Looking for an Investable Market Bottom? Check This Out
Shah Gilani|June 2, 2022
The bear market boundary has been breached.
With the Nasdaq Composite, the Nasdaq 100, the Russell 2000, and the S&P 500 (based on its May 20, 2022 intraday lows) are all 20% off their most recent all-time highs, many of you came to me with questions.
How low could we go? When will we reach the bottom? And how will we know it’s time to invest?
Barely or Bear Market? The Truth About the S&P 500
While the standard measure of a bear market is a drop of 20% from a stock or a market benchmark’s most recent all-time highs on a closing basis, I use intraday price peaks and troughs, not closing prices.
Why? Because intraday prices matter. The investor psychology that causes prices on an intraday basis to do what they also matter.
For example, a couple of weeks ago on, Friday, May 20 , the S&P 500 fell 2.319% intraday from Thursday’s close, but closed that day up .57 points, or up .000146% if you think in percentage terms, which you should.
At the intraday lows on that Friday, the S&P 500 was in bear market territory, down 1,008.3 points, or 20.925% off its January 4, 2022 intraday all-time highs. Even if you use the January 4 record closing price for SPX, 4,793.54, the benchmark still fell intraday on May 20 by 20.6991%, into bear market territory.
If you didn’t consider the index’s intraday lows and only registered its closing price that Friday, you’d say the S&P 500, the most followed barometer of what constitutes the U.S. stock market, never got into bear market territory. It closed that day 19.03% off its highs.
To not look at what happens intraday, especially on May 20 , and understand what investor psychology was and how frightening the selling was to knock SPX down 2.3% intraday, is a mistake. Psychology matters. Intraday prices matter.
That being said, the Dow Jones Industrials Average hasn’t fallen into a bear market, yet.
So, a good place to start looking to see how low we could go would be the lowest (intraday) levels the indexes in bear markets have already reached. From there, we’ll have to make some assumptions, take some measure of investor psychology, and do a little math based on history and earnings projections.
For our purposes, we’re just going to use the Nasdaq Composite (NASX), the market benchmark that’s led all other benchmark indexes higher since the financial crisis and Great Recession (and several times before) because it’s loaded with tech stocks that are changing how we live, work, and play. We’ll use the S&P 500 (SPX), because it’s the institutional U.S. benchmark index.
The NASX’s last, lowest intraday low was at 11,035 on May 20 . Just before that low and just after it the index traded around 11,113, then 11,092. If you draw a horizontal line across those three data points, you get a picture of what support looks like.
A lot of traders and investors draw support lines and know other investors are looking at those lines in the sand as support. So, support and resistance lines and other patterns technical analysts and traders and investors incorporate are psychologically important, because they’re widely followed and can be self-fulfilling. In other words, if a lot of traders think the market is prone to going lower if it breaks its technical support levels, they may sell when the index gets there or breaks below it. That can make technical markers self-fulfilling.
Sometimes, support levels hold, precisely because investors expect them to, or want them to, or buy at those levels because they are low points from which a bounce is entirely possible. That makes support levels sometimes an excellent place to buy into the market.
What happens when we get to support levels tells you what the pervading psychology of traders and investors is. Just look at what they do.
Do they buy the support or sell it?
Since we’re looking at how low we could go, we’re going to assume the worst and speculate that psychology is already frayed on account of spiking inflation, rising interest rates, that we’re already in bear markets, and the fact that there are more compelling reasons why the market should fall as opposed to reasons or positive narratives driving stocks higher.
The SPX’s last, lowest low intraday level was at 3,810 on May 20 . Just before that and just after that SPX traded at intraday lows of 3,858 and 3,875. Drawing a support line through those three data points isn’t as tidy a support line in the sand as what the NASX support line looks like. Sometimes support levels are more subjective on account of there not enough data points to connect to divine a support level that most traders might agrees is demonstrable support.
That said, SPX has some support around 3,858, some around 3,875, and the last hope for support at the lows of 3,810 – which may hint at the lows to come.
Finding the Bottom Before We Get There
How we low might go from where support is could be figured any number of ways, including by using other technical patterns, or incorporating historical reference markers, or making assumptions about earnings projections and valuation metrics assignable to earnings.
I’m putting aside further technical patterns because there aren’t any clear or meaningful technical markets or patterns that a lot of traders and investors would agree on that would make them viable markers.
On the historical reference side, we know that over the past 140 years, across 19 bear markets, the average market decline was 37.3%, and the average duration of those bear markets was 289 days.
A 37.3% drop for NASX, from its highs, would take it down to 10,164. And a 37.3% drawdown on the S&P 500 from its highs would take that benchmark down to 3,020. Those could be investible bottoms. If we get there and they’re not the bottom, they’re still excellent places to start committing capital. In my case, I’ll be applying a ton of sidelined money down there.
On the earnings front, another way to look for what might be an investible bottom is to look at forward earnings projections for benchmarks (I’m just going to use the S&P 500 for this exercise). It makes perfect sense to assume how much analysts are cutting earning by because they’re considering the likelihood we’re headed into a recession, blend that with what the historical haircut earnings see in a recession is, which is a 24% drop, and apply an appropriate PE multiple to get to where the valuation of the benchmark makes sense. That constitutes another potential investible bottom.
The numbers work out like this…
Earnings for the S&P 500 in 2018 were $161.56; in 2019, they were $162.35. The average of those pre- COVID earnings comes out to $162.35. Then from Q2/ 2021 through Q1 / 2022 ( four quarters), S&P earnings totaled $215.97, a whopping 33% increase over the 2018/2019 earnings. If I take the average of those to earnings, I get a forward guesstimate of $188.50 in earnings.
Interestingly, that earning projection is 12.7% lower than the possible “peak earnings” of $215.97; and more interestingly and compelling as far as our math, those earnings, cut by 12.7%, are half the historical haircut earnings experience in post-WWII recessions. That’s right, in recessions earnings typically fall 24%. I’m just being more optimistic in my haircutting.
Now, the average PE (price earnings) multiple in the twentieth-century was 14x; in the twenty-first-century it’s averaged 19x. The midpoint of the two constitutes a 16.5x multiple. Multiply 16.5x earnings of $188.50, and you get the S&P 500 at 3,110. That would bring the S&P 500 down 24% from here (today, Wednesday morning, it’s at 4,100) and 35% down from its all-time highs.
That 35% drop is pretty close to the 37.7% drop I used in the historical breakdown earlier. And makes 3,110 in my book a very investible bottom.
And that’s how you find where investible bottoms might be.
Cheers,
Shah