Bear Market on Target
Adam Hamilton April 19, 2002 3596 Words
Six weeks ago I hammered out an essay called “More Bear Market Rallies!”. On the day it was published the Dow 30, NASDAQ, and S&P 500 closed at 10572, 1930, and 1164 respectively.
In this earlier essay, as the title delicately suggests, I advanced the controversial idea that there were simply no fundamental or technical reasons to get excited about the spectacular bear market rallies at the time in the major US equity indices. The Dow 30 and NASDAQ had each just advanced 10%+ within a very short time frame and the legions of perma-bulls were once again unleashing their boundless enthusiasm about the perceived bullish market behavior. I concluded my essay with the following words…
“This week’s exciting rallies look like classic bear market rallies, smell like classic bear market rallies, taste like classic bear market rallies, so they probably are, you guessed it, nothing more than bear market rallies. Caveat emptor!”
Not surprisingly those particular foundationless rallies did indeed fail shortly after my essay was published. As of April 17th the Dow 30, NASDAQ, and S&P 500 have dropped an absolute 3.3%, 6.2%, and 3.3% respectively. These are definitely not trivial losses over such a short six-week period in the elite American flagship equity indices! Investors who chose to believe the phalanx of bullish propaganda in early March have since had the miserable misfortune of watching their capital bleed away at frightening annualized rates.
This week, I was struck by the many similarities between the rallies of early March and our current sharp stock market rallies. On Tuesday April 16th alone the DJIA rallied 2.1%, the NASDAQ 3.5%, and the S&P 500 2.3%. As always when the markets move, the Wall Street crowd wasted no time in crafting a bullish excuse to explain the action and seized on some quarterly earnings reports from Intel, Novellus, and Texas Instruments as the rallying cry. This particular somewhat arbitrary causal attribution by the market punditi was quite ironic because Novellus and Texas Instruments both reported losses!
As the expected bullish clamor waxed ecstatic following the exciting trading day, prospects of continuing massive daily rallies danced like sugar plums in investors’ heads. All kinds of glowingly-positive statements were made by the usual talking heads proclaiming that the horrible corporate earnings recession, the worst since the Great Depression, was finally ending and all would be well.
Wall Street advisors brazenly continued to feed the same old line to the investing public that they have worn out since mid-2000, the increasingly ubiquitous “this quarter was tough but next quarter looks grand”. With every subsequent bad quarter Wall Street continues to push out the brass ring of the elusive profits recovery yet one more quarter into the future. One would think that sooner or later investors would catch on to this psychological propaganda ploy and begin to grow suspicious of the terrible track record of this omnipresent prognostication!
Nefarious Wall Street mind games aside, the big daily rallies this week were indeed exciting and interesting. But investors would do well to be exceedingly careful not to take them out of context. Without the benefit a proper long-term strategic perspective, it is incredibly easy to fall into the lethal quicksand of reading too much into day-to-day market noise. Just as a military general flying over a battlefield in a helicopter has a far greater strategic perspective of what is truly unfolding below as compared to a general stuck on the ground in a tank, an investor who views day-to-day market tactical action through a longer-term strategic perspective can make far superior decisions.
With this crucial goal in mind, this week we decided to update the graphs from my “More Bear Market Rallies!” essay of six weeks ago in order to attempt to sort out the tactical noise from the true strategic market situation. Ignoring the latest reincarnation of the endless Wall Street enthusiasm following this week’s rallies, has anything fundamental or technical truly changed in the flagship US equity indices that warrants a shift back to unbridled optimism on the markets’ near future prospects?
Is the bear market on target or has the bear been scared away by the charging bulls?
In addition to the usual strategic dotted-red technical trendlines from the previous essay, this time around we added the two most popular moving averages, the 200-day and 50-day, to our graphs.
Moving averages are an interesting and useful analytical tool because they help filter out much of the unimportant daily market noise. The moving averages offer a wonderful quick visual perspective on the macro-trends evolving in a particular market. Longer moving averages like the 200-day often run roughly parallel with the primary strategic trend channel, rendering them very useful to quickly discern which way a market is migrating.
Unfortunately, like all other useful tools, moving averages can be abused. You can buy a hammer at the local hardware store and use it to build a house, a very useful application of the tool, or you can use the very same hammer to smash your neighbor’s windows, not an acceptable use of the tool. Lately we have marveled at the growing number of bullish analysts who are trumpeting simple moving average crossovers as a solid way to predict future market movements. Is this particular use of the moving average tool constructive or destructive to speculators heeding these signals?
