Investment markets have been in decline since recent highs in May, with major moves during late July and early August taking markets into or near bear-market territory (defined as a 20% decline or more).

This summer’s market issues are eerily similar to last summer’s, notably global debt worries and European bank panics.

However, this summer’s downturn has been more rapid in nature, generating higher levels of anxiety and market volatility.

Despite the meaningful declines, most markets remain higher today than they were one year ago.  Additionally, corporate earnings are significantly higher, and equity valuations are more attractive.

There are major variations in the returns of different sectors of the market, but in general, returns are up, earnings are higher, and investments look less expensive.

Q: So why all the recent panic selling?

The recent decline appears to have been triggered by a fear of the US debt default (which never materialized), the US debt downgrade (which counter-intuitively caused borrowing to get less expensive), and continued banking crisis in Europe (a legitimate issue that needs resolution).

Most importantly, investors appear to have a large store of negative “muscle memory” due to major downturns in 2007-2009 (The Great Recession) and 2000-2001 (The Dot Com bust), vowing to not get “caught” again.

Lingering fears and rapid selling are to be expected.  Investors are frustrated from having generated such little return over the past decade, while having had to live with such large degrees of volatility (see Chart I).

Chart I – A “Lost Decade”…or More (13 Years)

However, despite thirteen years of lackluster returns and high levels of volatility, there are reasons to believe we may be nearing a long-term market bottom.

Furthermore, today’s price levels present attractive levels for long-term investors to get fully invested, regardless of the possibility of more near term downside.

Are we near a potential turning point to the upside?

When markets sell off into major corrections or bear markets, investors can look to a number of indicators to provide clues of whether we are near a bottom.

Indicators used by LGA include the following:

  • Low price-to-earnings (P/E) ratios
  • Recovering leading indicators
  • Base metal recoveries to indicate expansion
  • Oversold sentiment levels
  • Extreme spikes in the volatility index (VIX)
  • Technical moving average crosses
  • Etc.

In this newsletter, we will focus on two of the above indicators.

From a near term perspective, volatility (as measured by the VIX index) tends to spike incredibly high during major market selloffs.  Sometimes called the “Fear Index,” VIX tends to spike alongside a major capitulation in the markets, as investors sell heavily into a crescendo that often marks a point very near the bottom of the downward move.

Occasionally, there is a second, more muted market decline that finishes the move or retests the VIX crescendo low.  As VIX starts to calm, the worst of the decline is typically in the rear view mirror and it is time to be more fully invested.

Looking at the past five years, we have plotted the S&P 500 and VIX index on the same chart to illustrate the  predictive power of this technical indicator in identifying equity market bottoms (see Chart II):

Chart II – Volatility Spikes Mark Bottoms

As illustrated in Chart II, markets tend to bottom shortly after a volatility spike.

VIX spiked over 80 in 2008, with a market bottom occurring approximately 4 months later.  VIX also spiked over 40 during the summer correction of ’10, pre-dating the US equity market bottom by only two months.

In both cases, emerging market equities turned to the upside even sooner.  Recently, VIX hit 48 intraday on August 8th, and subsequently receded back into the 30s.

Our research indicates that it is rare to see VIX re-accelerate to the upside once it begins to decline from peaks as it is currently doing.

Consequently, we would place good odds on the assertion that we have either reached or are within a short time period of a market bottom from the recent 20% correction.

Once again, it is possible that emerging markets lead out of this current downturn, beginning to rise sooner than US markets. Timing is all TBD, but VIX peaks have historically been useful for anticipating market bottoms.

Long-term valuations levels are attractive

The second indicator we will review is more long-term in nature: the price-to-earnings (P/E) ratio.

P/Es measure the price levels that investors are willing to pay for a given level of earnings.  High P/Es indicate that investors are extremely bullish and are willing to pay high prices for a given level of earnings, while low P/Es indicate a bearish outlook and low prices for a given earnings level.

Equity markets tend to go through long-term 10-17 year periods of flat returns, followed by 10-17 year periods of above trend returns.

The net average is a long-term return in the 8-10% range, with frustrating results during sideways markets, and down-right euphoric returns of of 16-20% annually during bull markets.

