NASDAQ Pendulum

Adam Hamilton    February 23, 2001    3500 Words

 

“It might have been half an hour, perhaps even an hour, (for I could take but imperfect note of time) before I again cast my eyes upward. What I then saw confounded and amazed me. The sweep of the pendulum had increased in extent by nearly a yard. As a natural consequence, its velocity was also much greater. But what mainly disturbed me was the idea that had perceptibly descended. I now observed --with what horror it is needless to say --that its nether extremity was formed of a crescent of glittering steel, about a foot in length from horn to horn; the horns upward, and the under edge evidently as keen as that of a razor. Like a razor also, it seemed massy and heavy, tapering from the edge into a solid and broad structure above. It was appended to a weighty rod of brass, and the whole hissed as it swung through the air.” – Edgar Allan Poe, The Pit and the Pendulum, 1842.

 

An early master of American literature, Edgar Allan Poe’s masterful prose has terrified and inspired audiences for over 150 years.  Love him or hate him, Poe’s contributions to the literary world are indisputable.

 

The macabre master was born in Boston on January 19, 1809, and died 40 short years later in 1849.  He had a tough early life, as both his parents, touring actors, died before he was three.  He was taken in by a prosperous merchant family and the rest of his childhood was uneventful.  After high school, Poe enrolled in the University of Virginia, but only stayed for a single year.  He was a fair student, but he had an insatiable gambling addiction which eventually ran up considerable debts that his foster family refused to pay. 

 

Young Poe, devoid of means to support himself, decided to join the Army.  Later, he was released from the Army and received an appointment to West Point due to his foster father’s influence.  Soon tiring of the rigid and disciplined lifestyle, Poe consistently disobeyed orders six months later to contrive his release from West Point.  He later married his 14 year old cousin, creating much scandal.  Poe’s short life was VERY non-conventional, to say the least! 

 

Although his life was quite bizarre in many respects, Poe was a master wordsmith and a genius with the English language and the art of written communication.  He deserves tremendous credit for elevating the short story to a form of art.  He was also one of the early detective story authors and perfected the psychological thriller.  American literature owes a deep debt of gratitude to the enigmatic Mr. Poe for his fantastic contributions.

 

One of his more intriguing short stories, in my opinion, is entitled “The Pit and the Pendulum”, of which excerpts are reproduced in this essay.  The Pit and the Pendulum (henceforth “Pendulum”) is a dark fictional story that gives a first person account of a condemned man’s perspective in the fearful Inquisitor’s dungeons of Toledo, Spain.  The awesome wordcraft and raw power in the short piece never cease to amaze me.

 

Lately, as I have talked with people around the States who are NASDAQ investors, the power and continuity of the perpetual dance between greed and fear that drives equity valuations has been strongly reinforced in my mind.  All markets, including the NASDAQ, move in cycles.  Sometimes greed takes center stage and prices are bid to ludicrous and unsustainable levels, like last March.  Later cold, black fear takes over and terrified investors sell with both hands, regardless of the price, just to get away from “those infernal markets”.

 

For some cryptic reason, as I have talked with people losing tremendous amounts of money in the NASDAQ, Poe’s incredible short story kept coming to mind.  The NASDAQ index is like a giant pendulum, sometimes briefly propelled to one extreme by kinetic energy.  As the pendulum reaches the top of its swing, stellar valuations are achieved.  The kinetic energy (movement) of the pendulum is converted into potential energy, and the pendulum temporarily hangs weightless in space.

 

Without the benefit of a longer perspective, if one caught a glimpse of the pendulum at the top of its arch, they could erroneously conclude that the pendulum was just meant to be at those levels, that equity prices, even if overvalued by all historical and rational standards, had reached some kind of new reality where gravity was suspended.  Last March, in the heady days of the NASDAQ bubble, the US equity markets were just that kind of alternate “reality”.  Everyone was convinced the markets were going higher, except for the usual band of malcontent contrarians including us at Zeal.

 

Since the crash of the NASDAQ last year, which the perpetual bulls on bubblevision are STILL deathly afraid to admit was actually a crash, there has been a titanic struggle between greed and fear, between hope and despair.  The emotions that NASDAQ investors have gone through in the last twelve months since the lofty NASDAQ top are incredibly similar to the prisoner of Poe’s Pendulum.

