The Bear Market of 2008

"The market is most dangerous when it looks best;
it is most inviting when it looks worst."
- Frank J. Williams

Traditionally, a bear market is defined as a market decline of 20%. The Dow Jones Industrial Average officially reached bear market status on July 2 when it closed down 20.8% from its record high last October. Over the past week, the technology-heavy Nasdaq index and the broader S&P 500 index have also dropped into bear market territory.

The current bear market was ushered in by a dismal June - the worst for the Dow since 1930. The economic reasons for the market decline are well known. U.S. economic growth has slumped amid difficulties in the credit and housing markets, while rising prices for oil and other commodities have boosted inflation. This has put the Federal Reserve in a difficult spot. They are unable to cut interest rates due to inflation concerns, but are hesitant to raise rates for fear of slowing the already tepid economy.

Perhaps the only good news is that stock prices are now beginning to look more attractive. The S&P 500 is trading at a price-earnings multiple of about 15 times this year's expected earnings. To put this in perspective, the average P/E ratio over the past ten years was 18.7. This suggests that U.S. stocks are reasonably priced, but not yet at bargain-basement levels. Another valuation approach is to compare the market's earnings yield (earnings divided by price) with the yield on U.S. government bonds. The earnings yield for U.S. stocks is currently about 3.4% higher than the yield on 10-year Treasury bonds, suggesting that stocks are more attractive than bonds.

This does not guarantee that stocks will turn around any time soon. It is all but impossible to pick a market bottom prospectively. There have been nine bear markets since 1960 ranging from a few months to two years in duration. Bear markets typically end with investor panic and a selling climax, but they can also simply run out of steam in a less dramatic fashion. Historically, stocks have snapped back relatively quickly. Since 1960, it has taken an average of only 12 months for the stock market to recoup its losses from the bottom of a bear market.

According to David Swensen, the highly regarded investment manager of Yale University's endowment, investors should be wary of their instincts in harsh economic times. "The human tendency in this kind of environment is to do something - to make a change," he says. According to Swensen, most people get nervous during an economic downturn and want to sell stocks. "And that's exactly the wrong reaction. Buying high and selling low is not a way to make money."

Our advice is simple. Establish a sound asset allocation strategy that fits your investment objectives and risk preferences and avoid the temptation to time the market. If historical precedent has any value, you should be rewarded in the long run.

As always, please feel free to contact me if you have any questions or comments.

Jeffrey J. Brown, MD CFA
Principal, Shearwater Capital

July 2008

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