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By Adam Hamilton, Zeal | 26 January 2008
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So is a new bear looming? It depends on what kind of bear we're talking about here. There are short-term cyclical bears that last a couple years or so, which tend to cut major stock indexes in half. And there are far worse long-term secular bears, which tend to run for 17 years or so. We may be entering the former but we never left the latter!
Yes, you read that right. Some unrepentant contrarians still believe we remain deep in the bowels of the ravenous secular bear that awoke after the 2000 bubble tops. I am one of them. I realize this probably seems absurd on its face, as the SPX soared 101.5% higher from October, 9th 2002 to October, 9th 2007. How on earth could a double in five years happen deep within a secular bear market?
It turns out the stock markets meander in great cycles lasting about a third of a century each. I call these the Long Valuation Waves. As an LVW begins stocks are deeply undervalued and despised. These fear extremes exhaust all selling until buying pressure eventually takes the driver's seat. This launches a mighty secular bull market that runs higher for 17 years or so, half of an LVW.
But by the end of this secular bull, stock-market valuations are extremely overvalued and unsustainable. The popular mania's tremendous greed sucks in all buyers and soon there are not enough left to outnumber sellers. Thus stocks start grinding sideways to lower for the second half of the LVW which also runs about 17 years. These secular bears exist to take stocks from hyper-overvalued levels back down to deeply undervalued levels. Then the entire LVW cycle begins anew.
If these long valuation cycles are new to you, I strongly encourage you to read one of my essays on the Long Valuation Waves that explain them in depth. Our current LVW started in 1982 when the stocks of the SPX were ridiculously cheap and trading at P/E ratios under 7x earnings. Stocks then soared in the first half of this LVW, powering higher for 17 years in one of the greatest bulls in history.
But by early 2000, stocks were ridiculously overpriced and deep into classical bubble territory. The SPX was trading at 44x earnings, way above the 33x seen at the infamous 1929 stock-market top! So the second half of this LVW arrived and stocks started receding to bleed off their excessive valuations. By the SPX's latest October 2007 top, it was trading near 21x earnings or just under half its early 2000 valuation levels.
What we witnessed between March 2000 and today, despite the massive 5-year SPX cyclical bull within this span, is a classic LVW valuation mean reversion. At best in early October, the SPX was just 2.5% (nominally, unadjusted for inflation or earnings) above its March 2000 highs. So over all the years since, the US stock markets were dead flat. Yet despite this sideways trading, valuations have been cut in half so great LVW progress has been made.
With almost 8 years of sideways trading, and general valuations shrinking relentlessly, there is just no doubt we are in the second half of a Long Valuation Wave. The "second half of an LVW" is just a synonym for a secular bear market. The problem is these secular bears tend to run for 17 years in duration and we are merely starting to approach the half-way point today.
Could the SPX really continue grinding sideways on balance for another decade? Ouch. To explore US stocks' behavior in these second halves of LVWs, I decided to compare today's SPX with its last secular bear straddling the 1970s. I've been analyzing such comparisons with the Dow 30 for five years now, most recently in March 2007. So this kind of analysis certainly isn't new.
But I hadn't yet done this analysis with the much bigger SPX, which is a far broader and better measure of the general US stock markets than the elite blue-chip Dow 30. Looking at the SPX since 2000 compared to the last LVW second half in the 1970s offers a lot of additional insights not apparent on the usual Dow 30 comparison.
Click Here, or on the image, to see a larger, undistorted image.
The Dow 30 secular bear comparisons worked beautifully and offered powerful evidence that we remained in an ongoing secular bear until October 2006. That month the Dow first exceeded its January 2000 high of 11723. As the Dow broke through 12k two weeks later, 13k in April 2007, and then 14k in October 2007, the long-trading-range secular-bear thesis looked broken. This elite index was 20.8% above its 2000 top!
This didn't bother me all that much, as a 21% gain in nearly 8 years is a joke. We are talking about 2.5% compound annual returns here, worse than inflation. Almost any other investment under the sun would have performed better. This, and the fact that the far-superior SPX measure of US stocks was only up 2.5% at best over all these years, led me to believe that the 17-year secular bear was very much alive and well.
The Dow 30 chart of the 1970s secular bear showed 17 years of flat tops in the 1000 to 1050 range. This historical precedent led contrarians to expect that today's Dow wouldn't head much above 12k or so, largely killing the secular bear theory once the Dow headed higher. But check out the SPX chart above, it is quite different. Despite languishing in an indisputable secular bear in the 1970s, the SPX exhibited periodic higher tops [[unadjusted for inflation! : normxxx]] It offers a whole new perspective on bears.