 

In The Pit and the Pendulum, a man just sentenced to death awakens in a dark subterranean dungeon.  He has no idea where he is being held or what surrounds him, as the cell is initially bathed in total oppressive darkness.  He gingerly explores his frightening new environment in the complete blackness, eventually tripping on a coil of rope in the middle of the dank room.  The prisoner is stunned to find that, although he trips and falls flat on his face, that his head never hits the ground!  In the middle of his cell, in the void under his head, he discovers a large circular pit.  Still devoid of light, he scrapes some small pebbles from the dungeon floor into the dark abyss and listens to them careen down the pit and eventually hit water at the bottom with a distant splash.  He is greatly relieved that he didn’t trip a step or two later as he would have fallen to his death in the pit.

 

As the condemned prisoner gropes around and searches his cryptic and foreboding surroundings, carefully avoiding the pit, he realizes how hungry he is becoming.  Exhausted, he falls asleep, and when he wakes up he feels around himself and finds some food and water left for him to consume.  Famished, he drinks the water, and a small glimmer of hope fills his soul.  Soon afterward, however, he feels very sleepy and he realizes the drink was drugged just before he falls into a drug-induced slumber.

 

When the prisoner wakes up again, the dungeon cell is lighted and he is tied down to a table in the center of the room, like some strange pagan sacrifice on a stone altar.  Struggling against his bonds, he is unable to move.  Flat on his back, he surveys his newly lighted surroundings, noticing terrible instruments of Inquisitor torture on the various walls.  He begins to get a really bad feeling.

 

Finally, he looks up, and notices a pendulum high in the ceiling of the dungeon immediately above him, swinging in small arcs.  The opening quote of this essay above describes his amazement when he realizes the pendulum is really razor sharp, a cleverly designed torture device that will eventually rend him asunder as it lazily swings lower and lower.

 

Although NASDAQ investors certainly have not been tied to a table and forced to play in this dangerous market, they may as well be tied down because the emotions of most people prevent them from selling until the worst possible moment.  Since last March, the NASDAQ pendulum has swung back and forth, always moving lower and lower.

 

While the index plummeted from near 5100 to the levels today, the average NASDAQ investor, whether professional or amateur, went through the same broad array of emotions as Poe’s prisoner.  When sharp trading rallies would occur in the bear market, such as the Fed-induced mania rallies in early December 2000 and January 2001, NASDAQ investors would rejoice.  They forgot their temporary losses and jumped for joy in their newfound “knowledge” that the bottom had been put in and all was well in equity land.  The intricate interplay between greed and fear continued unabated, just as the prisoner of the Pendulum was wracked by fear as he watched the razor sharp pendulum almost imperceptibly swing lower and lower and almost overcome with joy as he came closer to working out a means of escape.

 

Poe again…  “What boots it to tell of the long, long hours of horror more than mortal, during which I counted the rushing vibrations of the steel! Inch by inch --line by line --with a descent only appreciable at intervals that seemed ages --down and still down it came! Days passed --it might have been that many days passed --ere it swept so closely over me as to fan me with its acrid breath. The odor of the sharp steel forced itself into my nostrils. I prayed --I wearied heaven with my prayer for its more speedy descent. I grew frantically mad, and struggled to force myself upward against the sweep of the fearful scimitar. And then I fell suddenly calm, and lay smiling at the glittering death, as a child at some rare bauble.”

 

Like the tied down prisoner in the Inquisitor’s dungeon, most NASDAQ investors have been paralyzed into lethal inaction.  They have watched the NASDAQ pendulum swing, slowly from the extremes of last March, gradually picking up speed as it nears the bottom of its arch.  These investors have been hypnotized by the falling NASDAQ, watching the index fall in awe but unable to bring themselves to try and escape the carnage.  The million dollar question becomes where will the pendulum stop swinging on the downside?  Where is the long-awaited but elusive NASDAQ bottom?

 

From a historic perspective, as we have discussed in many past essays on this endlessly fascinating NASDAQ phenomenon, the bottom is highly unlikely to manifest itself until several distinct events occur…

 

First, valuation levels, as defined by historic norms such as price earnings ratios, must reach HALF their historical average value.  For normal markets with long histories, such as the DJIA and S&P 500, an average P/E of around 7-8 probably represents half normal levels, a mega-bear market bottom.  For the speculative upstart NASDAQ, only three decades old, the bottoming P/E may be a little higher, around 10x trailing earnings.  Even with the NASDAQ languishing at current levels, it is nowhere near having a collective P/E of 10x earnings.  This target, although continuously variable as earnings generally deteriorate in NASDAQ stocks, is probably around 750 on the NASDAQ Composite Index.  ANYTHING below 1000 is a LONG way down from here!

