Monday Morning: If history repeats, bottom is yet to come

Is the stock market still overvalued, or is it now cheap?

If you ask a dozen different market gurus that question, you would probably get a dozen different answers.

Yet it is a question every investor must answer, perhaps with the assistance of an investment adviser. The answer will determine what actions the investor should take: Continue to stand pat and wait for the market to recover; build a cash reserve; or begin to commit current reserves to the market.

Every time I begin to think the market is looking attractive, I remember the 1973-74 bear market. I wasn’t an investor then, just an observer as executive editor of InvestmentNews’ sister publication Pensions & Investments. But many institutional investors I interviewed at that time thought the market was cheap long before it stopped declining.

The current environment reminds me in some ways of the 1973-74 period. That period also experienced a bubble, or at least a mini-bubble. Anyone remember such hot stocks as National Student Marketing? Investment concepts that now look ridiculous commanded high multiples then, just as some Internet concepts commanded such multiples last year.

When the 1960s bull market collapsed, the decline took far longer than anyone anticipated. The market actually began correcting in 1969 and didn’t hit bottom until late 1974. Small-cap stocks in 1969 were down 25.1% while large-cap stocks were down 8.5%. In 1970, the small-cap stocks plunged again, falling 17.4%, but large-cap stocks managed to gain 4%.

Many people believed the correction was over in 1971 when small-cap stocks gained a handsome 16.5%, and large-caps gained 14.3%. They were convinced when small-caps gained 4.4% in 1972, and large-caps were up 19%.

But a false dawn, or, as some market experts called it, a “bear trap,” grabbed investors with a vengeance in 1973. That year, small-caps were down an incredible 30.9%, while large-caps dropped 14.7%. The carnage continued in 1974 as small-caps declined another 19.9%, and large-caps were down 26.5%.

Even the “nifty fifty,” stocks such as IBM, Xerox Corp. and Polaroid Corp., which many believed were immune to market corrections, fell out of bed those two years. By the time the market bottomed, the Dow Jones Industrial Average had lost almost half its value. That is, it was a 50% correction.

We have a long way to go before the current correction equals that one, but there are enough similarities to make one wonder if it could happen.

The primary similarity is that the market has just experienced a significant bubble, driven by the Internet and technology companies. Investors overreacted on the upside; they’re also likely to overreact on the downside.

A second similarity is that energy prices are high and rising, and inflation seems to be creeping up. The 1973-74 period was the era of the first oil shock.

Of course, there are as many differences as similarities. First, inflation, though edging up, is low and interest rates are low and edging down, not high and rising as in 1973-74.

Second, there is no Vietnam War to distort the U.S. economy. Unemployment is low, though apparently beginning to edge up, while it was high in the earlier period.

Those differences favor today’s market. Another key difference may not.

In 1974, Congress passed the Employee Retirement Income Security Act, which set strict funding standards for pension funds. Even before Erisa was passed, companies began to step up the funding of their pension plans, and the contributions helped lift the market out of its doldrums. Small-cap stocks surged 52.8% in 1975, and large-cap stocks jumped 37.2%.

Today there is no pending Erisa to spark fresh money flows into the market. And the bear market may even induce some 401(k) participants to withdraw part of their assets to permanently reduce their equity exposures.

The current market weakness began in last year’s third quarter. If it is to last as long as the 1973-74 bear market, it has another nine months to go.

Perhaps I’ll wait a little longer before I get back in.

Mike Clowes is the editorial director of InvestmentNews

Related Topics: Just Thinking