Eve of a Bear?
Adam Hamilton March 16, 2007 3089 Words
It is hard to believe that only several weeks ago the US stock markets were carving exciting new highs and complacency reigned supreme. The S&P 500 and NASDAQ were trading at their highest levels since 2000 and 2001 respectively while the Dow 30 soared well into new all-time record territory.
It seemed like the best of times, but the markets were getting overextended to the greed side and it was only a matter of time until the tide turned. Ever-vigilant, contrarians have been steadfastly warning about the dangers inherent in the roaring stock markets for some time. On the Friday just days before the markets topped I wrote the following in an essay.
“And the general US stock markets almost certainly remain mired in a secular bear despite the cyclical bull we’ve seen over the last four years. Such secular bears tend to last seventeen years or so in history, but ours only started in 2000 so it is almost certainly not over yet. And it is totally normal and expected for powerful cyclical bulls to erupt in the midst of these long secular bears to keep hope alive and seduce the bulls into complacency ahead of the next brutal downleg.”
One of the great ironies of the financial markets is the tragic fact that no one wants to listen to contrary opinions when they are the most valuable and could prevent the most harm. Back in October I wrote an essay after the Dow 30 hit its first record highs. The conclusion? “Our current cyclical bull is long in the tooth and likely to roll over soon into a cyclical bear.” Yet because of the rising stock markets few were interested in the mushrooming risks so I shifted my research focus back to commodities.
But today, with the Dow 30 down 5.8% at worst so far, finally investors are once again willing to hear a contrary opinion. Thankfully it is certainly not too late. While the selloff we’ve seen to this point may have felt steep, that was only because the markets have been bereft of downside volatility for so darned long now. If what we’ve seen so far was just the eve of a bear, then 9/10ths of the potential selling likely still remains ahead.
On what basis can such a grim hypothesis be constructed? Markets tend to move in great cycles throughout history, long bulls followed by long bears. These cycles are best measured by general stock-market valuations, or P/E ratios. The Long Valuation Waves each run about a third of a century in duration, with the first half being a great bull witnessing rising valuations and the second half being a great bear suffering through falling valuations.
One doesn’t have to be a math professor to figure out that one-half of a third-of-a-century cycle is about 17 years. Our last Long Valuation Wave peaked in early 2000 and we have been in a secular bear since. But this is only 7 of the 17 years of secular bear that we should expect. Of course conditions haven’t felt bearish since the stock markets have been in a strong cyclical bull since 2003, but this perception is deceiving.
As of their recent February highs that so captivated the bulls, the S&P 500 was still down 4% since 2000, the NASDAQ still down a whopping 50%, and the Dow 30 up a modest 9%. These are catastrophically bad returns for 7 long years even before the pernicious effects of inflation. The Great Bear that awoke back in 2000 is very much alive and well despite the powerful stock rally since 2003.
The primary reason that Great Bears last for 17 years is they do a masterful job of stringing the bulls along. They are not an endless grind lower, but instead a series of periodic multi-year downlegs (cyclical bears) punctuated by spectacular multi-year cyclical bulls. This pattern gradually turns the screws to the bulls, continually providing them with just enough hope so they stay fully invested until the very end. Long bear markets are the most masterful orchestration of naked psychological warfare that I have ever seen.
The best way to attempt to grasp this deadly mind game is to consider today’s secular bear compared to the last Great Bear in stocks in the 1970s. The charts in this essay do just that. Lest you fear that I am one of the newly-minted weathervane bears jumping on this bandwagon, I first built this chart and wrote about it five years ago in March 2002. The Curse of the Long Trading Range is not a new concept by any means.
This chart shows today’s Dow 30 since 2000 rendered in blue superimposed over the Dow 30 from the 1970s Great Bear rendered in red. Since it is general stock-market valuations that drive these secular bears, P/E ratios and dividend yields are noted at key technical points. Because it is easy to manipulate perceptions of scale and slope on charts by playing with non-zeroed axes, the small inset chart in the lower right shows the identical data with true zeroed axes for accurate visual scaling.
Unfortunately this comparison is rock solid and is not a cunning sleight of hand. The world’s most elite blue-chip stock index has cut a path over the past 7 years that is virtually indistinguishable from the sorry one it trod back from 1966 to early 1973. And as you graybeards would probably rather forget to avoid dredging up the emotional trauma, 1973 and 1974 witnessed one of the worst cyclical bears in US financial-market history.
Man, the US military could sure learn a thing or two about psychological warfare from studying Great Bear markets! The red Dow 30 line from the 1970s shows an incredibly wild ride. The markets would grind relentlessly lower and spawn enormous losses. But just before total despair and capitulation selling set in, the bear would back off and gigantic bear-market rallies would erupt. These rallies sometimes turned into cyclical bulls lasting for years.
