Waiting for the end

In the run-up to the U.S. elections, investors might have been forgiven for thinking the worst of the bear market was behind them.

The S&P 500 had bounced off of its low of about 840, set on October 27, to above 1,000 by November 4, 2008 – Election Day. The choice of Illinois Senator Barack Obama was largely based on change with much of the election night coverage showing a sea of optimistic faces.

But optimism is precisely the opposite of what many market watchers have been looking for: capitulation. Conventional wisdom holds that in market downturns as dramatic as that derived from the credit crisis, savvy investors should wait for signs that everyone else has lost all hope in the capital markets before stepping in and picking up oversold bargains.

SO HAS THE MARKET CAPITULATED? “History says that you’ve capitulated when the market trades into the single digit P/E multiples,” says Kim Shannon, president and chief investment officer of Sionna Investment Managers.

“Last I looked, P/E multiples in Canada were about 12 on a trailing basis, which is very cheap – I haven’t seen them this low in a long, long time. But we know earnings are declining, so the P/E multiple is going to rise a bit.” In a bull market, investors use market pull backs as a buying opportunity, and the reverse is generally true in a bear markets – rallies are often used as selling opportunities. So far, Norman Raschkowan, chief investment of- ficer at Mackenzie Financial hasn’t seen this kind of selling. “You’re going to have that churning, and it will seem like [the market is] bouncing along the bottom for a bit,” he says.

“I don’t sense a degree of panic from the average investor that you might associate with these kind of movements in the markets.”

CHARGE LED BY D.I.Y. As bad as the markets have been since mid-September, they really did not fall as far as some had expected. There’s still a good chance of capitulation at some point and according to Bruce Curwood, director of research and strategy at Russell Investments Canada, the charge will likely be led by do-ityourself investors.

“There are a number of investors out there and most of them are not informed,” says Curwood. “They get panicked by headlines in the paper, so some people run for the exit. As people sell out, that’s the point you talk about market capitulation, when retail investors throw their hands up and say I want out at any cost.”

What sets the current bear cycle apart from outright capitulation is that the decline has been in marked stages, indicating the collapse of confidence simply isn’t there.

“What often happens to mark the bottom is an oversold market where you get all these sellers going out at once and capitulating,” says Jeffery Shaul, president and CEO of Robson Capital Management. “But this kind of steady decline means people are holding on, which suggests we’re not at a bottom.”

Shaul expects more problems to crop up in the American economy before the markets turn around. He’s worried about rising credit card default levels in the U.S., and when major corporations are forced to re-evaluate their pension assets. “You’re going to find significant deficiencies in funding,” he says. “Then you’re going to continue to see worsening in the real estate market and significant layoffs,” he adds.

OPTIMISTS SEE REBOUND Curwood is slightly more optimistic. He says markets always come back, and with government intervention, it is likely things will turn around; he’s just not sure when that will happen.

“It’s not the time to make a major decision or do anything dramatic,” he says. “Markets are moving; there are huge swings over the course of the day. Just hunker down, put the money in a strategy you can tolerate for a long time. Don’t sell out after going down 35%.”

For the average investor, dipping a toe back into the market is still a frightening proposition. Investors should be wary of mistaking the euphoria that followed Obama’s election victory for a turn in investor confidence. The fact of the matter is, the incoming president may have little control over the direction of the economy.

“The credit crisis is so large, and looms over anything politicians could do, that the course for the economy will be dependent on the results of the unfreezing activities on the part of the Treasury and the Fed,” says Fritz Meyer, senior market strategist for Invesco AIM, the American sister company of Canada’s Invesco Trimark.

He says the policy initiatives that are already in place are slowly having an effect, and that the U.S. economy will likely emerge from the downturn ahead of Europe. Emerging markets should hold up well, but the pace of growth will be moderate.

“The election has come and gone and I think its effects will be de minimus on the markets for the time being,” Meyer says. “At the same time, I think the market has bottomed… [but] obviously there are no guarantees.”

The recent spike in the VIX (volatility index) took it to a reading of about 80, nearly double its historic levels, which Meyer says suggests “this probably was the mother of all panic-selling indicators. I suspect that did mark the market bottom.”

Shannon is less sure.

“Nobody rings a bell at the bottom of the market to let us know its happening,” says Shannon. “You don’t get capitulation in a couple of days. I think we still have a ways to go.”

Make that, quite a long ways to go.

“History says you go through sideways markets for 15 to 30 years, and we’re in year eight, I believe, of a sideways market,” Shannon says.

“We’ll have lots of volatility, lots of opportunity to make money, but at current levels there is opportunity to pick away at this market and your five- and 10- year returns are likely to be quite good in the fullness of time. But it could well be a psychological rough ride still to go.”