The stock market has been working its way higher since its late November lows.  A somewhat positive ending to what was a very dismal year.  The Dow was down 33.8% in 2008.  To put this year’s performance in perspective, today’s chart illustrates the 15 worst calendar year performances of the Dow since its inception in 1896.  As today’s chart illustrates, the Dow’s performance in 2008 ranks as the third worst on record.  Only 1931 and 1907 endured greater declines.  It is of interest that major banking crises occurred in 1931, 1907, 2008, and 1930 - the four worst calendar years on record in terms of stock market performance. 

From last week’s Chart of the Day. 

Good news! Brian Wesbury says it all in this brief email, we couldn’t  summarize it any better.
Roland

Stocks are Dirt Cheap To view this article, Click Here
Brian S. Wesbury - Chief Economist
Robert Stein, CFA - Senior Economist
Date: 12/29/2008

One year ago, we thought the Dow Jones Industrial Average would finish 2008 at 15,000. Needless to say, the Dow is nowhere near this level and would need an unprecedented miracle to get there in the next few days.

Nonetheless, our model for valuing the broad US equity market continues to signal that “fair value” for the Dow is at or above 15,000.

Don’t take this as another forecast – given economic issues, the Dow is not likely to get to 15,000 anytime soon. What this model is saying is that if the Dow were trading at 15,000 today, expectations of future returns would settle at an historical average rate of return.

So, with the Dow roughly 44% below our estimate of fair value (needing to rise about 75% to get to 15,000), investors can reasonably expect a rate of return that is well above historical averages in coming years.

To get fair value for the stock market we take the level of corporate profits that the government generates (based on reports to the Internal Revenue Service) and then discount these profits by the prevailing 10-year US Treasury interest rate. This simple “capitalized profits” model suggests that broad US equity market in the US is at is cheapest level since at least 1953.

In other words, the market is cheaper than it was in 1974, 1982, and 1994 – all of which had huge bull markets ahead of them. True, interest rates are currently at historically low levels and this can skew our fair value measure higher. (If interest rates are low, the model discounts profits less than usual, meaning profits appear more valuable.)

To address this potential problem, we use a 5% 10-year Treasury yield, instead of the current bubbly yield of 2.15%. The 5% yield reflects the average since the mid-1990s. In addition, we assume corporate profits fell at an annual rate of 10% in the current quarter (2008-4Q), which is slightly faster than the 9.2% decline experienced over the past year. Even using these conservative estimates the market is cheap.

Another reason to be bullish on stocks is that although awful data reports are ahead – for example, we expect real GDP to contract at an annual rate of roughly 6% in Q4, the worst in more than 25 years – the most intense parts of the economic contraction are already behind us.

History shows that the stock market tends to bottom before recessions end. The stock market bottomed in August 1982, and was up 26% before the recovery began in November 1982. And in 1974, the stock market bottomed in December, and was up more that 24% by the time that nasty recession ended in March 1975. We believe the current recession will end sometime early in 2009, which suggests that US stocks have probably already bottomed.

Attentive readers will note that the stock market did not start rising until well after the 2001 recession had ended. However, our models show that the stock market was wildly overvalued prior to the 2001 recession, and remained overvalued until mid-2002.

Knowing when the recession may end is a key to this relationship (and forecast). On this front there seems to be some good news. While weak housing data from November reflects credit market problems and panic that spread after the failure of Lehman Brothers, recent market action suggests that this is ending.

Not only have mortgage rates plummeted (pushing mortgage lenders to hire back laid-off workers), but risk spreads are coming down sharply. Scott Grannis, author of a must-read blog – Calafia Beach Pundit – points out that two-year swap spreads have narrowed significantly. This is a sign that risk aversion hysteria is on the wane.

While many are suggesting that “this time it is different,” and certainly this past year has witnessed unprecedented events, the market is dirt cheap. And even though our mothers told us that we wouldn’t touch a hot stove twice, we will brave another stock market forecast for 2009. We expect a 30% increase in the Dow during 2009, taking it back to 11,000 by year-end, and then another 25% gain in 2010. Most amazing of all is that the market will still be undervalued, even if these large gains in the next two years occur, suggesting that above average returns will be the norm for the next few years.