Then by the time the top of any particular cyclical bull arrived, when the Dow once again neared its 1966 highs near 1000, investors would totally forget all their bear-market-bottom agony and fears. Even worse, their memories were so short and their greed so unbridled that they would think a new secular bull was being born. Yet right when things looked the best and the markets neared or exceeded their old highs, the sadistic bear would spring his trap once more and unleash a brutal downleg that again spawned huge losses.
This cycle continued over and over again throughout the last Great Bear. By the time it ended in 1982, investors were so demoralized and hated stocks so much that major financial magazines ran covers declaring stocks dead as an investment. It was 17 years of exquisite psychological warfare designed to slowly boil the bulls without them knowing and ultimately slicing every last pound of capital out of their flesh.
I find that most investors tend to believe that bear markets are declining prices for long periods of time. This definition is technically true, but myopic. Secular bears are really long periods of time when the markets trade sideways on balance, huge cyclical bulls followed by devastating cyclical bears. It is this sideways trading that slaughters even the bravest buy-and-hold investors in the end. Imagine if the Dow 30 is still trading near 12000 a decade from now.
As mere mortals, we humans are really not allotted much time at all to build our fortunes. If the average investor finally starts getting serious at 30, and plans to retire at 65, he only has 35 years to multiply wealth. But if he is unfortunate or foolish enough to get trapped in a secular bear, he could lose nearly half of his entire investing lifespan and emerge with no nominal gains and big inflation-adjusted losses. The opportunity costs of letting capital languish without growing for 17 years are catastrophic.
Of course hindsight is 20/20, and no one would have waited 17 years for the Dow 30 to decisively break 1000 once and for all if they had known how long it would take. Unfortunately we appear to be in a very similar situation today. The Dow 30 has had 7 years since 2000 to make new highs and enter a new bull, but the sum total of its performance as of its recent February highs was a trivial 9% gain. A savings account would have done better with a tiny fraction of the risk!
Even worse, today the stock markets are at the same phase in this Great Bear where they rolled over into the brutal 1973 and 1974 downleg in the last Great Bear. Over the past two years or so especially the comparison between the 1970s Dow and today’s Dow is uncanny. And heaping even more burning coals on the head of today’s Dow, the valuation trends over the past 7 years are very similar to those of the 1970s too.
Both Great Bears started at high P/E ratios and low dividend yields. Then these key valuation metrics gradually declined throughout the bears. Indeed this is the purpose of bears fundamentally, to maul stock prices long enough for earnings to catch up with them. At the end of Great Bulls stock prices shoot stratospheric and disconnect with their underlying earnings. Then the long bears hold down stock prices long enough for earnings to finally catch up and make the stocks fundamental bargains again in the end.
One of the most persuasive and pervasive arguments on Wall Street these days is that we cannot be on the eve of a bear because today’s valuations are so reasonable compared to where they were in 2000. This is certainly true. In early 2000 the Dow 30 was trading at 44.7x earnings and yielding only 1.0% in dividends, radically overvalued and bubbly. But at its latest interim top a few weeks ago it was only trading at 16.7x and 2.4%, not too far over historical fair value.
Yet back at the dawn of 1973, on the top edge of the cliff, the US stock markets were also trading at moderate valuations, 18.7x and 2.7%. These valuations are so close to each other despite the vast gulf of history between them that it is uncanny! This gives me goosebumps. Not only are today’s stock markets at the same stage where the last Great Bear launched a brutal downleg, but they are at the same valuation level. Yikes.
The problem with Great Bears is that they do not just drive stocks from overvalued to fair-valued, but they ultimately drive stocks all the way down to deeply undervalued levels. So while 17x earnings today may seem far superior to 45x at the bubble top, and indeed it is, 17x is still a far cry from the 7x levels where Great Bears tend to end in history. Given today’s levels of earnings what black depths would the Dow 30 need to plumb to hit 7x? 5150.
5150?!? Inconceivable? Preposterous? Absurd? Perhaps. But before you dismiss this thesis outright, I would humbly encourage you to humor me a little bit longer. Once again we seem to be dealing with a market phenomenon here that hasn’t been seen for three decades. So it behooves us to examine the last Great Bear of the 1970s to see what degree of declines are possible 7 years into secular bears.
This next chart zooms in on the first chart. It shows our current Dow from 2002 superimposed over the Dow 30 from 1968 to 1974. This period of time encompasses an incredible cyclical bull in both markets and the wickedly ugly cyclical bear in 1973 and 1974. Once again note the disturbing symmetry between our markets over the past couple years with those of decades past.
Our current cyclical bull, if the highs of several weeks ago indeed prove to have marked its end, rallied 75% since October 2002. It was a tremendous run by any standards, and very profitable for those who rode it. The analogous cyclical bull in the last Great Bear ran 57% higher from July 1970 to January 1973. So while our current cyclical bull was bigger and longer, its technical behavior matched its ancestor’s remarkably well.
