After the past week, virtually every economist and analyst has been forced to admit that we have yet to see the bottom of this bear market. The Dow, S&P 500 and Nasdaq all reached levels last seen in 1997. If they are honest, economists and analysts will also admit that there is no way to know when and where the bottom will be reached.

We have warned investors for months that market risk remains high and until there is some kind of confirmation that a bottom is in place, the safest place for assets is in a government insured money market fund. That advice is as pertinent today as it was six months ago.

Consider this comment from Paul Volcker, former U.S. Federal Reserve Board chairman, and now a member of President Barack Obama’s economic advisory team. This is from a recent speech he gave in Toronto.

“This is not an ordinary recession. I have never, in my lifetime, seen a financial problem of this sort. It has the makings of something much more serious than an ordinary recession where you go down for a while and then you bounce up and it’s partly a monetary – but a self-correcting – phenomenon. The ordinary recession does not bring into question the stability and the solidity of the whole financial system. Why is it that this is so much more profound a crisis? I’m not saying it’s going to get anywhere as serious as the Great Depression, but that was not an ordinary business cycle either.”

Below is a chart of the Dow Jones Industrial Average from 1970 to the present. It illustrates a couple of important concepts. Be aware that this is a logarithmic chart. That means that the compounding effect has been removed and price movements are proportional. So a 40% decline is going to appear the same whether it occurred in 1975 or in 2008.

I added the red lines to show a couple of extended periods where this index produced zero return on a buy-and-hold basis. The first ended in 1983 when the market began the longest, most powerful bull trend in history. This is important because the majority of people working in the financial industry and the majority of today’s investors began sometime after 1983. Very few of today’s investors or advisors experienced or can remember the prolonged sideways market that prevailed through the 1970s.

Rod Jackson is our primary investment/market analyst, consultant and strategy architect at Strategis Financial Group. Rod began his career in the financial industry in the late 1970s. Rod joined Strategis in 2001 and immediately began warning us that he believed the market was at the beginning of a period of sideways market movement that was likely to continue for up to two decades. This is a pattern that recurred several times in market history.

It was not a message that people wanted to hear at the end of the longest bull market ever. Remember, most investors had never suffered through a significant bear market. So in their experience, the stock market almost always produced double-digit annual returns. Now that we find ourselves in a situation where stocks have a deficit return over the past 10 years, investors seem more receptive to the concept that there can be prolonged periods where market returns are negative. Well known analyst and author John Mauldin in his weekly email commentary noted that if you look at the S&P 500 over the past 100 years, there are many 20-year periods with total returns were less than 3%. If you factor in inflation, there are many 20-year and 30-year periods with negative total returns.

If Rod is correct, we could see several more years of corrective market action. That does not mean that there will not be profit opportunities for investors. On the chart above, look at the sharp correction that ended in 1975. Notice that the Dow recouped the entire loss in just over a year. There were gains to be had for someone with a methodology that allowed him to trade in and out of market cycles and sectors. It does mean that investors cannot simply buy an index fund and expect that they will have a substantial gain after holding it for 10 years or more.

The blue line on the chart marks what Rod Jackson considers is the next level where the Dow will find substantive technical support. In other words, he believes continuing downside risk is about 40% below the current price. The first time Rod told us he thought the Dow could drop to 4,000 it was trading above 11,000. The possibility of that big a decline seemed remote. Now that the index has fallen nearly 5,000 points since that forecast, the possibility of an additional 2,000-point drop does not seem impossible.

Please note that this is not a prediction that the Dow will immediately drop another 40%. In fact, the market is oversold at this level and some kind of an intermediate rally is expected. But most experts are predicting that the recession is likely to continue well into 2010. That leaves plenty of time for both up and down volatility in the markets. This sideways period could easily continue another seven or eight years and still be within that normal 20-year pattern. That means there could be a strong rally for a year or two followed by another downturn where we could see the Dow even lower than current levels.

While Rod Jackson does not profess to be able to predict exactly what the markets will do or when, right now I would not be willing to bet against his assessment of continued market risk.
F.S.

You requested this MarketOwl free e-newsletter. Please add support@marketowl.com to your e-mail address book to ensure prompt delivery.