost.