Are you a Bull or a Bear? Is this Stock Market Broken? Where's the Bottom?

The Battle Between the Bulls (those who think the stock market will go up) and the Bears (those who think the stock market will go down) continues.

Are you a Bull or a Bear?

The Bulls

On March 11, 2008, Investors Intelligence released their latest Bull Bear Ratio.

As of that date, there are 31.1% Bulls and 43.3% Bears. The Bull Percentage is very low (and even less than the Bear percentage) which suggests that we may have some sort of bottom. Many other metrics show that the stock market may be oversold.

In addition, the market as represented by the S&P 500 recently successfully re-tested the 1270 lows and may be poised for a double bottom reversal, if we breakout from current resistance.

Dean Reese, on the Trading Goddess Blog, makes an argument that the market is not broken based on rare relative strength levels (RSI) and the 38.2% Fibonacci Retracement off a five year trend.

The Bears

However, looking at the chart from many angles, the intermediate trend looks down.

The S&P 500 is still below both the 50 and 200 day moving averages.

While we appear to have a double bottom based on the bottoms on January 2008 and March 2008 at the 1270 level, we do not have a double bottom reversal just yet. We need to see strength first.

The S&P 500 also appears to be forming a possible inverted cup and handle bearish formation.

In addition, the three year (or more) uptrend appears to be over.

Looking from a non-technical perspective, there were nine recessions from 1950 to 2007, and the average length of the decline was around 10.3 months. If we use this average, and use the start of the decline as October 2007, then we estimate that the downturn will end around August 2008.

How deep will the S&P 500 fall?

Dean Reese in the same blog entry on the Trading Goddess Blog, claims we can have a tradable bounce based on the 38.2% Fibonacci Retracement Holding (S&P 500 is very near the 38.2% Fibonacci Retracement Levels based on a 5 year trend).

While 38.2% is a potential support area, the market could find support even lower.

I added more annotations and comments to Dean Reese's chart:


If we consider the 50% and 61.8% Fibonacci Retracements, they both coincide with other areas of support and appear to be valid areas of support.

In addition, if we look at the period from November 2003 to August 2006, we notice a lot of congestion (the box on the diagram). This suggest much stronger support in this area.

Investors and traders who started going long towards the end of 2006, did not have much time to get on board, and most likely have been shaken out. Those who were in the market from the end of 2003 to the end of 2006 are starting to get nervous.

But because of the congestion from November 2003 to August 2006, we can speculate that we can find a stronger bottom here, from around the 1070 level to the 1267 level. This happens to coincide with the 61.8% (1077) to 50% (1172) to 38.2% (1267) Fibonacci retracement area.

So yes, it is possible that we still have up to 17% downside on the S&P 500 (if 1070 is the estimated bottom).

Silver Lining?

But as with all recessions and bear markets, this too will end, and we could have a great investing opportunity sometime this year or next year.

Interesting Symmetry

I flipped over the annotated chart above. Compare the chart above and the chart below. Notice the amazing symmetry? And you know what happened from 2000-2002.

Stock Market Performance During Recessions

Common Wisdom often suggests that the US Stock Market indices go down during a US recession. How true is this?

According to National Bureau of Economic Research (NBER), there have been nine Recessions (*) from 1950 to 2007.



The S&P 500 Stock Market return during these nine recessions has averaged -0.4% with a low of -22.9% (1973 to 1975) to a high of +16.4% (1953 to 1954).

If we look at the return of the S&P 500 six months before the Start of the Recession to the Peak, the S&P 500 during this period returned an average of -3.7%.

If we look at the return of the S&P 500 six months before the Start of the Recession to the Trough, the S&P 500 during this period returned an average of -4.1%.

Any Positives?

The S&P 500 during US Economic Recession from 1950 to 2007 has been mildly flat to down, confirming common wisdom. However, we can take some positives from the data.

The average ratio between the length of time of an Expansion to the length of time of a Contraction, is 6.7. This means that for every month the US market contracts, (during this particular 1950 to 2007 period) the US market expands 6.7 months.

The S&P 500 return from Previous Trough to Current Trough (8 entries from 1950 to 2007) averages a whopping 80%. If we annualize this per year, the stock market S&P 500 returned 11.7% during expansion phase from 1950 to 2007.

