Managers: We’re almostat bottom

After months of a brutal sell-off, the U.S. stock market could be close to finding a bottom as hundreds of billion of dollars in government support work their way through the financial system to quell the credit crisis, money managers say.

While cautious about making such a definitive call, they agree that a stock market recovery — albeit a limited one — is quite possible before the end of 2008, given that valuations are at historic lows.

“A number of things suggest that, if it’s not the bottom yet, we’re quite close. If you are looking for a bottom in the market, look at valuations on a historic price/earnings basis relative to other recessions,” Jonathan Armitage, New York-based portfolio manager and head of U.S. large-cap equities for Schroders PLC, said in an interview. The firm has $259 billion under management.

“In terms of timeline, if you look at financial crises in developed markets over the last 20 years, markets discount the bad news and start to rise sometimes around 12 to 14 months after the start of a financial crisis,” Mr. Armitage explained. The credit crisis began 14 months ago, in August 2007.

“If you look at periods of economic recessions in the U.S. since World War II, the worst-case scenario was in 1973-‘74 and the worst (Standard & Poor’s) decline from peak to trough was 48%,” added Mr. Armitage.

The S&P 500 index is hovering below the 900-point level, or about 43% below its all-time high of 1,565.15 set on Oct. 9, 2007 — two months into the current credit crisis. The S&P 500’s P/E has dropped to about 11, closing in on its average level of nine during prior recessions and a far cry from its long-term average of 17.

Mr. Armitage noted that market cycles are not completely alike. In this latest case, the sell-off reflects the deep extent of the financial crisis as an enormous amount of leverage remains, both on the financial and consumer sides, he said.

“It’s not unreasonable to see a market bottom between now and the first quarter 2009,” Mr. Armitage ventured. “But it’s completely different to say the market is going to start moving way up, which is a much more complex call.”

James Paulsen, chief investment strategist at San Francisco-based Wells Capital Management, said markets are trading “on pure emotions and momentum, and not much on fundamentals.” Wells Capital has $246 billion under management,

“We are close enough to previous lows, and we see technical testing of those lows,” Mr. Paulsen said. “At some point, we are going to reconnect with the fundamentals and, granted, they are worsening. We could see a lot of bad things happening in the economy, but they are already priced. There is a recession already priced in here.”

Trading on Wall Street on Oct. 24 seemed to support Mr. Paulsen’s view, as U.S. equities held comparatively better than their battered peers in Asia and Europe.

“People are behaving as if it were the second coming of the Great Depression,” he added. “We have a complete lack of confidence. This process will have to work its way. If the market is still in the same area a week from now, there’ll be greater confidence.”

Even though many economists agree the U.S. is already in a recession and the unemployment rate will likely worsen, some view that so much gloom had been priced into stock prices.

Almost half of the S&P 500’s decline from its October 2007 peak occurred over the past five weeks — reflecting forced liquidation related to exposure to Lehman Brothers Holdings Inc., the federal government’s dramatic announcement of a $700 billion rescue, and massive hedge fund and mutual redemptions pouring in at the end of September.

“I’m telling our clients the valuations are very good at the moment, even if your assessment is that earnings will perform poorly. I’m estimating that forward-looking P/E for the S&P 500 for the next 12 months may be as low as 10.5,” said Komal Sri-Kumar, managing director and chief global strategist at TCW Asset Management, Los Angeles, with $118.2 billion under management. Mr. Sri-Kumar noted the S&P 500 is already close to such valuation levels.

“There were policy mishaps in the government’s handling of the credit crisis,” he said, referring to public panic in response to the hasty announcement of the government’s bailout package.

“We are now bumping along the bottom as far as share prices are concerned. People are selling indiscriminately due to hedge fund redemption and mutual funds are forced to sell because of outflows. This is why the market is becoming oversold,” Mr. Sri-Kumar added.

The market has been caught in a tug of war between bargain-hunters and managers still executing sell orders placed in late September, at the height of the panic.

The Dow Jones industrial average is in the same 8,500 area it was during the last recession in early 2003 and during the crisis sparked by the failure of hedge fund Long-Term Capital Management in the fall of 1998.

Mr. Sri-Kumar said it was difficult to see the market going much lower as the rescue package, which has not been yet implemented, kicks in, while the 50% decline in crude oil prices since July also brings some relief to the economy.

One upside: “Whether Sen. Barack Obama or Sen. John McCain is elected, the negative impact of the credit crisis has been so severe that the new president will have very little flexibility in terms of policy affecting the capital market, such as increasing the capital gains or dividend tax rate, which would spook the market,” Mr. Sri-Kumar said.

Regardless of who wins, the first year of a new presidential term has been good news for the market, which rallied in 11 out of 14 such years since 1953.

While money managers focus on valuations to forecast a turnaround, brokers are less sanguine on the outlook for a bottom, as the market’s wild intraday swings show no clear conviction either way.

“I’m not calling a bottom. All leading indicators remain in a free fall and point towards weak economic growth over the next six months,” said Myles Zyblock, chief institutional strategist at brokerage firm and prime dealer RBC Capital Markets in Greenwich, Conn.

“Epic deleveraging increasingly puts in front of us a high risk of a global economic recession of unknown intensity. Over the next six to nine months, it will get worse before it gets better,” Mr. Zyblock said of what he described as one of three major U.S. financial crises — along with the savings and loan debacle of the 1980s and the 1929 market crash.

Mr. Zyblock also noted that Japan’s Nikkei 225 index, which skirted 40,000 in the late 1980s, soon plummeted amid large-scale deleveraging and lingers in the 8,000 range today.

The Chicago Board Options Exchange Volatility index, or VIX, has hit one record high after another other in recent weeks. Spikes in the VIX or “fear gauge” are historically followed by sharp rebounds as confidence returns to markets.

But this scenario might play out differently.

“The market volatility indicates more an attempt to find a bottom than an actual bottom. It’s a process, but the market will regain its footing once we consider that the economy will start to recover in the spring of 2009,” said David Resler, chief economist at Nomura Securities International Inc. in New York.

But the notion of a market bottom is not a preoccupation for Bret Hammond, chief investment strategist at TIAA-CREF in New York, with $420 billion under management.

Mr. Hammond predicts a substantial rally is truly far away. “In the past months, we have been reminding our clients more often that rebalancing is a good strategy, rather than trying to time the market or sitting like a deer in the headlights,” Mr. Hammond said.

Contact Isabelle Clary at [email protected]