Bear Trap for Bulls
Adam Hamilton July 14, 2000 3937 Words
"The great strength of the Bear, his swiftness and utter insensibility to danger when wounded, render him as dangerous to the hunter as the Tiger or the Lion. The first shot is seldom fatal upon him, on account of the thickness of his skin and skull, and the great quantity of fat and flesh that envelope his heart, and make an almost impenetrable shield in front." – Three Years Among the Indians and Mexicans, Thomas James, 1846
The bear, by all accounts, is a magnificent animal, captivating men through the ages. In recent history, the bear has become an idiom used to describe a negative trend in financial markets. Has the bear briefly visited the US equity markets in the last quarter and gone back into hibernation? In this essay, we will marvel at the biological wonder of the bear, explore some of the great beast’s giant footprints in ancient history, and step back to take a look at the US equity markets since 1995 to determine if they have been visited by the bear or may be treading into dangerous bear territory.
As the largest living land carnivores, bears can grow massive. Polar bears have been scientifically documented of attaining lengths over ten feet and weights exceeding an incredible 2,200 pounds. Large brown bears can outrun a horse with bursts of speed in excess of 35 to 40 miles per hour. All bears are capable swimmers, with the polar bear (ursus maritimus, “sea bear”) being known to swim greater than 60 miles through open ocean without rest, paddling with its giant forepaws at an average speed of 6 miles per hour while using its rear paws as rudders. Polar bears are also excellent divers, reaching depths of 15 feet and staying submerged for minutes. While underwater, they keep their eyes open and can attack prey as big as young whales in the frigid arctic seas. Polar bears have been filmed leaping out of water 8 feet into the air to shred an unexpecting seal lounging on an ice flow. Betraying their ponderous bulk, bears are agile and dexterous, and most species can climb trees with considerable skill and speed. Bears have outstanding color vision, and are capable of visually tracking small movements from several hundred yards. Bears are also well known for their outstanding sense of smell, which many biologists have compared to the olfactory acuity of a bloodhound. Bear observations have shown incredible levels of intelligence for the efficient predators, demonstrating conscious thought, rapid learning, and a developed level of self-awareness. Bears have been known to perform reconnaissance from tactically selected ground where they can observe passing humans while remaining invisible. While being pursued by their only predator, human hunters, bears have been observed carefully modifying their path to avoid leaving tracks. Finally, bears have been observed to use sophisticated strategies to either avoid or deliberately set off the trigger mechanism of live traps. “The rule about bears is their unpredictability.” – Anonymous… Without any doubt, bears are some of the most fascinating and formidable predators and carnivores on the planet.
Bears captivated the Ancients as well. The Hebrew prophet Daniel used the bear as an idiom to describe the great empire of the Medes and Persians, which superceded Babylon as the greatest empire of the Middle East about two and half millennia ago. The imagery is quite vivid … “And behold another beast, a second, like to a bear, and it raised up itself on one side, and it had three ribs in the mouth of it between the teeth of it: and they said thus unto it, Arise, devour much flesh.” -- Daniel 7:5 … Like a great bear, the Medes (present day Kurds) and the Persians (present day Iranians) relentlessly consolidated their power and advanced on three other ancient empires in the Middle East, devouring their flesh like a bear wolfs down fresh meat. Medo-Persian power lasted for centuries until a young Greek upstart warrior in his early twenties, Alexander (later “the Great”) utterly annihilated the Medo-Persian empire in a brilliant military campaign that would take him all the way to modern India. Several hundred years later, one of the most popular beasts for the Romans to place in the Coliseum to maul gladiators, slaves, and Christians was the bear. Bears were highly sought after by the promoters of the games, as they were incredibly difficult to bring down and put on one of the best shows for bloodthirsty fans. The great bear was so revered by peoples throughout history, that the most prominent constellation in the sky is named after it. Ursa Major, the Great Bear (the Big Dipper makes up the bear’s tail (the handle of the dipper), rear hip, and lower back) burns brilliantly in the heavens each evening. It was named after an ancient Greek myth… Zeus, the Greek king of the gods, saw a beautiful mortal maiden, Callisto, and fell in love with her. Zeus had a problem, however, as Callisto was a virgin follower of the goddess Diana, the huntress. Zeus assumed the form of Diana, approached Callisto, and revealed himself and seduced her. Later, as Diana and her nymphs were bathing, Diana noticed Callisto was pregnant and exiled her. Callisto wandered, and later gave birth to Zeus’ son, Arkas. Unfortunately for Callisto, Zeus’ wife Hera found out about the affair, and in a fit of anger and jealousy turned Callisto into a great bear. Years later, Arkas met his mother, still in bear form, and tried to slay her, not knowing it was Callisto. Zeus, in order to protect his concubine and his son forever, placed them among the stars and made them neighboring constellations. (Arkas is the root of Arcturus, the brightest star in the neighboring constellation Bootes, the herdsman… classical astronomers knew the whole constellation as Arcturus, not just the alpha magnitude star. Arcturus means “bear watcher” in Greek.) The whole story can be found in the Roman poet Publius Ovidius Naso’s (aka Ovid) excellent book Metamorphoses, Book II. The Ancients clearly shared our modern captivation with the amazing bear, immortalizing it in history, mythology, and the celestial heavens.
