Monday Morning: Looks like the market has room to grow

Just as I was thinking the stock market recovery was perhaps getting ahead of itself, along comes a timely report from Eric Bjorgen, a senior research associate at The Leuthold Group in Minneapolis, that provides perspective.

This is typical of the analysts at Leuthold. They often seem to anticipate questions investors may have that market history can help answer, and they do the research before anyone asks.

In this case, there were two related questions: How strong has this market recovery been compared with past recoveries, and is the market ahead of itself?

Mr. Bjorgen anticipated the questions, and his research suggests that the current recovery is below average, and the market isn’t ahead of itself, at least by historic standards.

As of Aug. 19, the Standard & Poor’s 500 stock index had gained 29% from its bear market low Oct. 9, well below the average of 40% to 44% gains for the 10th and 11th months following a bear market bottom.

This could mean that investors are still shaken by the collapse of the bubble and are therefore pricing stocks with extra caution, or that the market regards the economic recovery that underlies the market as being weaker than current data suggest, or that all the uncertainties surrounding Iraq and global terrorism are holding back investors.

Historic perspective

To conduct his research, Mr. Bjorgen first identified all the bear markets since 1900 where the market dropped at least 20% from peak to trough, a typical definition of a bear market. He then added two more declines where the peak-to-trough losses were greater than 19%.

Mr. Bjorgen examined the market performance one, two and three years after its bottom, the average cumulative monthly performance over the three years following bear market lows, and the average monthly return segmented by the number of months into the recovery.

He found that the average peak-to-trough bear market decline over the past 100 years was 37%, though eight of the 22 bear markets saw declines of more than 45%.

The 2000-02 bear market experienced the third-largest decline of the S&P 500 in history, a loss of 49%.

Mr. Bjorgen also found that the majority of stock market gains for the recovery occurred during the first year. The average stock market gain a year after the low point was 47%, though they have been as little as 13% and as great as 172% (following the July 1932 low).

By the end of the second year of a recovery, the market typically has gained 61% from its low, but in the third year, the cumulative gain falls to 56% because a new bear market often has begun by this time.

Mr. Bjorgen’s research confirms that the biggest monthly gains are made during the first month of a market recovery. The market gains about 13%, on average, in the first month.

The monthly gains for subsequent months are far lower, dropping to just over 4% in the second month and hovering below that in subsequent months.

While down months occur only 26% of the time in the first 12 months of a recovery, they do occur, and on average, the returns are negative in the 13th month. By the third year, there is a 50% chance any month will be down.

The stock market gained 19% in the first 20 days of the current market recovery, but at the end of three months, the gains were merely tracking the historic returns and are now below average.

According to Mr. Bjorgen, based on historic gains, the S&P 500 should peak at about 1250 toward the end of the second year of the recovery, suggesting that the market could still gain about 25% from current levels.

Anticipating objections that looking back to 1900 is no longer relevant because of changes in the economy, Mr. Bjorgen examined bear market recoveries from 1957 to present. Even on that basis, the current recovery lags the average, though by a smaller amount.

The message seems to be: Based on market history, the current recovery is actually below average, and the market has room to generate significant additional returns.

One other encouraging point: Mr. Bjorgen found that the market has suffered a loss in the second year after a market low only three times, and the last time it happened was 70 years ago.

Unfortunately, the research doesn’t tell us what sectors of the market are likely to perform well in the second year of a recovery. But it is nice to know that if you invest in a diversified portfolio, the odds still are in your favor.

Mike Clowes is the editorial director of InvestmentNews and sister publication Pensions & Investments.