Is This the Market Bottom?

The news isn't pretty: Earlier this week, the S&P 500 closed below 700 -- its lowest level since October 1996. Many former stalwarts are faring even worse: General Electric (NYSE:GE) hit an 18-year low yesterday. Bank of America (NYSE:BAC) hasn't traded at these levels in 25 years. Citigroup (NYSE:C) hit an all-time low of $0.97 at one point Thursday.

This hurts, there’s no doubt. And as we watch stocks fall to new lows day after day, it seems as if the market's slide will never end.

But while these sorts of apocalyptic figures make for exciting minute-by-minute updates on CNBC, they're not much use to you. They don't say anything about how stocks will behave in the future, which is what actually matters when you're deciding how to invest today. That's one reason investors always ask, "Is this the market bottom?"

Well, is it?
Opinions vary. Nouriel Roubini, one of the few economists who predicted this crisis, wrote a January piece masterfully titled "The Latest Bear Market Sucker's Rally Is Losing Its Steam as an Onslaught of Awful Macro and Earnings News Takes Its Toll," in which he predicted the S&P could fall as low as 500 -- more than 25% below where it stands right now.

But last fall, in a New York Times op-ed piece, superinvestor Warren Buffett compared today's overwhelming pessimism to 1932, 1942, and the 1980s -- all fantastic times to buy stocks. Lately he's been adding shares of Burlington Northern (NYSE:BNI) and Ingersoll-Rand (NYSE:IR). Although Buffett doesn't try to time market bottoms, his urge to "be fearful when others are greedy, and be greedy when others are fearful" has helped him to make eerily prescient moves in the past.

When he says it's time to buy, it pays to listen.

One approach to answering the question
My colleague Morgan Housel wrote an excellent piece examining historical market valuations. The one-sentence summary is as follows: When things get scary, investors frantically sell stocks down to incredibly low multiples.

Using historical data from Standard & Poor's, my research shows that the average of the lowest quarter-end price-to-earnings ratio (P/E) during all recessions since 1937 is 11.7. With the S&P trading at 11.9 times earnings, we've about hit that point.

However, looking at some of the lowest recession P/Es since 1937 also shows that if corporate earnings stay depressed, stocks could fall even further:

Sources: National Bureau of Economic Research, Standard & Poor's, and The Wall Street Journal. 

Applying these multiples to the S&P today means that the bottom could be anywhere between here and another 50% decline.

But what if the economy gets really bad?

Another Great Depression?
With comparisons between the Great Depression and the Great Wipeout of 2008 growing ever louder, a simple worst-case approach is to look at how Depression investors fared.

According to the National Bureau of Economic Research, we're 14 months into this recession, and thus far, the S&P 500 index has lost 52%. Fourteen months into the Great Depression (January 1931), investors were down only 46%.

But while the stock market was hit harder in 2008, economic conditions were far uglier in 1930. Back then GDP had fallen 8.6%, unemployment reached 8.9%, and deflation was running 6%. Our 6.2% GDP decline, 8.1% unemployment rate, and likely deflation almost appear mild compared to 1930.

So relative to 1931, if stocks today have been hit harder on less-dire economic news, does that mean we've already seen the bottom?

Not necessarily.

Even though stocks had already fallen dramatically since the October 1929 market crash, investors who bought in January 1931 were down another 71% by May 1932. This goes to show how difficult it is to time market bottoms, and it demonstrates that even though stocks have fallen considerably, they could still fall even more.

That's actually not so bad …
The good news is that it doesn't much matter whether you accurately time the bottom.

See, conventional wisdom holds that the Depression was a bad time to be an investor. Excitable market commentators like to cite the statistic that it took until 1954 -- 25 years! -- for the market to return to its 1929 levels.

That figure is true, but misleading. It assumes that investors put all of their money into stocks just before the market crash, stopped purchasing stocks thereafter, and never collected dividends.

Remember, we're now 14 months into this recession -- not at its starting point. So for the sake of symmetry, let's ask how long it actually took new money invested 14 months into the Depression (January 1931) to break even. According to number-crunching I've done using rare Ibbotson Associates data, the answer is less than five years. And an investor who continued to purchase stocks on a monthly basis would have broken even in little more than two years.

Take a look at how investors who bought stocks in 1931 fared after completely missing the bottom during the worst economic period of the 20th century:

Sources: Ibbotson Associates, National Bureau of Economic Research, and author's calculations. According to NBER, the second 1930s recession ended in June 1938. Assumes reinvested dividends.

The Foolish bottom line
So, then, how can we use this data? There are three applications for investing today:

1. It's very difficult to time the market bottom. Just because stocks have fallen and valuations are low, does not mean they can't fall further. So if you're going to need the money in the next five years, there are safer places for it than stocks.

2. Market timing isn't necessary to achieve great returns. The Depression was a terrible time to be a speculator. But long-term investors who continued buying stocks did just fine.

3. Stick to a proven stock-buying strategy. As I mentioned before, Warren Buffett built his more than $50 billion fortune in large part by purchasing stable businesses in strong competitive positions -- at discount prices. That's what led him to American Express (NYSE:AXP) in the 1960s, Washington Post in the early 1970s, and Coca-Cola (NYSE:KO) soon after the Black Monday 1987 crash. He didn't try to time markets; he just bought stocks when they were cheap.

And he says they're cheap again today.

If Buffett's investing approach makes sense to you, now's a great time to begin bargain-hunting. Like Buffett, our Inside Value team is amazed by the bargains we're finding today. If you'd like some help getting started, click here to try the service free for 30 days.

Ilan Moscovitz is greedy with chocolate cake and fearful of heights. He doesn't own shares of any companies mentioned in this article. The Motley Fool owns shares of American Express. Coca-Cola and American Express are Inside Value recommendations. The Fool's disclosure policy is overly aphoristic.