(*) Definition of Recession According to NBER

According to NBER:

The NBER does not define a recession in terms of two consecutive quarters of decline in real GDP. Rather, a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. For more information, see the latest announcement on how the NBER's Business Cycle Dating Committee chooses turning points in the Economy and its latest memo, dated 07/17/03.

Other Views of Stock Market Returns during US Recession

New York Sun Article.

MarketWatch's Mark Hulbert Article.

BestWayToInvest Article

S&P 500 Index Values used in Research

The NBER Cycle link only provides the month start and end of a Recession. S&P 500 prices were sampled at the first day of the month mentioned by NBER.

Risks of US Recession may be Increasing

According to many sources, the risks and odds of a United States Recession may be increasing.

Here's an article from MSNBC.

Here's one from TheStreet.com.

According to the TheStreet.com article, different firms rate the odds of recession in the US:

1. Bill O'Donnell UBS 67%
   
2. Jack Ablin Harris Private Bank 65%
   
3. Kevin Giddis Morgan Keegan 60%
   
4. Greg Collins Fountain Hill Investments 60%
   
5. Robert Pavlik Oaktree Asset Management 45%
   
6. Tobias Levkovich Citigroup 40%
   
7. Fred Dickson D.A. Davidson 40%
   
8. Richard Sparks Schaeffer's Investment Research 20%
   
9. Neil Hennessy Hennessy Funds 0%
   

What are the Odds of Recession in USA Now (January 2008). Calculated Here.

Many people are concerned about the slowing economy and a possible US Recession.

Can we calculate the odds of a recession?

There are many models, but one of them is by the Federal Reserve Board's Jonathan Wright. It takes three items into consideration:

1. 10 Year Treasury Bond Yield
   
2. 3 Month Treasury Bond Yield
   
3. Federal Funds Rate
   

More information on this available here

Odds of Recession as of January 2, 2008

Current Numbers:

1. 10 Year Treasury Bond Yield: 3.91% (50 Day Moving Average: 4.17%)
   
2. 3 Month Treasury Bond Yield: 3.26% (50 Day Moving Average: 3.34%)
   
3. Federal Funds Rate: 4.25%
   

If we calculate using the current yields, the Odds of Recession as of January 2, 2008 over the next 12 months is 12%.

If we calculate using the 50 day moving average of the yields, the Odds of Recession as of January 2, 2008 over the next 12 months is 9.5%.

The Odds of Recession has gone down since we last calculated the odds on September 1, 2007 (23% odds of recession over the next 12 months from then).

Recession Odds: 23% and How to Calculate Odds of Recession

Is there a way to calculate the odds of a recession in the US?

There is one model which takes into account the spread between the 10 Year Treasury Bond Yield, the 3 Month Treasury Bond Yield and the Federal Funds Rate. This model was created by Federal Reserve Board's Jonathan Wright in The Yield Curve and Predicting Recessions.

Some general points regarding the Yield spread and the Fed Funds Rate:

1. The bigger the difference between the 10 Year Treasury Bond Yield minus the 3 month Treasury Bond Yield, the less likely a recession will occur within the next twelve months. This the the normal upward sloping yield curve. The bigger the difference between the 3 Month Treasury Bond Yield minus the 10 Year Treasury Bond Yield, the greater the chance of a recession within the next 12 months. This is the inverted yield curve case.


2. The higher the Fed Funds Rate, the greater the odds of a recession within the next twelve months.

To Calculate

To Calculate, use the calculator on this website. The calculation is based on Jonathan Wright's work mentioned above.

You will need these:

1. The 10 Year Treasury Bond Yield. Get the information from Stockcharts.com using $UST10Y. The value of the $UST10Y, is the Yield on the treasury. Currently, as of August 31, 2007, the 10 Year Yield is 4.54%


2. The 3 Month Treasury Bond Yield. Get the information from Stockcharts.com using $UST3M. Currently, the 3 Month Treasury Bond Yield is 4.01%.
   
3. The Fed Funds Rate. Go to Bankrate.com to get the current Fed Funds Rate. It is currently at 5.25%. You can also estimate the odds of a Fed Rate Cut Here.

Chance of Recession as of August 31, 2007: 23%

Now to do the actual calculation, go to the website with the calculator.

Using the values mentioned above, we find out that there is a 23% chance of recession within the next twelve months. If the Fed cuts rates by 0.50%, then the odds of a recession (let's assume that the yield spread remains the same) goes down to 18%.