"Apparently there is nothing that cannot happen today."

—Mark Twain

It's difficult to find words to describe the pure bloodbath witnessed in stocks over the past few days, past few months, past year. Since November 4 alone, the S&P 500 is down over 25%; it has lost roughly 49% on a year-to-date basis, and is 52% below its October '07 closing high. Although tired of hearing the word "unprecedented," the large-cap index is on pace for its worst calendar year return for any period studied since 1928.

In our view the driving force of this decline is uncertainty and fear. There are many questions, but not many clear answers. It is unclear how long and how deep any recession will be or how many jobs could be lost. It is unclear when the credit markets will begin functioning more normally or housing will bottom. It remains unclear what the impact of the government's numerous programs enacted over the past few months will be or the ultimate fate of the big three automakers. Moreover, there remain questions about when the selling, including that by hedge funds, will subside.

Recently, we had the opportunity to hear a savvy hedge fund manager's perspective of the current market environment. He believed there were a number of "ridiculously" cheap priced stocks; though he also said investors' mentality reminded him of 70s. In his view, many investors believed stocks were attractively valued back then, but they were afraid they would be cheaper "tomorrow." We will term this Stock Deflation. Deflation is a persistent decrease in the general level of prices of goods and services. So even if something appears like a bargain today, the thought is why buy today if a better deal may be had tomorrow.

Yet, eventually investors usually recognize value—but the timing is uncertain. The same hedge fund manager gave the example of Warren Buffett who was buying Washington Post stock during another brutal market in the early 70s. Around the time of his purchase, the stock market placed an $80 million value for the company, when many others on the Street, including Mr. Buffett believed its collection of media assets were worth closer to $400 million. Part of the reason others didn't buy was the thought the price of the stock, like most things in the market, could become cheaper tomorrow; so there was essentially a buyers strike (much like today). And in fact the stock did go down quite a bit more after Buffett's initial purchase. Yet, even though he didn't get instant gratification, Berkshire's original $10 million investment from 1974 had grown to $205 million in 1985, for an annual return of 32%, according to Roger Lowenstein.

Coming into this year, we clearly underestimated the severity of issues facing the economy. Yet over the past few months we have repeatedly mentioned that we believe "time" would be a key element to a longer-term market recovery: The two most recent mega bear markets (‘73/'74 & ‘00/'02) lasted 21 and 31 months, respectively, versus the current bear market of just 13 months.

However, even in the worst bear markets, there are typically strong shorter-term rallies. Indeed, October 10 had many signs of a panic low. On that day, we saw over 75% of the issues on the NYSE make new 52-week lows; there was record trading volume; extremely oversold conditions; and a reversal in price action that resulted in an all too brief rally. Then last week, it appeared stocks had successfully retested the lows, and we thought odds favored at least a short-term rally (though we still believed time would be a key element in a longer-term recovery). Yet, with the lows breached this week, that near-term thesis was proven wrong.

So the question to ponder now is where from here. The reality is no one knows for sure. Figure 1 displays a graph that depicts investors' emotions throughout a market cycle. During periods when investors are most exuberant is typically one of the worst times to invest for the long-term, since expectations become unrealistically high and stocks are generally priced for perfection. Conversely, when the outlook is the bleakest, stocks are often valued in a way that any incremental good news can have a major positive impact. The issue is one never knows exactly what part of the cycle we are in, and to be honest, there were a number of times earlier this year that it would have been difficult to imagine a greater level of pessimism. At a minimum, we believe that investors are well beyond the desperation phase and potentially closer to the despondency stage. What we could be seeing is that the last move down tends to be the sharpest: 44% of a bear market's loss, on average, occurs in the last 25% of the cycle, according to a study from Birinyi Associates.

Figure 1. How Most Investors Feel At Different Points Of A Market Cycle

What has been so challenging about this market is the ferociousness of the move down. It took 31 months for the S&P 500 to retrace 49.1% during the 2000-2002 bear market. The current market has already slightly exceeded that decline in magnitude, but it did so in just 13 months (see Figure 2).

Figure 2. The Recent Bear Market Losses Have Occurred Much Qucker Than 2000-2002 (S&P 500)

With this sharp downward spiral, stocks have and remain massively oversold on some measures. The S&P 500 is roughly 40% below its average price over the past 200-days (see Figure 3). Typically, just like a rubber-band that gets stretched too far, one could expect some type of reversal, or reversion to the mean. Going back as far as 1928, the only other time the S&P 500 was more extended on this metric was in 1932, which eventually led to a sharp snapback, though, there was no way to know from what level or time the potential reversal would develop.