But by early 1973, complacency had again grown great enough to tempt the Great Bear out of his slumber for another feast on the flesh of fattened investors. Over the next couple years gradual-yet-sustained selling on balance drove the Dow 45% lower, from over 1050 to under 600. The same 45% decline applied to the recent February highs would yield a Dow 30 trading near 7000 by the end of 2008!
Now 7000 is not 5150, but I think any investor would agree that either eventuality would be devastating. It would not surprise me one bit to see the next cyclical bear lop 50% off of the headline stock indexes. And provocatively, since the Dow is now following the last Great Bear’s pattern so well, there are a couple ways to argue for the potential of a 50% loss.
For example, if you look at the first chart again, you will notice a striking symmetry between cyclical bulls and their immediately following cyclical bears. The steeper and longer the preceding cyclical bull, generally the steeper and longer the subsequent cyclical bear. Perhaps these symmetrical tendencies will hold in this secular bear as well.
Our current cyclical bull achieved a massive 75% run compared to 57% in the last Great Bear, or 1.3x. If we get a roughly symmetrical cyclical bear, it could hence conceivably grow to 1.3x the 45% loss in 1973 and 1974. That works out to a 59% decline! Yikes. Coincidentally that would carry us down to 5250, right near half fair-value levels at 7.0x earnings. While I suspect a 60% decline is far less probable than a 45% decline, it is still possible.
And talking strictly in valuation terms, the late 1974 cyclical-bear bottom happened near 8.3x earnings. Our Dow 30 today would have to fall near 6100, or down 52%, to hit a similar valuation at today’s earnings levels. Realize I am not bandying about these numbers as exact predictions, merely trying to illustrate that a 50% decline in the Dow 30 is certainly within the realm of probability based on historical precedent.
So as these charts show, we probably are on the eve of a bear. Believe me, I don’t like it any more than you do. It is far, far easier to make money in a bull market when a rising tide lifts all boats. Successfully trading in bear markets is vastly more arduous. It requires a huge amount of fundamental and technical research to pick the right stocks at the right times along with a hefty dollop of luck. I’d prefer bull to bear any day.
Yet, the markets don’t care one bit what you or I want. They’ll do whatever the heck they want to. If we want to survive and even thrive, we have no choice but to go with the flow. Fighting the markets is hopeless. And if you are going to ride the bear, there are two very dangerous misconceptions prevalent today that could do you great harm. Neither are supported by history, they are fabricated fears.
The first is that a cyclical bear is sharp and fast, like a crash. This couldn’t be farther from the truth. The 1973 and 1974 cyclical bear took two full years to unfold, not a matter of weeks like a crash. After the initial selloff which was similar to what we’ve seen in the last several weeks, there were only two additional months with steep declines (marked above). So don’t look for a crash, look for a long, demoralizing period of gradual selling on balance.
The second is that a stock bear will drag down everything with it. This myth has no basis in history and is solely the result of careless analysts extrapolating the behavior of the last few weeks out into infinity. During the 1973 and 1974 cyclical bear for example, gold literally tripled over the exact period of time that the stock bear ran. And elite gold miners’ stocks followed gold up on balance over this period of time, not the general stocks down.
Both of these increasingly popular misconceptions are very important and I would like to address each in its own essay. But if some rookie with little knowledge of history who has never actively traded through any bear has tried to convince you that gold stocks are doomed with general stocks, I’d encourage you to read an essay on this very topic I wrote last month. Not all stocks fall in bear markets, and a gold mine is probably the best thing any investor can hope to own when general stocks are burning around him.
Realize that a Great Bear exists to drive down valuations to undervalued levels. Thus the most richly-valued stocks are the most susceptible to sharp declines. But stocks that are already undervalued, like many elite commodities producers, ought to thrive. They, along with precious-metals stocks, become real-asset-based safe havens in bears, beacons of refuge for flight capital to bid higher.
Just as we successfully traded the last cyclical bear from 2000 to 2002 to outstanding realized gains, we are going to do it again here if we are indeed on the eve of a bear. If you’d like to invest and speculate in the types of stocks that have usually thrived in past bears, please subscribe today to our acclaimed Zeal Intelligence monthly newsletter. It explains what stocks we are trading and why, truly cutting-edge research.
The bottom line is the odds are rising that we are indeed in the eve of a new cyclical bear. If this particular specimen follows precedent, the Dow 30 could fall 50% or so over the coming two or three years. Prudent and careful investors and speculators will thrive, but those caught unaware will be utterly slaughtered. Bears are brutal and unforgiving times to enter the markets armed with anything less than the best knowledge and research.
Cyclical bears within secular bears are not fast and sharp crashes, but long slow demoralizing grinding affairs that unfold over years. As paper assets are relentlessly shredded in these ugly events, real assets like commodities tend to shine. Like a minefield, a bear can be successfully navigated and yield big profits if you are careful and meticulous.
Adam Hamilton, CPA March 16, 2007 Subscribe at www.zealllc.com/subscribe.htm