There are many separate varieties of moving average crossovers. One common strain involves watching the endless dance between long and short moving averages, like the 200-day and 50-day for example. When the short moving average crosses the long one, or vice versa, speculators use it as a buy or sell signal depending on the particular school of technical analysis they follow. We are not considering these types of long and short moving average crossovers in this essay.
A simpler strain of moving average crossovers involves watching an actual index oscillate around its moving average. Per this theory, if a stock index itself trades higher than its 200-day (or 50-day) moving average, then it must be a buy signal since the index is heading up above its mean. Conversely, if the same stock index falls below its moving average, then a sell signal is triggered.
I suspect that these simple single moving average crossover theories are experiencing a resurgence in popularity because the NASDAQ is finally once again meandering around its 200-day moving average for the first time since the bottom fell out of the index way back in September 2000, ancient history in light of today’s relentless pace of change. Because the NASDAQ remains the primary nexus of speculative excess while legions of tech investors lavish attention on their failed bubble, investors today tend to place inordinate interest in anything happening in this index.
In order to attempt to determine if simple single moving average crossovers of the index itself have any predictive value, we added both the 200-day and 50-day moving averages to the three updated index trend graphs in this essay. We specifically searched for erroneous trading signals.
Per the simple moving average index crossover theory, if an index crosses over its own moving average while heading higher, it is a buy signal. If an index crosses over its own moving average while heading lower, it is a sell signal. But, what if an index crosses over its moving average heading up and then soon fails and falls lower? Or what if an index falls below its moving average but then soon reverses and runs higher. These events create false buy and sell signals respectively and can lead speculators to make poor capital deployment decisions.
In all three of the following equity index graphs, major false buy and sell signals from the simple moving average crossover theory are noted with white and yellow dots. The white dots correspond to the white 200-day moving average lines and the yellow dots to the yellow 50-day moving average lines. If a dot appears above its moving average, it represents a false buy signal. If a dot appears below its moving average, it represents a false sell signal.
On balance, we believe that simple moving average index crossovers appeared to actually have little predictive value and even the potential to be dangerous as so many false signals were triggered.
Just as in “More Bear Market Rallies!”, we will start with the elite Dow 30, the flagship US equity index of immense financial and psychological importance.
From a strategic trend perspective the Dow’s strong downtrend remains fully in force, despite the sharp rally this week. The DJIA is currently trading near the center of its wide downtrend pipe. In order for the technical action to get really interesting, the Dow 30 would either have to trade above 11,000 for some weeks after an upside breakout or fall below about 9100 on a downside breakout. Barring the breakout possibilities, the index’s technical action is more of the same now trademark Dow lethargy, a slowly meandering primary bearish downtrend punctuated by occasional sharp bear market rallies to keep everyone awake.
Fundamentally the Dow 30’s price to earnings ratio remains extremely high at 39.2, well into historical bubble valuation territory which starts at double fair value (27x earnings). History has consistently proven without exception that excessive P/E ratios this high are never sustainable over the long run. Either corporate earnings must rocket or stock prices must plummet to return the P/Es to historical normal territory. There are no other options.
In order to migrate back to its historical average earnings multiple of 13.5 times, the elite Dow 30 companies would have to somehow manage to miraculously triple their aggregate earnings to justify current stock prices!
With the dismal recent record of US corporate earnings growth coupled with widespread accounting fraud and deceit, it is virtually impossible to conceive of such a mega-bullish scenario where the profits of the mature Dow 30 companies could grow so explosively. Historically long-term earnings growth for large mature US companies runs roughly in line with US GDP growth, and not even the most incorrigible and obnoxious perma-bulls today are daring to predict the double-digit GDP growth that would be necessary for any substantial increase in US corporate earnings.
Since all contrarian investors have to abandon the joyous naiveté of perma-bulldom and perceive the markets through the hard lens of historical precedent and fundamental reality, we know that there is a vastly higher probability of Dow 30 stock prices falling than of corporate earnings soaring in order to bring the current extreme DJIA valuation multiples back into historical line.
It is certainly no fun being bearish, but successful long-term investing demands that we respect the markets and protect our scarce capital through the inevitable down periods of market history. There are currently no compelling reasons, fundamental or technical, to believe that this particular Dow 30 bear market is anywhere close to heading back to hibernation.
