Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into account your personal situation, circumstances or needs.

Mark Lamonica: So, Shani, I'm reading a book called "Master of the Senate," and that is one of four books that Robert Caro wrote on Lyndon Johnson, and it is this amazing series, and it's this in-depth exploration of his life from his childhood in Texas to his presidency.

Jayamanne: You do know that this is still an investing podcast, or have some change has been made that I just, like, don't know about?

Lamonica: We're going to get to the investing part. This is relevant. Trust me.

Jayamanne: Okay.

Lamonica: So, I read the part of the book that talks about the 1956 Democratic Convention where Kennedy gets picked to run in the presidential election against Eisenhower. And Lyndon Johnson was going for the nomination. Now LBJ was a Majority Leader in the Senate at the time, and one of the things he was most known for was his vote counting.

Jayamanne: Yeah, I would probably think the ability to count would be an important prerequisite to becoming President, but I think I'm getting less show as time passes.

Lamonica: Well, touché.

Jayamanne: Yeah.

Lamonica: Touché. But vote counting is obviously pretty tricky in any legislative body, but LBJ was just really meticulous. So, he wouldn't speculate. He wouldn't put anybody in one column or another column until he absolutely knew for certain their vote. Well, he goes to Chicago for this 1956 convention as a candidate for the nomination, and he wanted to be president more than anything else. So, it was this driving force in his life, and he showed up as a huge underdog in the race to another candidate named Adlai Stevenson.

Jayamanne: It feels like you started telling this story in 1956, Mark.

Lamonica: I'm getting there. This will make sense. So, he was such an underdog that he was kind of concealing his candidacy because he didn't want to suffer the humiliation of losing. And then, former President Truman endorsed another candidate, so not Stevenson, and all of a sudden, LBJ developed this absolute belief, just this certainty that he was going to win. And this belief drove him to put any rational assessment of his chances aside to publicly and openly pursue the nomination far beyond the point where it became obvious to his staff, his family and his colleagues and friends that he had zero chance.

Jayamanne: Like I'm really into this story now.

Lamonica: Are you?

Jayamanne: Yeah.

Lamonica: You do like politics?

Jayamanne: Tell me what happened.

Lamonica: Well, he lost. But the way he was acting just confounded everyone that this cautious man, who is so meticulous in everything he did, this man that just could not afford to lose and suffer humiliation, put all rationality aside and just went for this and he did it for one simple reason that he wanted his version of the facts to be true so badly that he concocted this story that convinced him he would win. So, the investing question that we'll explore today is are investors doing that with this endless speculation of if the market has bottomed out.

Jayamanne: And once the initial shock that investors feel when a bear market starts wears off, there's this natural shift to try to figure out when it's over. And obviously, that desire for it to be over makes a lot of sense. Portfolio values have gone down. There is often a pretty fearful environment and dire outcomes being predicted, and investors want, they need the situation to end.

Lamonica: And when you want something so badly, you can of course start to see things that aren't there.

Jayamanne: Like a mirage for people lost in the desert.

Lamonica: Wow, that's actually really good.

Jayamanne: Thank you.

Lamonica: You know, if I would have used that analogy, you would have missed that whole 20-minute lesson on LBJ in the 50s.

Jayamanne: Yeah, I'm well aware. You know, the good thing about podcasts is that you can actually skip parts of it.

Lamonica: Okay. Like the boring parts?

Jayamanne: Yeah, exactly.

Lamonica: Okay. Well, personally, I liked my LBJ story, and I might be the only one that liked it, but I did.

Jayamanne: You know, I think this could be a really good spin-off for you.

Lamonica: Okay. What is that?

Jayamanne: Like history lessons from Kermit the Frog.

Lamonica: So, I'm never going to live that down?

Jayamanne: No, I don't think so.

Lamonica: Okay. Why don't we get back into this? We can talk about some of the signs of the market bottom. Is that okay, Shani?

Jayamanne: Yeah, sounds good.

Lamonica: Okay. Well, we're told that we should invest when there is blood running in the streets which is kind of unhelpful, right?

Jayamanne: Yeah, it is unhelpful, but of course, it's referencing the notion of taking a contrarian stance against market psychology, which tends to get extremely negative in a bear market.

Lamonica: Okay. So, why don't we talk about that? Let's talk about market sentiment. The American Association of Individual Investors publishes a weekly survey basically just if investors are bullish or bearish, and unsurprisingly, they are very negative. So, on October 20th, the survey revealed that 56% of survey participants thought the market would fall in the next six months. Only 22% of investors thought the market would rise and the remainder are neutral.

Jayamanne: And that's a really negative reading. The 31st really pessimistic reading out of the last 39 weeks. The historic average is that 30% of investors think that the market will fall over the next six months, a category that Mark always votes in.

