Have We Reached a Market Bottom?

The Dow Jones Industrial Average has been trading between 8,000 and 9,000 for the last few weeks. Some financial professionals have been proclaiming a bottom to the stock market. They point to the 40% drop in the Dow, which is almost the worst it has performed since World War II, and contend that the bad news about the economy has been factored into stock prices. Things should improve from hereon forward, they proclaim.

But look at what's happened in the last week. The Federal Reserve lowered short term interest rates to an effective rate of zero. Barack Obama announced his choices for chair of the SEC and CFTC, and a Fed governor. His transition team has been leaking proposals for a stimulus package that could exceed the $700 billion TARP program. GM and Chrysler got critically needed bridge loans that will carry them through the next three months, until the Obama administration can make longer term decisions about auto maker aid. The Bush administration has announced that it will seek authority to spend the second $350 billion tranche of the TARP program (which means more money will probably flow into the economy even before Barack Obama is inaugurated). But what happened in the stock market? There were ups and downs, but by the end of the week, the market was little changed.

One could argue that the good news about the economy--which consists almost entirely of actual or proposed government actions--has also been subsumed into stock prices. From this perspective, the implementation by the Obama administration of its announced programs could have limited impact on stock prices. The government may have expended its ammunition. If so, we would then be at the mercy of economic, as opposed to political, forces.

The news from the economic front is ugly. Unemployment is rising while economic activity is slowing. Real estate prices show no sign of bottoming out. Europe's economy is sliding faster than expected. China and Japan are busy trying to prop up their own economies. The dollar has reversed its gains and is sliding again (a consequence of the Fed's interest rate cut), setting the stage for potential capital flight. Stores are offering enomous discounts before Christmas in order to lure in suddenly thrifty consumers. Employee pay raises for next year will be modest at best; many will see shrinking pay checks. Yes, oil prices are dropping like a rock, but that's only because the economy is swooning. Is all this subsumed in stock prices? Or is it possible that the worsening recession will push stock prices down from current levels?

Only by looking backwards can we call the actual bottom of a market. The rest of the time, we can only make our best guesses based on the limited information we have about the future. But remember that if the bad news about the future can be incorporated into stock prices, so can the good news. Indeed, one would expect that this always happens, since investors would rationally incorporate all information into stock prices. If that's the case, unexpected news will dictate where stock prices go. Be cautious. It's been unexpected news that has driven the market and the economy down since 2007. If you're going to invest in the market, do it a little bit at a time. We've seen all too clearly the dangers of embracing too much risk.