After some heart-stopping drops in the US equity markets in the first six months of 2000, many bulls are proclaiming the shortest “bear market” in history has ended, and once again the great financial beasts of burden, the tech stocks, can drag the equity markets ever upward forever. Bullish sentiment is on the rise, valuations are climbing, and even ever-patient contrarians and goldbugs are becoming discouraged. Equity bulls are laughing at the mighty bear, joking he is in hibernation forever, never to maul the stock market again as long as miracle technology stocks offer financial salvation for the masses. Was there ever a bear market? If so, has it ended?
In order to discuss a bear market, we must first define the term to ensure we have a common point of perceptual departure. Here are a few excellent definitions of a bear market…
· A long term downtrend (a downtrend lasting months to years) in any market, especially the stock market, characterized by lower intermediate lows (those established in a time frame of weeks to months) interrupted by lower intermediate highs. -- Trader Vic- Methods of a Wall Street Master, by Victor Sperandeo.
· A bear market is a decline of at least 15% in each of three important stock averages: the Dow Jones Industrials, the S&P 500 Index, and the ...Value Line Index. -- Martin Zweig's Winning On Wall Street, by Martin Zweig.
· An extended period of price declines.... -- Wall Street Words, by David L. Scott.
Even by simply reading these definitions, it is quite obvious the action we saw in the US equity markets in the last three months does not, in itself, constitute a bear market. We will take a look at four major US equity indices’ daily trading closes since 1995, and see what insights we can glean from a more strategic perspective on the market festivities in the first half of calendar 2000. There is no better index from which to embark than the mighty DJIA, the king of stock market indices. In the last century, no stock index has been more important than the Dow Jones Industrial Average. Started by journalist Charles Dow in 1896 with twelve stocks, the DJIA has grown into the most important indicator of the overall condition of US equity markets today. Of those original twelve stocks, General Electric is the sole remaining survivor in the current DJIA. Today thirty stocks make up the index, which is unique among major indices in that it is not market capitalization weighted. Even though upstart NASDAQ appears to be slowly gaining ground, the DJIA is the most important stock index in the United States, and is a bellwether for the US economy.
Even with the recent carnage, the DJIA looks surprisingly healthy when five and a half years of daily trading closes are observed. Though the DJIA’s 100 trading day moving average is below its linear trend line, the current dip looks no more severe than events in 1998. The light black horizontal line near the top right of the graph shows twelve months of daily closes. Year over year, the index has lost a mere 3.5%, not even enough to qualify as a correction, let alone a bear market. In the last twelve months, the 100 day moving average has appeared to flatline, and it may indeed be a market top of an incredible five year bull market. The latest quarter of data shows a very intriguing and well-defined horizontal wedge formation that will break out soon. Given DJIA valuation levels, the probability of a downside breakout is much greater than the probability of an upside breakout. The DJIA had a market capitalization weighted average price earnings ratio of over 40 at the end of last quarter. The historical average P/E ratio for US equity markets is 13.5x earnings, so valuation risk in the DJIA is still very high. In order to trade at 13.5x earnings, the DJIA would have to plummet to 3500, a level not seen since 1994. Upon close examination, it is quite obvious there is not a bear claw wound to be found on the DJIA. The bear is likely prowling, but it hasn’t struck the index yet… What about the S&P 500, the 500 biggest and best companies in the United States? Has the bear been seen attacking that index?