 

Second, the NASDAQ pendulum will most likely not bottom without massive capitulation selling and widespread fear and loathing of the index.  At historical bottoms, the general public absolutely hates investing, and the popular financial press spews forth nothing but gloom and doom stories on the broken stock market.  The popular press accounts of a reviled market at a major bottom make Poe’s twisted prose seem mellow!  Case in point is the popular financial media’s treatment of gold at the moment.  As gold is near a major long-term bottom, the media, with their usual total lack of foresight and understanding, proudly proclaims “gold is DEAD!”.   A NASDAQ bottom will NOT occur while most professional money managers, the financial press, and average investors are bullish.  We are looking for a period of time when the NASDAQ is avoided like the Black Death by investment capital, when it is feared as much as the cruel Inquisitors’ dungeons of the Middle Ages.  This day obviously has not arrived yet!

 

Finally, there are many technical indicators of a bottom.  One is a second top in intra-day volatility to complete a “double volatility top”.  Our “Volatility Squared” essay showcased our historical research of analyzing intra-day volatility of past stock market bottoms.  All of the examples of major bottoms of the equity markets in the past century showed daily volatility spiking up dramatically twice… first in the initial crash event, and later as the ultimate bottom was reached.  This ties in closely with the massive capitulation selling noted above which is needed at the bottom.  Only when there is a gut-wrenching washout will the evidence begin to tilt in the favor of the ever-popular bullish assertion that the bottom has been breached.

 

Like Poe’s prisoner, many NASDAQ investors are tying themselves to the Inquisitor’s table because they are emotionally attached to their losing investments.  They fear selling at a 50% loss, and they have tremendous faith and hope in bubblevision and the Wall Street hype machine.  They fancy themselves “long-term” investors, and they vow not to sell on “short-term dips”.  Their minds have been programmed by the mutual fund industry, and they act like obedient automatons.

 

These NASDAQ investors, many investing through the popular current day mania investment vehicle of mutual funds, lie on their backs, watching the razor sharp pendulum slowly swing lower and lower.  They see the NASDAQ dropping, and many instinctively know “gravity”, i.e. true fundamental valuations, will continue to pull the swinging NASDAQ pendulum lower.  Yet, the emotional ropes with which they bind themselves are stronger than the Inquisitor’s bindings of Poe’s prisoner in the Pendulum.

 

The graph below shows a graphical representation of the NASDAQ pendulum, gradually swinging lower to shred the investors willingly lying on their backs and subjecting themselves to the implosion of the bubble.  The graph is really TWO NASDAQ data series graphed on top of each other.  The black line represents the actual NASDAQ Composite Index, and the dates on the X-axis apply to this black current NASDAQ line.  The white line represents the NASDAQ Composite Index one year ago.  For instance, last year’s February 2000 NASDAQ (white line) is superimposed over today’s February 2001 NASDAQ (black line).  These two lines are superimposed so it is easy to visually comprehend what the year over year return for the NASDAQ has been.  Green shaded areas represent year over year gains in the NASDAQ, and red shaded areas represent twelve month losses.  All data is daily closing numbers…

 

 

Like Poe’s Pendulum, the NASDAQ pendulum has swung from one extreme and is well on its way to another.  On March 10, 2000, the NASDAQ reached its bubble peak at levels an amazing 112% over the previous year.  For investors who bought the index on March 10, 1999, they were sitting on mostly unrealized gains that represented more than a doubling of their initial risk capital.  Not a bad return if one can find it!  At this stage, the NASDAQ pendulum was at the top of its arch.  It had no motion and hung in space, all kinetic energy converted into potential energy.  Unfortunately for the perma-bulls, fundamentals, like gravity, soon caught up to the sharp pendulum and begin to pull it back to earth.

 

On November 9, 2000, the one year gains in the NASDAQ turned neutral, and began accelerating to the downside.  The guillotine in the graph represents this critical point.  (Sorry!  We couldn’t find any razor sharp swinging pendulum graphics…  In this politically correct world, Microsoft hasn’t released their “Inquisitor Clip Art Collection” yet!)  This is the cold hard reality point where smart speculators decide, “Hey, the NASDAQ just nosed over to negative year over year returns… maybe it is time to get out and search for other investment opportunities.”