P/Es play a large role in determining the beginning and end of these long-term market cycles.  Typically, long-term sideways markets begin when investors have reached overly euphoric levels, willing to pay over $20 for each $1 of corporate earnings (in other words, a P/E ratio greater than 20).

Conversely, long-term bull markets tend to begin when investors are overly pessimistic, willing to only pay only $8-12 for each $1 of corporate earnings (or a P/E ratio of 8-12).

US equity markets have gone nowhere for the last thirteen (13) years, with a sideways market kicked off in 1999 at a blistering peak P/E ratio of 42.1 (during the euphoric dot com years)!

Since 1999, companies have continued to grow their earnings, but investors have been less and less willing to pay premiums for these earnings, causing the typical compression in P/Es that occurs during sideways markets.

Despite high levels of volatility over short-term 3-5 year cycles, this longer term trend of increasing earnings and compressing P/Es has marched onward and will continue to do so until bargain-basement valuation levels are reached (P/Es in the 8-12 level), and a new secular bull market is born (see Chart III below).

Chart III – Secular Market P/E Valuations

What should investors do?

There is no doubt that it has been painful for investors to cope with marginal returns over the last 13 years, especially for retirees who haven’t had new funds to reinvest into the market at depressed prices.

However, long-term P/E analysis leads us to believe that we may be within 1-4 years of a new long-term bull market, if we aren’t already in one (e.g. the long-term P/E ratio was near 8 in March of 2009 after markets plunged 55% from their peaks in 2007 to their lows of 666 on the S&P 500).

Bottoms can easily be identified in hindsight, but investors must make decisions in the present.

With S&P 500 earnings estimates for 2011 in the $100 range, an 8-12 bottom P/E ratio would suggest that an 800-1200 level would be the current low levels of support for the S&P 500.

Given that these levels are above the 666 lows of March 2009, one could make an educated guess that these lows will not be reached again, and we may have already started the long-term bull market.

Now, earnings can always decline and negate this analysis, but street analysts are estimating 10%+ growth rates in earnings for 2012, lending further support to the conclusions.

The above notwithstanding, long-term bottoming processes can often be incredibly volatile, as they can be accompanied by dramatic fights between doomsday prognosticators and deep value investors.

Furthermore, the general public seems to be disgruntled with equity investing, which causes low liquidity in the market and consequently larger volatility when large orders are placed by either the optimists or the pessimists.

However, history tends to repeat itself, and eventually we would expect the value investors to triumph.

What if there is more near-term downside ahead?

From a long-term perspective, short-term volatility is inconsequential.

What matters more is the relative levels of valuation for entries and exits.  If the market is near a major long-term bull market beginning, long-term investors don’t care about the last 10-20% move downward…they just want to be invested.

Let’s take a look at one of the most famous investors of all time, Warren Buffett.  While others shout out about the declines and massive volatility, Buffet has gone about using major declines to invest large amounts of his cash, making major investments in late 2008 as well as recently during the 18-20% decline.

While Buffett has occasionally suffered 20-40% declines after his initial investment, he tends to be rewarded over the longer term for having made an investment when valuations were low and others shunned such an investment.  Warren Buffet ignores the short-term volatility, and places his faith in the long-term future of America.  Once he has bought his investments at inexpensive prices, his favorite holding period is “forever.”

At LGA, we do not believe in holding forever, but we do believe holding current positions, and buying more, when valuation levels are extremely attractive, such as now.

We then use our models to improve results over the long-term 10-17 year cycles, the mid-term 3-5 year cycles, and sometimes even the shorter-term cycles where possible.

This can occasionally mean temporary declines if equities go from inexpensive to insanely inexpensive.

However, the approach allows you to have discipline around getting invested during panics, and outperforms over time relative to simple buy-and-hold strategies, and even worse…short-term gut reactions.

We believe that long-term investors will be well rewarded for being fully invested at current market levels, regardless of whether there is or isn’t any additional near-tem downside ahead.

No one can exactly predict what the lowest low will be and when it will occur.

Additionally, there will always by cyclical 3-5 year market cycles up and down…that’s just par for the course in investing.

However, we can determine when equities are a good long-term value, and that time is now.