Figure 3. S&P 500: Most Oversold Since 1932 (% Current Price Below 200-Day Moving Average)

Tactica Capital management recently reviewed nine recession-induced bear markets and rebounds since 1929. Tactica focused its analysis on recession-induced markets "since it is likely that the U.S. is now in a recession and bear markets triggered by recessions (e.g., 1973/1974) are deeper and longer than bear markets triggered by market crisis (e.g., October 1987 or August 1998)."

Tactica found the average recession-induced bear market lasted 21 months and showed an average decline of 41%. This work also showed the recovery phases after the eventual low was also typically very powerful as shown in Figure 4. To be fair, if a market goes down 50%, it has to go up 100% to get an investor back to breakeven.

Figure 4. Historical Stock Rebounds From Nine Recession-Induced Bear Markets

Interestingly, June of 1932 is the only time when the S&P 500 was further below its 200-day moving average, than it is today - and then it preceded a substantial move higher for equities.

To help provide some context to the current situation, Figure 5 shows a chart of an Exchange Traded Fund that seeks to replicate the inverse of the S&P 500. The ETF, not surprisingly, has gone nearly vertical recently and is well above its average price over the 200-days (blue line). The question investors should ask themselves is if this was an individual stock, do you think this type of parabolic move is sustainable?

Figure 5.  Chart Of Inverse S&P 500 ETF Looks Parabolic

With all this said, we can't know that stock prices can't or won't go lower. Among the most bearish estimates we have seen tossed around the Street is a level of 600 on the S&P 500. One of the simplest ways the bear case gets there is simply assuming the S&P 500 trades at a forward multiple P/E of 10x and then applying that to a below consensus earnings estimate of $60 (this estimate is well below the Street's current bottom-up estimate of $86). So let's say the bear case comes to fruition, since to be frank, they have been right so far. That would represent potential downside of 20% from Thursday's close of 752. Definitely possible, but we don't think it is the most likely scenario. But again let's assume it does happen. If that is the bottom, the previous table (see Figure 4) shows rebounds from recession-induced bear markets can also be very powerful and suggests there is a reasonably good chance that losses from here would be more than recovered over time.

Is there anything good or a potential catalyst on the horizon?

It's tough to say what turns this market around, but it almost always is without the benefit of hindsight.

1. The recent plunge in crude oil to under $50 has brought national gasoline averages closer to $2. As quoted in the Wall Street Journal, "Mark Perry, a professor of economics at the University of Michigan in Flint, sees lower energy prices as a continuing stimulus for the economy. Adjusting for inflation, consumers are paying less for gasoline now than they have paid throughout much of the past century. He estimated that at current consumption rates, Americans save $1.38 billion a year for every penny gasoline prices drop. That is about $290 billion since gasoline prices peaked in mid-July, and more than the tax rebates Americans received in the mail earlier this year."
2. Stock prices finally get to a point where investors with cash on the sidelines, even the bears, can't resist dipping their toe in the water.
3. Eventually tax loss selling should be finished and hedge fund redemptions should wane.
4. The Presidential transition phase is causing uncertainty and forcing some potential changes to be delayed, but that will be resolved in late January.
5. Signs of improvement in credit markets as government plans work their way through the system.
6. News that is still bad, but just not as dire as current expectations.
7. Announcement of a substantial stimulus package.
8. Some finality in the saga of the big auto companies.

Bottom Line:

What has occurred over the past year to equity markets has truly been tragic and is worst than the most pessimistic scenario that we could have painted. It makes us almost ill to see the S&P 500 and the Dow Jones Industrial indices trading with 7-handles (yesterday's close for the S&P 500 was 752.4 and Dow Industrials 7552.3), but as Mark Twain succinctly stated, "apparently there is nothing that cannot happen today."

The action in equities is much like what would occur if one pushed a boulder over the crest of a hill. With so much momentum in one direction, it is tough to pinpoint where the downward pressure subsides. It is understandable why some investors believe stocks will never do well again after the wreckage of the past year. But on the flip side, some investors thought the sky was the limit for Internet stocks, homebuilders, Chinese stocks, and most recently oil. Each of those investments had near parabolic moves and was more powerful and longer than what theoretically would be expected. However, in each case, once these assets peaked, the eventual corrections were very harsh and gave back a substantial part of the previous gains. In some ways, we believe the opposite is occurring now for equities. Although the healing process will likely require time, we believe investors with longer time frames of say, 4-5 years or longer, will be rewarded by owning stocks at current levels.

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Keith Lerner, CFA, CMT, is the chief market strategist with SunTrust Robinson Humphrey.