The Recovery Stocks Market Playbook: What's Next?

We continue to believe that March 9th likely marked the low of the banking crisis and perhaps the bear market. While we don't mean to beat a dead horse, our reasoning is that the combination of the Fed's actions, the fiscal stimulus package, the creation of the PPIP's, and the change made by FASB will wind up putting a dagger in the heart of the banking crisis. And in our humble opinion, with the end of the banking crisis comes the end of the need for the market to discount the potential for things to get worse in the economy.

Therefore, we feel it is probably best to start looking ahead. So, this weekend we thought we'd take a look back at history to see if we can't come up with a playbook for what to expect from the recovery phase in the stock market.

With any attempt to forecast the future comes the requisite caveats, the biggest of which is that we just don't have very many Bear markets featuring declines of more than 50% to draw from. Thus, our sample size could be considered a bit skinny from a statistical standpoint.

At the same time however, we will add that if we didn't think the exercise would be worthwhile, we wouldn't be wasting your time with it!

Is Buy and Hold Back?

For starters, we should point out that we don't believe that top stocks are about to embark on a secular bull market (think 1982 - 2000). No, the combination of the debt levels in the economy and the dueling crashes in stocks and real estate suggest to us that we may see a period of retrenchment and debt reduction among consumers. This period, which is likely to last many years, will feature more savings and less conspicuous consumption.

Therefore, we believe that we are likely in for a prolonged period of mini-bull markets and mini-bear markets while the economy recovers from the latest boom/bust phase (think 1965 - 1982). So, despite our proclamations that we've likely seen the worst of this phase of the bear market, we will not suggest that it's time to set it and forget it in the stock market.

In short, we are of the mind that the next several years will reward an actively managed approach to investing. There WILL be opportunities for profit, just as there have been over the past decade. However, let's not forget that the Lipper Large Cap Growth Fund Index was down more than -34% (-34.27% to be exact) for the ten years ending 12/31/2008. So, this is definitely not the time to return to the buy-and-hope approach.

Although we run the risk of belaboring this point, we want to make it clear that we are not purporting that everyone quit their jobs and begin spastically trading every wiggle and giggle in the stock market. But, we do think that investors will need to be more actively involved with their portfolios if they want to see growth over the next several years and that it wouldn't hurt to have a plan to play some defense every once in a while.

What's Next?

So, where are we now and where are we heading next? To begin with, we've not been shy about suggesting the current rally will wind up being more than just a bounce. And given the fundamental changes that are occurring right now, we feel pretty good about saying that we're currently in the process of exiting the bear phase and transitioning into a cyclical bull phase.

Looking back at history, the analysts at Ned Davis Research have identified five periods that can be used as a guide going forward. We'll call these moves mini-bulls that occurred within the context of a major bear market cycle.

First, let's look at the periods and the returns that were generated from these mini-bulls for the S&P 500:

Mini Bull Markets w/in Major Bear Cycles
Mini-Bull Period	% Return S&P 500
Nov 1929 - April 1930:	+45.8%
March 1938 - Nov 1938:	+62.1%
May 1970 - May 1971:	+51.2%
Dec 1974 - Sept 1976:	+65.9%
Oct 2002 - Oct 2007:	+101.5%

Source: Ned Davis Research

Using History As Our Guide

By doing some quick math, we can see that the average gain of these mini-bulls has been +65.3% (and for you stats aficionados out there, the median gain was +62.1%). Therefore, if - and this is a mighty big IF - the current rally does indeed become a mini-bull and IF the return falls within the historical average, we can expect the S&P 500 to climb somewhere north of 1100 before the bears begin to growl again.

The first point is that the S&P could gain another +33% or so from Friday's close if things go according to the playbook. And since hot stocks usually don't run in a straight line, it would appear that there is still time to find a way to profit from the move.

The next important part of the playbook is to attempt to identify the likely duration of a mini-bull move. And again, while our statistical sample size is small, it does help to look at what we might be able to expect going forward... remember, history doesn't repeat, but it often rhymes.

Using the five cases illustrated above, we can see that the shortest mini-bull was the first one, which lasted 155 calendar days; while the longest one was that most recent, and lasted 1826 days. Since the 2002 - 2007 move was nearly three times as long as the other four, we'll toss it aside. Averaging out the remaining four mini-bull cases, we see that the mean duration was just under a year - or 343 calendar days. So, with the current move less than a month old, there is a good chance that there is still some time available to get on board.

However, it is vital to understand that the returns of these mini-bulls are definitely front-end weighted. In fact, during the first three months of the move, the S&P has gained an average of +22.6%, which has represented 41% of the total gain. Going out six months, the average gain has been +36.2%, which was just about 65% of the entire move. So, it is easy to see that the majority of the move tends to occur in the early part of the bull run.

The next part of the playbook involves the "retest." In looking at the bear market bottoms of the past, we find that the vast majority of the initial moves off the bottom are "given back" before the move higher begins in earnest. We call this the "second chance buy" and THIS is the opportunity that you don't want to miss.

So, given that we've had a very nice run of +24.5% in the S&P since March 9th, we should be on the lookout for a "second chance buy" to present itself. This would likely occur in response to something bad coming out of the woodwork. And given that earnings season is about to begin, a batch of crummy reports could provide the bears the ammunition needed for a pullback/retest.

What if we're wrong and this is not the start of a new mini-bull? Since we manage money based on what IS happening in the market, we will make an adjustment if best stocks head lower. And the good news is that at some point, the current bear WILL end, so our work on the recovery playbook isn't likely to go to waste.