A bear market just ended? It sure wasn’t in the S&P 500, as the index gained over 7% year over year, right in line with historical average US equity market annual gains. The 100 trading day moving average is slightly below the linear trend of the data, but it is impossible to get alarmed at a chart like this. On the chart, the S&P appears very healthy and has witnessed no major carnage in five years. The bear may be coming, but it hasn’t mauled the S&P 500 yet... How about the ubiquitous NASDAQ? The brave new world where profits and valuations are irrelevant, and hopes, dreams, and blue sky reign supreme…
If you run out of entertaining things to do, consider turning on bubblevision as an amusing diversion. You will hear over and over that the “quickest bear market in history” has just ended on the NASDAQ. Was there ever a bear market? No one will argue that the drop from 5050 to 3200 in the last few months was not severe, but the graph above shows a longer-term strategic perspective of the NASDAQ that is worth pondering. Year over year, the NASDAQ returned an incredible 50%+! Bear market?!?! The 100 trading day moving average is still well above the five year linear trend (solid blue line), and stratospheric relative to the original trend (dotted blue line) prior to the burst upwards of the index in late 1998. If the NASDAQ had followed its original trajectory from 1995 to late 1998 until today, the index would barely be above 2000. Looking at late 1998 to today, and especially late 1999 to present, even the most incorrigible NASDAQ fans would be forced to admit this looks like a graph of a classic equity bubble. In order to ride the crest of this unsustainable exponential growth curve, the NASDAQ would have to punch through 7500 this year and 11000 in 2001. Will it happen? History and probability says it is EXTREMELY unlikely, as markets have a natural tendency to regress to their mean value. At the top in March, some analysts calculated the average P/E ratio of all the thousands of stocks on the NASDAQ was over 260x earnings! If these calculations were correct, the NASDAQ was and is the worst financial bubble in the history of the world. In order to trade at 13.5x earnings, the NASDAQ composite index would have to drop to an abysmal 250. (Yes, two-hundred and fifty, you read that right!) With the 100 trading day moving average barely turning down in recent months, and an amazing year over year return, those who claim NASDAQ experienced a “fast bear market” are full of hot air. The recent volatility will most likely prove to be a warning shot fired across the bow of the USS NASDAQ, trying to warn “investors” of low visibility and icebergs ahead… Deja vu? Has this happened before?
As always, history offers many priceless financial lessons for those willing to listen. From its closing top of 381 in September 1929 to its closing bottom of 41 in July 1932, the DJIA dropped a bone-chilling 89%. If the coming NASDAQ debacle unfolds similarly to the DJIA after the 1929 crash, it will be trading at 620 in 2002. (No two bubbles burst alike, so the comparisons should not be taken too far, but the magnitude of the resulting burst is usually similar across eras, markets, and nations.) Even more interesting, however, was the huge dead cat bounce of the DJIA after its initial slide in 1929. Just as real life bears we discussed above are extremely intelligent and cunning, so are bear markets. The “goal” of the bear market is to lure as many bulls as possible to their doom. In order to accomplish that devious stratagem, a bear market usually takes years, slowly breaking individual investor sentiment over the inquisitor’s wheel of ever accumulating losses. The initial drop of the DJIA in 1929 from 381 to 199 was 48%, and took about two months. The recent drop in the NASDAQ from 5050 on March 10 to 3205 on May 26 was 37%, and took approximately two and a half months. Here is where it gets REALLY provocative… From the temporary bottom of 199 in November 1929, the DJIA retraced 55% of its losses, closing near 300 in April 1930. The bull was back, right? Wrong! Contrary to a cacophony of bullish predictions, the DJIA plunged into a gut-wrenching dive and burned in over two years later. DJIA 300 would not be seen again until 1954, an amazing 25 years after the dead cat bounce! (Now THAT is long term! Imagine all the brokerage TV commercials where folks say “dips” don’t scare them, because they are LONG-TERM investors, and equity markets ALWAYS rise in value. LOL! They may get a chance to test their resolve and see how “long-term” they really are!) For the NASDAQ to retrace 55% of its losses, it would have to attain a level of 4220, which was breached on July 14.
Interestingly, many brilliant analysts believe there is a high probability for a Fibonacci retracement in the index. Fibonacci, born Leonardo Pisano in the famous Italian city of Pisa (of leaning tower fame) around 1175, is one of the most famous European mathematicians of the Middle Ages. The Fibonacci series of numbers is derived by adding two numbers in a series to get the next, for example 1,1,2,3,5,8,13,21 is a Fibonacci series. Any given number is always the sum of the two numbers that precede it. The ratio between any two Fibonacci numbers, called the Golden Ratio, approximates 61.8%. The golden ratio is ubiquitous in nature, architecture, and engineering, and also in financial markets and technical charts. A 61.8% retracement in the NASDAQ would take it to approximately 4350 before it runs out of rocket fuel and begins its terminal descent… The plot thickens! The eternal equity bulls would have us believe the worst is over and the bull market will resume. Maybe they are right… but the poignant lessons of financial history, the immutable financial laws of returns regressing to the mean, the consequences of massive overvaluation, and the mighty weight of probability indicate the NASDAQ has a LONG way down to fall before speculative excesses are wrung out.
