Is The Stock Market Bottoming?

Is the Dow's next stop 5,000 or 10,000? After Tuesday's 236 point gain, spurred on by Fed Chairman Bernanke's upbeat talk of an economic recovery in 2010, investors saw a glimmer of hope.

But is it false hope or the beginning of the market's turn? To get answers, TIME's John Curran spoke with Jim Paulsen, chief investment strategist at Well Capital Management:

If the stock market rallies in the weeks ahead, is there any reason to believe in it?
Well, I don't know why there wouldn't be. But I'm interested in the way you phrased your question because it is exactly where the consensus is today. There is absolutely every belief that we could go lower; and while we could rally, the belief is that it won't stick. It just says volumes about where we are right now. It's not just you. Even bulls like myself have that same feeling in their depths.

But there's absolutely no rational reason why a rally couldn't be considered the real thing. I've looked at all of the major stock market collapses that we've had (40% decline, or more) including this one. Since 1900, we've had six others, and two of them were Depression related — one was the beginning of Great Depression and one was in the middle of the Depression era, in 1937. And the other four were outside of that era. When you look at those, what you find out is, off the low of every one of those you had a violent recovery. Not a slow, arduous crawl higher, but a violent recovery.

For example, the Depression collapse didn't finally bottom until 1932 after falling 90%. However, from its low in 1932, it went up 300% within one year. So, here's my point. The feeling I get all over Wall Street is that even if we recover from this, it will be a slow and arduous process. It'll take a long time. But history would suggest just the opposite. (See pictures of the stock market crash of 1929.)

Spontaneous combustion?
There's a reason for it. If you have a slow and shallow bear market, powerful officials don't get to exercise their power, so they debate whether they should use it at all, and then they just use the minimal amount, which doesn't do much to build the next rally. But if you have an outright panic, where it collapses, policy officials throw everything including the kitchen sink at it, which is just the thing we need to produce a strong rally. (See 25 people to blame for the financial crisis.)

Is investor psychology close to where it needs to be at for something explosive to happen?
The most outstanding feature of this crisis compared to any other that I've been through or studied is not that we have debt problems or not that the stock market's come down. The most outstanding feature to me is the level of fear this financial crisis has created — the panic, the sheer loss of confidence. I certainly have not been through one like this. Even the '82 market one wasn't this bad from a fear perspective.

At the bottom of any kind of bear market you get some level of fear and capitulation. It's hard to know the precise point of the extreme, but today there are many things that tell me that fear is way over the top, not the least of which is the level of cash holdings by private households and businesses as a percent of GDP — it's at a post-World War II high. There's so much sideline buying power — dry powder — and everywhere you look and it shows up in the Fed's statements. Part of this is because the Fed is dumping so much in [to the economy] and part because people have gotten very liquid and "safe." (See pictures of the top 10 scared traders.)

The new penny stocks, practically, are the big banks and the automakers. Will we look back in 10 years and wish we had bought them now?
Viewing them as stock groups, I think we will. But that's an important distinction — in both cases, if you buy an individual automaker or an individual bank, you could pick the wrong one and it could be liquidated. But if you talk about the industry group, the answer is yes, especially for the banks.

The S&P 500 financials sector has lost 45% this year. I don't think it's because the financial sector's fundamentals worsened by 45% in six weeks. We cut the value of financial stocks in half mainly because our leadership created a run on the bank stocks by openly debating whether they should nationalize banks. There are certain things you just can't openly debate as a leader, like you can't openly debate whether you're going to do a surprise attack on another country. Or you can't debate whether you're going to close XYZ Bank, because while you're debating it, the consumers will make a run on it. And you can't openly debate whether you're going to nationalize bank stocks because in the meantime, everyone's going to sell them.

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