The recent action in the most popular 200-day and 50-day moving averages of the Dow 30 has also been interesting. During 2000, with the DJIA hopelessly locked in an almost unnaturally constricted trading range, the index was constantly crossing its moving averages like a needle on a seismograph rendering their predictive value absolutely useless. This odd period of flat moving averages is outlined in the graph above with the light white circle.
Beginning in 2001, however, soon after Alan Greenspan and his Fed launched their most aggressive easing in the entire 89-year history of the private US central bank, the Dow 30 volatility picked up dramatically. With increasingly choppy trading, simple index moving average crossovers became less common and therefore more interesting for speculators to observe. Unfortunately for the theory, however, there were at least six major false signals triggered.
The Dow has recently twice traded above its long 200-day moving average, triggering a buy signal, but then soon dropping back below its 200-day moving average once again, proving to be a false buy signal. The white dots above mark these episodes which would have cost traders considerable amounts of capital if they had heeded the false simple index crossover buy signals. Similarly, the short 50-day moving average spawned four major false buy and sell signals, marked by the yellow dots above.
The simple index crossover of its moving average appears to have little predictive value for the Dow 30 in recent years. Not surprisingly, it didn’t fare much better in the NASDAQ, still the Graveyard of Fools who can’t quit lusting after the last dead bubble long enough to search for the next great investment opportunity.
The trend action in the embattled NASDAQ, still doomed to experience the full fury of a true supercycle post-bubble bust, also remains incredibly bearish. The popular index has continued to relentlessly deteriorate from six weeks ago, as we expected and predicted in the “More Bear Market Rallies!” essay. The heavy top resistance line of the primary NASDAQ strategic downtrend is forging relentlessly lower, now down around 1950 or so. In the conspicuous absence of a technical breakout leading to the NASDAQ trading above 1950 for a few weeks, there is yet no technical reason to grow excited. The NASDAQ bear market is right on target.
Provocatively, a secondary bottom support trendline is forming well above the NASDAQ’s primary bottom trendline most recently hit after the September 11th attacks. This secondary trendline is shown in the graph above as a dashed-red line between the two primary dotted-red trendlines. We will call it the middle trendline, or midline.
In mid-2001, as the widely loved at the time sharp bear market rally was failing and rolling over, the NASDAQ bounced off the midline several times before finally plunging below it, then rapidly plummeting down to 1695 even before the September 11th attacks provided a convenient excuse for it to be sold down to the bottom of its primary strategic trendpipe. In 2002 this same descending midline has also provided some support for the NASDAQ, marking a recent bounce that led to the very bear market rally we were warning about six weeks ago.
After watching this new midline continue to coalesce, I am starting to suspect that the NASDAQ could plunge quite sharply after it falls below the midline, at roughly 1650 now. Whether the NASDAQ knifing down through this midline yet again to head all the way down to the bottom of its strategic trendpipe occurs on some spectacular surprise geopolitical event or just general investor fear of the rampaging bear, it looks all but inevitable.
Technically the besieged NASDAQ continues to look ugly and there is no reason to get excited about any bear market rally that is confined within these well-defined strategic downtrend lines. Unfortunately for the remaining NASDAQ perma-bulls who do not yet fully comprehend the horrific damage that bubbles always wreak before the bust process runs its full course, the fundamentals for this hyper-speculative index remain breathtakingly atrocious.
Trading at almost 66x earnings today, the NASDAQ companies either need to massively ramp up their true honest GAAP earnings by four or five times current levels or else NASDAQ stock prices will be forced down to return valuations to more normal levels. There are no other alternatives, corporate earnings must rise or stock prices will fall.
Given the exceedingly poor track record of the elite high-flying NASDAQ companies to consistently earn profits for their shareholders, the continuing rampant accounting frauds and deceptions eagerly perpetrated by many NASDAQ-listed corporate managers, and the incredibly dismal profits recession in the United States, I believe that the probability of the NASDAQ companies actually earning their way out of this valuation anomaly is effectively zero.
Even in light of the colossal damage we have witnessed since 2000, the post-bubble NASDAQ bust has not yet fully run its course. The vastly overvalued and over-hyped tech stocks it contains remain the most dangerous major equity investments in the United States today. It is tragic and shameful that the Wall Street propaganda machine continues to lure investors into the NASDAQ like some dark Pied Piper of Doom. The ultimate price that investors will have to pay in scarce capital and misery before the NASDAQ hits its true long-term bottom will be tremendous.
Just like the DJIA in the early 1930s, the NASDAQ truly has become today’s Graveyard of Fools. It is sad to witness.