Lamonica: That's me – permanent bear, right? Well, we'll get to me in a little bit. But obviously, it's a pretty negative reading. In fact, we've been getting the most negative readings since 2009 when the GFC market fall bottomed out. So, in the September 22nd reading of this year, the number was over 60% bearish and only 17.7% bullish. So, that bullish measure is the 20th lowest of all time, and the 60% bearish was the highest since March 5th, 2009, when it hit the highest reading in history at 70%. And interestingly enough, on that March 5th reading the market hit the low of the GFC bear market the next week in March.

Jayamanne: And this whole blood running in the streets thing is related to another saying that we hear a lot and that is to reach the market bottom we need investors to capitulate. And if we go to the dictionary, and look up capitulate, we get the definition of surrender often after negotiation of terms. And in investing that negotiation that is referenced is a negotiation with yourself. It means giving up on all the unrealistic scenarios you were thinking about in the bull market when you extrapolated out those higher returns into the future.

Lamonica: So, no Bentley?

Jayamanne: No Bentley, Mark.

Lamonica: No retiring at 30?

Jayamanne: I mean, I'm almost 30, so hearing that is pretty painful.

Lamonica: But no retiring at 30?

Jayamanne: No.

Lamonica: Okay. So, when we say capitulate, we mean that literally a lot of investors just give up. So, a study in the Quarterly Journal of Economics found that between 1960 and 2007, the likelihood for an investor to stop investing increases the more recently that they've experienced low stock market returns and that right there is the start of finding a market bottom.

Jayamanne: And this is one of the really negative things about bear markets is that they cause investors to lose hope to such a degree that they stop investing, something that we assure that listeners of Investing Compass won't do.

Lamonica: And that is something that we've been insulated from a bit in Australia because the ASX has not fallen that much relative to global indexes, and we've been protected as Australians from global market falls because the Australian dollar has also fallen, which helps anyone investing overseas. But losses have been bad. We've seen a bit of a rally in the last week. But we need to remember that if we go back to last week, the Russell 2000 Growth Index, which tracks small growth companies, was down close to 30%. Tech-heavy NASDAQ 100 was down around 35% and very speculative investments, as represented by the ARK Innovation ETF, for example, that's down 64%.

Jayamanne: And these are the things that were in many new investors' portfolios. And at the peak of bubbles, it is the people that jump into the market at the end that push it to new heights. And when many of these investors give up after a fall is what brings the bear market into the dramatic last fall. And there are certainly signs that people have given up.

Lamonica: Yeah. We've seen this with trading volumes. So, Charles Schwab trading volumes have dropped 52% since Q1 2021. Drops have also occurred at Morgan Stanley, which is down 16% year-on-year, and Robinhood where July was the weakest month since March 2021, and Robinhood, of course, is where most of the Bentley by 30 crowds hanging out. The question is, is that big enough reduction to signal a market bottom?

Jayamanne: And the answer is that nobody knows, but we certainly are seeing signs of it. The other signal that many people use far after it is obvious we've hit a market bottom is to look at valuation levels, and this is an area that is extremely murky at the time. The notion is, of course, that at some point during a bear market, shares become cheap. That is a whole point of waiting to buy when blood is running in the streets and when investors have capitulated.

Lamonica: And the problem when looking at valuation levels is the fact that when we examine something like the price to earnings ratio, we always concentrate on the P or price. But many bear markets accompany an economic downturn, which means the E or earnings also drops. And so, once the economy recovers and that E or earnings goes back up, people can look back and say, of course, the shares were cheap, but they don't necessarily look like that at the time.

Jayamanne: And what is happening right now, and frankly, what we said would happen, although we were a quarter too early, is that earnings estimates are starting to get cut. The economy is slowing due to the impact of rising interest rates and inflation is starting to take its inevitable toll on margins and earnings.

Lamonica: Yeah, that's right, Shani. So according to FactSet, analysts have cut their third quarter earnings targets in the U.S. by 6.6% and fourth quarter estimates are down by 4.5%. We talked about this in a previous episode when we pointed out how high profit margins were compared to historic margins. But we are finally starting to see margin compression due to the impact of inflation. So, in five straight quarters, we've seen the S&P 500 have reduced profit margins or the difference, of course, of profit margin, the difference between what a company earns and what it makes in profit. And again, according to FactSet, the Q3 blended profit margin, which means estimates and numbers that have been reported, so far, the S&P 500 is at 12%, previous quarters at 12.2% and a year ago was at 12.9%.

Jayamanne: And this is that hit to profits from the impacts of inflation. And as the economy slows, we will not only see revenue fall, but also the impact from compressed profit margins. And this is natural and why it's hard to look at valuation levels like the price to earnings ratio when evaluating if a market is cheap. During the GFC in March of 2009, when the market hit a bottom, the P/E of the S&P 500 was 110, and that is certainly not a signal that the market is cheap, but it was because of the fall in earnings. Once the earnings recovered to a normal level, it became obvious the market was cheap, but that of course was in retrospect.