This information contains forward-looking statements about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated wit h any forecast and the opinions stated here are subject to change at any time and are the opinion of the individual strategist. Data comes from the following sources: Census Bureau, Bureau of Labor Statistics, Bureau of Economic Analysis, the Federal Reserve Board, and Haver Analytics. Data is taken from sources generally believed to be reliable but no guarantee is given to its accuracy.

If you are a long-term investor who is wondering when the economic and stock market recovery will begin, then you need to click here to watch this short video from economist Brian Wesbury.

Update: Here is more sound insight from First Trust. 

It’s because of the insane level of derivatives being trading throughout the global financial markets - about $700 trillion.  There’s not much new here for me to comment other than I still view derivatives as THE biggest threat to owning dollar-based assets in long term positions.   

However, if this is a new topic for you, the below piece from 60 Minutes does a nice job of explaining what derivatives are and how they work, in common sense language:   

Even if the derivative house of cards does not collapse any more than it already has, I am no less long term bearish on the dollar and other currency-based investments.  Eventually the American greenback will return to its slide in buying power and investors that own hedge positions will be thankful.

My favorite method to hedge against a devaluing currency is with gold - both through direct ownership in gold bullion and by owning shares of a gold-mining mutual fund.  So if you have concerns over the Fed’s devaluation of our currency then this is where you should be. 

To put the Fed’s actions in perspective, consider this:  Eight years ago there were just over $5 trillion circulating through the system.  At last check this number had risen to nearly $9 trillion - almost a double in the quantity of paper money.  That action, historically, spells inflation. 

Recently I returned from Europe to see firsthand how our friends across the pond were being impacted by this economic environment.  Not surprisingly, things seem very similar to life in the States.  The shopping centers were busy, the restaurants were full, and the only negatives I witnessed were in regard to the financial industry and media’s drumbeat of doom and gloom. 

Purchasing power parity tells me that the dollar is currently undervalued compared to the euro and the fact the stock market is rising in the face of negative economic data tells me there is a very good chance that we saw the market bottom back in November. 

Of course there are no guarantees but what I do know is that the economic news will continue to worsen but the upside to ownership investments look a whole lot more promising than the downside.

As of now, it looks like by mid-2009 we will be facing a rapidly improving economy and that’s why the stock market has been rising in the face of all the current bad news. 

Here is a short article from Steve, one of my favorite economic commentators.

The first of the two charts above shows that the recent level of volatility in the stock market has been very uncommon.  The second chart shows the average daily move in the S&P 500 since 1993 has been 0.77%.  In the month of October, the average daily move was 3.71%. 

That means in intraday trading, the market is valuing companies at an incredible variance.  Historically, it doesn’t last very long, and it does point toward market bottoms. 

Are we close to a bottom?  Yes.

Can it go lower?  Always.

Unfortunately my crystal ball broke the first time I tried using it.  What I do know is that stocks are cheap now.  Don’t sell, and if possible, buy!  But I think I can say with confidence that five years from now today’s prices will have been a dream to buy. 

In light of those who foresee the current bear market bringing about the death of stocks, here are 10 Market Rules to Remember from long time strategist Bob Farrell:

(Photo:  azrainman)

1)  Markets tend to return to the mean over time.

2)  Excesses in one direction will lead to an opposite excess in the other direction.

3)  There are no new eras - excesses are never permanent.

4)  Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.

5)  The public buys the most at the top and the least at the bottom.

6)  Fear and greed are stronger than long-term resolve.

7)  Markets are strongest when they are broad and weakest when they narrow to a handful of blue chip names.

8)  Bear markets have three stages - sharp down - reflexive rebound - a drawn-out fundamental downtrend.

9)  When all the experts and forecasts agree - something else is going to happen.

10)  Bull markets are more fun than bear markets.

Hat Tip:  Carpe Diem blog

Being an owner with your long term investment capital is never about following a short path to riches. 

It is nearly always about the compounded power of many market sessions.  Times like these are what challenge investors’ discipline and day by day we hold on past the doom-and-gloomers waiting for the breakout to emerge.

REALITY CHECK:  So here we are near the bottom and it seems that most of our peers have become overwhelmed and left the building.  Today being an owner often leads to second guessing … “you aren’t still investing in the stock market, are you?” … “that isn’t safe” … “I moved my money to cash and bonds” … but the market session that is right around the corner, THE bottom and the rally that follows, reaffirms once again that common stocks, over the long term, are the highest total return asset class of all.