On the moving average front, even though the NASDAQ’s long AWOL 200-day moving average has just finally swooped down to catch up with it, false buy signals already abound. Speculators who are using simple NASDAQ index crossovers of its 50-day or 200-day moving averages as signals to buy and sell are getting slaughtered. Yet, for some strange reason the usual financial television talking heads continue to hype simple moving average crossovers in the NASDAQ as if they were the key to trading success. Yet another devious stock market deception!
Finally, we will close with a look at the most important US equity index by far, the venerable S&P 500. At a staggering $10t in market capitalization, it is over twice as large and important as the elite Dow 30 and NASDAQ 100 companies combined, many of which are also included in the S&P 500.
Six weeks ago, in response to the S&P 500’s apparent breakout above its top resistance trendline, I said in “More Bear Market Rallies!”…
“When the Dow 30 and NASDAQ 100 bear market rallies fail, the S&P 500 will be dragged down kicking and screaming with them. The only way this current S&P 500 bear market rally will continue to trade above 1125 or so is if the Dow 30 and NASDAQ keep rallying, which is highly unlikely as we pointed out above.”
On April 17th, the day after this week’s spectacular bear market rallies, the S&P closed at 1126, only slightly above its top trendline. If the Dow 30 and NASDAQ 100 continue to deteriorate, as we are still expecting, the S&P 500 will once again be dragged back down into its primary bearish strategic trendpipe. Technically the prospects for this mega-index do not look encouraging because its apparent upside breakout earlier this year has now already failed and is heading back south.
Fundamentally, the S&P 500 looks almost as rotten as the Dow 30 and NASDAQ 100. Currently trading near 36 times earnings, the broad US stock market in general remains more overvalued in fundamental terms than it was at even the infamous 1929 bubble top! To have a few companies so dramatically overvalued is one thing, but to have the whole massive $10t S&P 500 index still trading well into bubble-territory is an incredibly ominous portent for near future S&P 500 action.
Just like the Dow 30 and NASDAQ, the elite component corporations of the S&P 500 either must somehow more than double their total aggregate earnings in the near future to bring valuations back towards the historical 13.5 P/E norm or S&P share prices will continue to slide. Historical overvaluation anomalies of this magnitude in the past have always been addressed with plunging stock prices to force valuation multiples back into line, as it is impossible for US corporations as a whole to grow their earnings faster than US GDP over the long run.
Not surprisingly, just as in the Dow 30 and NASDAQ, the simple moving average crossover buy and sell signals often proved false in the S&P 500, both on the buy and sell side.
Even illuminated in the dim light of our superficial review, the theory of using simple index moving average crossovers to trigger major buy and sell signals is obviously very dangerous in our secular bear market following the supercycle equity bubbles of the late 1990s. Market technicians have to be very careful today as the general market environment has changed dramatically. Old technical tools that worked fairly well in the incredible bull market from 1982-2000 may no longer prove accurate in our present vastly different investing environment.
Any way you want to slice the big three major US equity indices today, they remain fundamentally overvalued and technically bearish.
The only thing that can save US stock prices from plunging far lower is a sudden miraculous explosion of corporate earnings growth of unprecedented proportions. If corporate earnings do not only roar back but soar to the heavens very soon, the current priced-to-perfection stellar equity valuations will crumble as increasingly nervous investors sell their overvalued companies to attempt to avoid the inevitable day of reckoning.
The US corporate earnings realm is currently plagued with a myriad of vexing problems including tremendous productive overcapacity, very high consumer and corporate debt loads, dwindling demand, and widespread accounting fraud and deceit, making a miraculous jump in corporate earnings to bailout the overvalued US stock markets all but impossible.
Great equity bubbles do have consequences, and the brutal post-bubble busts we are suffering through in the States have yet to run their full courses according to the hard lessons of market and economic history. Investors should strive to preserve their scarce capital through these tough times by avoiding the vastly overvalued US equity indices. There is no excuse for destroying capital by taking big chances in brutal bear markets that history tells us are inevitable after widespread systemic speculative excesses like we witnessed in the late 1990s.
Want to survive this vicious bear with your capital intact? Sell aggressively into these bear market rallies, preserve your scarce capital elsewhere through the post-bubble busts, and wait for the enormous bargains to come when general equity market valuations finally unavoidably fall below their historical norms.
The bear market is running on target.
Adam Hamilton, CPA April 19, 2002 Subscribe at www.zealllc.com/subscribe.htm