Dead Cat Bounce Vs. Market Bottom: What Investors Need To Know

2022 was one of the worst years ever for the market. Stocks and bonds dropped heavily as a result of high inflation and rising interest rates.

But recently, the market appears to be finally gaining some momentum to the upside.

Over the past few weeks, the S&P 500 (SPY) and REITs (VNQ) rose by ~10% and this led many of you to ask me:

Is the market now recovering or is this just a dead cat bounce?

People are very opinionated on this question.

There are the bears who argue that the market has more to drop before it eventually recovers. Dead cat bounces (temporary market recoveries) are common during bear markets and with interest rates set to be hiked again in the near future, the market could face more downside pressure.

Then there are the bulls who argue that a market is a forward-looking machine and that valuations are already discounted. Sure, interest rates are rising, but the market has overreacted and prices are now headed higher.

And finally, there is me. My answer is always the same: it is impossible to know if the market is now recovering or whether this is just a dead cat bounce, and therefore, you should stop worrying about it.

You simply cannot know what the market will do in the next week, month, quarter, or even year. Some would argue that anything less than 3 years is random and mainly depends on luck in the public capital market.

There are countless studies that also prove this point and yet, individual investors still continue to worry about whether this was a dead cat bounce or not. According to a study by JPMorgan (JPM), individual investors have historically only earned a 2.9% average annual return, which is far short of market averages, and the main reason for these poor results is failed attempts at timing the market. Instead of staying invested and buying the dips, individual investors attempt to get in and out and stop investing during bear markets due to fears that prices will drop even lower:

This specific study applies to individual investors, but there are also studies that apply to professionals and the results are more or less the same. This is also backed by the beliefs of legendary investors like Warren Buffett and Howard Marks:

“We’ve long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.” Warren Buffett, CEO of Berkshire Hathaway (BRK.A) (BRK.B)

“Because we do not believe in the predictive ability required to correctly time markets, we keep portfolios fully invested whenever attractively priced assets can be bought. Holding investments that decline in price is unpleasant but missing out on returns because we failed to buy what we were hired to buy is inexcusable.” Howard Marks, Co-Chairman of Oaktree, part of Brookfield (BAM).

If professional investors cannot time the market, despite dedicating their whole life to it, can you really do it?

Clearly, you can’t, so why bother?

Instead of wasting your time and effort on attempting to predict short-term results, which isn’t possible, I think that you should instead attempt to predict long-term returns, which is much easier to do.

Therefore, what you should really be asking is:

Have prices dropped low enough for stocks to offer attractive long-term return prospects?

That’s a question that we can actually answer for some, but not all stocks.

Even here, most investors are overconfident about their ability to understand all sorts of businesses.

Realistically, your circle of competence is limited and you can only be an expert in a few things.

My specialty is real estate-heavy businesses like REITs (VNQ).

I specialized in commercial real estate during my university studies and later worked in private equity real estate before finally becoming a REIT analyst.

This does not mean that I am always right. In fact, I still make many mistakes (BRMK is a recent one!). Still, it increases my odds of being correct as I attempt to predict the long-term prospects of various REITs because I understand what drives their fundamentals and can judge whether I think that they are over or undervalued relative to their fundamentals.

Today, I think that most REITs are severely undervalued and are set to deliver exceptionally high total returns in the coming years, but few seem to be buying them because prices may or may not drop lower in the near term.

On average, REITs now trade at just around 12.8x FFO, which is a measure of cash flow that’s used for REITs. This is a historically low multiple and it compares very favorably to the 20x EPS of the S&P 500. This is particularly true since the S&P 500 companies are more heavily exposed to the risk of a recession, geopolitical threats, and the strong dollar headwind.

	REITs	S&P 500
Valuation Multiple	12.8x	20x

Click to enlarge

They also trade on average at large discounts to their NAV, which means you get to buy real estate at a discount relative to what you would pay in the private market. Just to give you a few examples: we estimate that AvalonBay (AVB) is priced at a 35% discount to NAV, Prologis (PLD) at a 25% discount, and Simon Property Group (SPG) at a 40% discount.

Why are REITs priced so cheaply at the moment?

REIT valuations collapsed in 2022 because of fears of rising interest rates.

But the thing is that REIT balance sheets are today the strongest they have ever been. Leverage is low at around 35% on average, practically all of it is fixed rate, and maturities are long as well. Besides, interest rates only rose because inflation was high, which benefited REITs as it grew the replacement value of their properties and allowed them to hike rents.

This explains why most REITs have hiked their dividend in 2022 as cash flows hit new all-time highs:

So again, I have no clue how REITs will perform in the short run.

I cannot tell you if we have hit a market bottom or if this is just a dead cat bounce.

However, what I can say is that REITs are now priced at heavily discounted valuations, they offer high dividend yields, and they continue to grow at a good pace. If a REIT pays a 6% dividend yield, grows at 5% per year, and is 40% discounted relative to its long-term fair value, you don’t have to be a genius to see a path to ~15% average annual returns in the years ahead.

There are many such REIT opportunities in today’s market.

Bottom Line

My advice would be to stop worrying about whether the recent surge was a dead cat bounce or not. You cannot know and you risk missing these long-term opportunities by staying on the sidelines.