Lamonica: And that is why we like to look at the CAPE ratio, or the cyclically adjusted price to earnings ratio, by looking back in time and using an average level of earnings over the past 10 years, the natural cyclicality of earnings are smoothed out.

Jayamanne: Do you think people are bored of us just talking about the CAPE ratio all the time?

Lamonica: I think people are bored in general of everything I have to say, and I'm a little bit bored of myself, Shani. But the CAPE ratio, we'll just talk about it a little bit longer. How about that? Deal?

Jayamanne: Sounds good.

Lamonica: Well, the CAPE ratio has certainly come down. So, it was at the second highest level in history in late December, early January when we were telling people not to buy at the dip in our episode "A sale worth skipping."

Jayamanne: Which did turn out to be a good advice.

Lamonica: It did turn out to be a good advice every once in a while, right? But the CAPE has come down from there. So, right now, before this current surge in the market, so a week ago, CAPE was sitting at around 27. So, that compares to an average of 26.44 since 1990, which means we can say that the market went from historically high valuation level to just about average.

Jayamanne: And I think that's progress at least.

Lamonica: It is, it is.

Jayamanne: So, speaking of averages, we can now look back on the average market fall in bear markets. In the 26 bear markets that have occurred since 1928, the S&P 500 has fallen an average of 36% during a bear market, and during the GFC, it felt just over 50%. At the lows, the S&P 500 fell only 25% this time. So, maybe we have more to go or maybe this is just a better bear market than most.

Lamonica: And the issue is that we don't know. So, Warren Buffett in one of his laundry list of famous quotes said, in the business world, the rearview mirror is always clearer than the windshield. And his point is obvious. After something has occurred, it looks incredibly clear that what happened was something that was obvious and that everyone should have known was going to happen at the time. But when you're living through it, it doesn't seem so clear.

Jayamanne: And that is what this endless speculation about if we have hit a market bottom is about. It's about hope, but it's also about sifting through all these signs and indicators to try and figure out if we are there yet. And this is why you get all those bear market rallies and all this volatility. And in the textbooks, it seems like the market only goes in one direction and that assent or dissent is really clear.

Lamonica: That's right. So, we hear about the bubble inflating and ignore the fact that it wasn't a smooth climb. We hear about the market falling into bear market territory and forget that there were all sorts of volatilities when it was happening.

Jayamanne: And this is where we sit right now. We have a steep fall in the first part of the year. We had a rally when the market thought inflation was under control. We've had another fall when it became obvious it wasn't, and that central banks would keep raising rates. Then we've had another rally in the past week when it seems like maybe they would just slow the rate increases.

Lamonica: And now, in the Q3 numbers out of the U.S., we are finally starting to see the impact of this incredibly difficult environment on companies. And we are starting to see a slowing economy getting reflected in future earnings.

Jayamanne: So, the question is, Mark, do you think that we've hit a market bottom?

Lamonica: Well, the answer is, I don't know and neither does anyone else listening, and neither does anyone else who is making a prediction. My own true sense is that we haven't, and we'll see another drop, but that is pure speculation. And if I was a speculator, maybe I would make some sort of bet on that, but I'm not. I'm an investor.

Jayamanne: And as investors, we need to take a step back and say, it doesn't matter over the long term if we've hit a market bottom or if the market bottom occurs later this year or sometime next year, we will hit a bottom and then shares will go up. Again, over the long term, history has suggested they do go up.

Lamonica: And this is why we need to look at our own personal situation. And I talked about one opportunity I was looking at a couple of weeks ago and that was American Tower, and it continued to fall after that podcast, and I bought more. So, that was my first significant buy since March of 2020, and I did that because I thought it was at a price that allowed me to have confidence that it would help me to achieve my goals.

Jayamanne: And for everybody listening, it's important to acknowledge that your ability to achieve your goal is not reliant on knowing exactly what the future holds. You don't need a crystal ball to get where you want to go. So, go ahead and speculate on if we've hit a market bottom – we've just spent a whole episode talking about it – but also know where you want to go and keep your focus on the long term.

Lamonica: All right. Well, thank you guys for listening today. Thank you for suffering through my LBJ story. After this podcast ends, I'm going to tell Shani about the rest of the book.

Jayamanne: Oh, don't.

Lamonica: Yeah. So, it covers quite a period of time. So, get excited. Shani is looking at me in utter contempt. But thank you for listening. We'd love a rating or a comment in the podcast app. And of course, my email address is in the show notes if you have any questions, show ideas, comments, book reviews, anything you want to send. Thank you very much.