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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
Zealllc.com
Mars
16, 2007
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comments, or flames? Fire away at
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