How about the NASDAQ 100, the 100 largest companies on the NASDAQ? Have they seen a bear market? Bubblevision has been zealously advising converts to take refuge in the “safety” of the big techs, saying they are strong enough to withstand any financial storm, and they even have …(please insert drum roll here) … EARNINGS! Here is a five year graph of daily closing prices of the NASDAQ 100…
As the graph makes clear, the big techs did not even pierce their five year linear trend line in the recent volatility, and the year over year return for the index is still a mind boggling 66%+. A “quick” bear market in tech stocks? Never happened. Just as in 1929, in order for commercial interests to avoid the coming carnage, retail investors are being herded into big “safe” stocks so Wall Street insiders can sell out without incurring major losses. As more and more people pile into fewer and fewer stocks, the valuation risk has grown extreme beyond comprehension. The single biggest risk when investing is simply paying too much for any investment (just a future stream of cashflows). At the end of June, the market capitalization weighted average price earnings ratio of the NASDAQ 100 was a breathtaking 106x!! That means, if everything was constant and earnings didn’t rise, it would take, on average, 106 years for a NASDAQ 100 company to earn what an “investor” initially paid for the stock. (a whole century… now THAT is long term investing! … perhaps this is why the index is called the NASDAQ “100”) The NASDAQ 100 weighted average dividend yield was an abysmal 0.03%. A full 21% of the 100 companies (which bubblevision claims are “safe”) had ZERO profits. In order to trade at a historical average P/E ratio of 13.5, the index would have to drop below 500, for a terrifying 87% loss. Are NASDAQ big caps going higher as the bulls trumpet everyday? Anything is possible in the markets, but it is not likely. Once again, the probability and weight of history and extreme valuations suggests the NASDAQ 100 has a MUCH greater chance of cratering than attaining new highs, although a Fibonacci retracement to 4100 would not be surprising before the index shatters.
So where the heck are the bears? I saw an excellent special on National Geographic Explorer last weekend on the polar bear. The whole documentary was most interesting, but the highlight for me was the following scene... A mighty polar bear jumped off an iceflow and swam 25 miles to a remote and rocky island in the Hudson Bay. After his long swim, the bear reached the island and found nothing, no food. The bear climbed out of the water onto Walrus Island, and carefully chose a hiding spot on strategic high ground on the island, downwind from the mass of the isle. Like a professional sniper, the bear waited and waited, and finally the first walrus arrived at the shores. The bear saw the first potential meal, but decided to patiently wait for several more hours. As time passed, thousands more walruses (if two cactus are cacti, are two walrus walri?) arrived and stormed the island. The big walrus bulls took the high ground furthest inland because it was the best sunning spot with the least traffic. The bear patiently watched as female and baby walruses clambered up onto the edges of the island. Finally satisfied the ambush situation was exactly perfect, the hungry bear carefully climbed down a steep talus cone facing away from the center of the island and entered the water. If he had charged straight down to the walruses, he would have faced a gauntlet of 18 inch tusks on big and ornery bull walruses, allowing the females and young ones on the edges of the island time to escape into the sea. In a brilliant and stealthy flanking maneuver, the intrepid bear swam around Walrus Island the long way, and searched until he found a perfect soft target, a young and tasty walrus calf just off the rocky shore. After meticulously planning the hit, the mighty bear leapt out of the water and mauled his intended target with surgical precision. It was awesome!
I suspect, in the light of history and investor psychology, a big, hungry, and mean bear is hiding out in the rocks surrounding the financial markets. He is up high and out of sight, and is silently licking his chops, a bloodlust in his eyes as he eagerly salivates over the fat and tasty walrus tech stocks lounging below. Always retaining the crucial strategic advantage of surprise, he will strike when the timing is right for him, and when the perceptions of safety in the tech herd are the strongest. He hasn’t eaten for almost thirty years, and his rage continues to multiply exponentially. He is biding his time, laying in stealth, and the walruses have no fear. Make no mistake, however, the bear will have his way when he considers the timing right!
The bulls are claiming the recent bounce off the short-term index bottoms was a bear trap. How do you trap the most awesome of natural predators? It is very difficult. A leg-hold bear trap is four feet long and contains fifty pounds of hardened steel. A massive logging chain is needed to secure the bear trap to a large tree so the bear won’t go anywhere once it is trapped. The jaw spread on the trap is almost 18 inches, and some traps have serrated jaws to ensure the incredibly muscular bear won’t be able to get away once the trap is sprung. The springs in the trap are so powerful, that it can’t be set by hand. Two strong men must use long wooden poles as lever arms and struggle to compress the springs. Once the trap is set, the bear has to be lured in, which is extremely challenging. As we discussed earlier, bears are very intelligent and can usually spot a trap before its steel jaws clamp shut around its mighty leg. If the bulls made a single error in setting their bear trap, the mighty bear will capitalize on their mistakes…
The equity market bulls may THINK they have just set a bear trap, but those same bulls will gallop right through it. A bear is much stronger than a bull. The heavy trap will probably cleanly sever the bull’s smaller leg as he flauntingly tries to gallop past the trap but instead trips it, severing muscle, tendon, and bone in a terrifying snap. The three-legged bull, now in great pain, will trip in his full gallop and hit the earth headfirst, in a tremendous crash heard around the financial world. The equity bulls’ days are numbered…
Don’t be a tech walrus … the hungry mega-bear stealthily prowls!
Adam Hamilton, CPA July 14, 2000