When Will the Market Recover?

To many frightened investors, the current global financial crisis and stock market turmoil appear to be without precedent. But to financial historian Jeffrey A. Hirsch, the plunge is reminiscent of patterns that have been repeated over the decades — and these help provide reassurance that the market will recover. Although the historical data won’t tell you where the Dow Jones Industrial Average will be in the next few months, it can provide valuable perspective to help you figure out your long-term strategies.

Hirsch’s conclusions about the current situation based on historical precedents…

We have endured equally bad markets before. The current crash has taken the Dow average down as much as 47% from its October 2007 peak, reminiscent of the bear market that followed the Arab Oil Embargo of 1973 (down 45.1% from January 1973 to December 1974). This bear market feels worse, though, and has shaken investors more because…

This meltdown happened so quickly. The one in the 1970s took two years, while this year the stock market dropped 18% in a single week in October and 25% in less than a month.

It affected not only stocks but also investments that we regarded as “no risk,” such as our money-market funds.

The credit crunch has impacted us directly in personal ways, affecting our ability to get a loan for, say, a car or a small business.

But things are probably not as bad as they seem. Here’s why…

We are not headed for another Great Depression. During that period, the Dow lost 89.2% from September 1929 to July 1932. More than 9,000 banks failed as the Hoover administration employed a disastrous, hands-off policy. With no Federal Deposit Insurance Corporation to provide insurance for bank accounts, many people lost all their savings, resulting in the haunting images of breadlines and shantytowns.

Today Federal Reserve Chairman Ben Bernanke — who has studied the Great Depression extensively — has helped lead a response to the crisis by flooding the financial system with liquidity and lowering key interest rates. Also, the Treasury Department is injecting many billions of dollars of capital into banks… FDIC insurance has been increased temporarily to $250,000 per account… and money-market fund­ assets have been temporarily guaranteed. All this doesn’t ensure that the crisis will end quickly, but it likely has headed off what could have been a much worse disaster.

Expect the market to remain volatile well into 2009. The 2007-2008 bear market was 408 days old on November 20, when the Dow dropped to what could be at least a temporary bottom of 7,552. That compares with a historical average of 406 days for bear markets. The bear market of 1973 through 1974, however, lasted 694 days.

How long this bear market will last depends on a number of factors, including how quickly or how extensively the credit freeze-up will thaw. Trillions of dollars of hard-to-value financial instruments still are unraveling, so we can’t accurately predict the consequences for the financial system. And it is difficult to forecast when corporate earnings, consumer confidence and retail sales will recover. A lot depends on when home prices stop plunging.

In addition, the first year of a new presidency is historically the rockiest for the stock market because an administration tends to take its toughest and most unpopular fiscal measures early on. However, after a Democrat has taken office following a Republican administration, the Dow has averaged a 14.3% gain in the first year.

Once it starts, the stock market recovery will take a long time. We have bounced back from every major crash in the past century, but the interval needed to reach new market highs has varied enormously. After the Great Depression, the Dow didn’t reach its previous peak for 25 years. After the January 1973 peak of 1,052, the Dow took nearly 10 years to recover to that level.

Wise: Prepare yourself for a recovery akin to what occurred after the 1973-1974 bear market. If we follow a similar script, which is likely, the Dow could approach the 10,500 level within six months. But it could take until 2018 to return to its all-time high of 14,164, reached on October 9, 2007, which would translate to mid-single-digit annualized returns for the next decade.