Interestingly, this guillotine marked point where gains turned into losses is NOT the bottom of the pendulum arch, where it is swinging at its top velocity towards opposite extremes.  The bottom of the NASDAQ pendulum arch is at the point where the collective NASDAQ P/E trades at its historical average.  This could be between 13x (if one is pragmatic realist) and 20x (if one is a raging optimist).  The turning point in the graph is simply the point where profits evaporated and losses begin to accrue for one year NASDAQ investors.  The pendulum continues to accelerate to the downside.

 

On March 12, 2001, the year over year NASDAQ return will look abominable, as today’s levels will be compared with the NASDAQ top of one year ago.  Unfortunately for those poor misguided souls still believing the hype and holding onto NASDAQ 100 stocks or mutual funds for dear life, this is NOT the bottom of the pendulum arch either!  If the NASDAQ stays flat for the next few weeks until March 10, it will represent a one-year loss of 54%, a staggering number.

 

A 50%+ loss is catastrophic for scarce capital.  If a trader loses 10%, it is not a big deal.  In order to make back the 10% loss and return to his original capital investment, the trader simply has to find an investment with an 11% return.  If the same trader loses 25%, it is a lot harder to make up for his loss.  He must find an investment with a 33% return just to break even.  With a whopping 50% loss, a trader has lost half his hard-earned capital.  In order to make himself whole again after that dire contingency, he needs to find a 100% return on his remaining capital, which is very difficult to do.

 

The longer the NASDAQ investors allow emotional bonds of greed and fear to tie them to the Inquisitor’s table, the larger their losses will continue to grow.  In the 1929-1932 US stock market crash, the bottom was almost 90% below the top.  If, God forbid, an investor loses 90% of his capital, he requires a NINE HUNDRED PERCENT return to just get back to his initial capital levels!  As anyone who plays the markets knows, 10-bagger type returns are extremely rare and very difficult to attain… the razor-sharp pendulum swings ever lower.

 

Poe again…  “Down --still unceasingly --still inevitably down! I gasped and struggled at each vibration. I shrunk convulsively at its every sweep. My eyes followed its outward or upward whirls with the eagerness of the most unmeaning despair; they closed themselves spasmodically at the descent, although death would have been a relief, oh! how unspeakable! Still I quivered in every nerve to think how slight a sinking of the machinery would precipitate that keen, glistening axe upon my bosom. It was hope that prompted the nerve to quiver --the frame to shrink. It was hope --the hope that triumphs on the rack --that whispers to the death-condemned even in the dungeons of the Inquisition.”

 

Where will the NASDAQ pendulum stop?  Where will its next extreme be?  As Poe’s physical pendulum was compelled to obey the laws of physics and gravity, the NASDAQ pendulum is bound by timeless historical fundamentals.  The NASDAQ pendulum will be at top velocity, at the very bottom of its swinging arch, when it reaches historic valuation norms, at a collective P/E of 13-20.

 

Then the NASDAQ pendulum will continue swinging, all its potential energy now converted into kinetic energy, which will carry it far to the opposite extreme, well past normal valuation equilibrium levels.  The ultimate NASDAQ bottom will be seen, if history is a valid guide, at a collective NASDAQ P/E of 7-10, one half normal valuation levels.  Only then will we have the long awaited “all-clear” signal and be ready to consider jumping back into the NASDAQ for a future bull-wave up.

 

In Poe’s gripping Pendulum story, the prisoner eventually escapes from the table while the razor-sharp pendulum of death is already taking very small bites out of the skin on his chest with each pass.  Unfortunately, as soon as he escapes this peril, the pendulum is withdrawn into the ceiling by unseen torturers and the next step of the prisoner’s trials begin.  He realizes that he was being toyed with the entire time, and that the Inquisitors are in total control.  To read Poe’s entire incredible short story and its amazing conclusion, do a web search for “The Pit and the Pendulum” and savor the works of a wild American literary genius…

 

For the remaining legion of NASDAQ investors, the razor sharp NASDAQ pendulum is swinging lower and lower.  If the last twelve months of NASDAQ have taught the American investor anything, it is that fundamentals DO matter.  NASDAQ investors need to break free from their emotional bonds to this crashing index and save their capital for deployment in other profitable investments before it is too late…  the die has been set and the razor-sharp glistening blade of the NASDAQ pendulum is slowly swinging ever lower…

 

We will let our friend Poe have the last word, as he has earned it…

 

“The surcingle hung in ribands from my body. But the stroke of the pendulum already pressed upon my bosom. It had divided the serge of the robe. It had cut through the linen beneath. Twice again it swung, and a sharp sense of pain shot through every nerve.”

 

Adam Hamilton, CPA     February 23, 2001     Subscribe