Most traders tend to think bear markets mean fast relentless declines, like this month. But this popular perception couldn't be farther from the truth. Bear markets are truly slow and boring, long drawn-out episodes designed to keep bulls' hope alive as long as possible to minimize preemptive selling. And secular bears' only purpose is to take general valuations from overvalued to undervalued levels, a very gradual process.
There is not a trader or academic on the planet who will argue that 1966 to 1982 did not witness a brutal secular bear. It is rock-solid fact. Yet as the red SPX line shows, the SPX actually made several major higher highs within this long-term bear! This radically alters my expectations for today's secular bear. The SPX can climb considerably above its March 2000 top yet still remain mired deep in bear-dom. The linked Dow chart compares the Dow (1900 - Present) to an inflation-adjusted Dow (1925 - Present). See HERE and HERE for larger and different views of the inflation adjusted Dow (note especially the 1970s decline and the breakdown from the 1982 bull in 2002!) Chart showing inflation adjusted dividend re-invested Dow Jones Utilities. The latter a big loser, especially when you consider these indexes are NOT adjusted for survivorship bias (the BAD stocks are selectively removed along the way)!
They say "the market always goes up in the long term," but at an average return of 1.9% per year, it can take many years to recover from a large decline. The peak in 1929 was not ultimately exceeded until 1992. When the market touched the bottom of the channel in 1982, its value was about equal to the value at the beginning of the chart in 1910.
In February 1966 (that LVW's equivalent to the March 2000 top), both the Dow 30 and SPX hit their ultimate bull-market highs. The Dow closed at 995 and the SPX 94. The Dow 30 managed to claw above 995 several times in the next 17 years, but only briefly. At best over this entire span in January 1973, it briefly closed 5.7% above its defining February 1966 secular bull top (its LVW peak).
But the SPX rendered above is an entirely different ballgame. It too was mired deep in an indisputable secular bear, yet it carved higher highs periodically. In November 1968, it briefly closed 15.2% above its February 1966 bull-market top. Four years later in January 1973, the SPX briefly closed 27.8% above its bull-market top! And 15 years into its bear in November 1980, it briefly closed 49.4% above.
Now did the SPX secular bear of the 1970s end in late 1968 because it made a new high 15% above its early 1966 levels? Did it end in early 1973 because it made a high 28% above its bull top? Did it end in late 1980 at a massive 49% above its bull top? The answer to all these questions, of course, is a resounding no. Not only were the new interim highs in each of these cases fleeting, but the real-inflation-adjusted returns each granted since 1966 were horribly bad.
So does the SPX edging 2.5% above its March 2000 bull top nearly 8 years later in October 2007 negate our current secular bear? How about the Dow 30 running 20.8% above its own January 2000 bull top? Most definitely not! Major new interim highs are possible deep within the bowels of even the most nasty secular stock bear. Indeed based on 1970s precedents, we should see several within 17 years.
Secular bears are not defined by the nominal market tops we all like to remember. In reality they are defined by valuation mean reversions driven by receding Long Valuation Waves. LVWs take the bubble valuations at bull tops and gradually bleed out the excesses until the stock markets are deeply undervalued and primed for their next 17-year secular bull. This valuation work is the sole mission of secular bears.
In the first chart above, I labeled valuations in both secular bears at key points in their histories. First let your eyes gradually follow the red 1970s line and observe the retreating SPX valuation trend as evidenced by the white SPX P/E ratio numbers. Through highs and lows, cyclical bulls and cyclical bears alike within that secular bear, stock-market valuations declined on balance. The 1960s bull-market excesses were very gradually being squeezed out, and the 1970s bear didn't end until valuations fell under 7x earnings.
Now let your eyes trail our current SPX rendered in blue, and note the yellow numbers highlighting its valuations at key points in time. Just as in the 1970s, valuations are gradually declining on balance through cyclical bear and cyclical bull alike. After nearly 8 years, I just don't see how anyone can rationally argue that we are not witnessing a classical LVW second-half mean reversion. There is no other explanation.
I also find it provocative that today, approaching the halfway point between 2000 and 2016, the SPX's valuations since 2000 have been cut in half. How symmetrical! Even at the October 2007 top which was a few percent above the March 2000 one, US corporations' earnings had grown so much in the intervening 8 years that valuations were half of what they were at the bubble top. This is very healthy and wonderful to see. Nevertheless secular bears don't end until 7ish P/E levels, one third of today's.
So if you want to understand secular bears, you have to think purely in valuation terms. High-to-high comparisons across many years miss the entire point. As the 1970s showed, even deep within secular bears new nominal highs can be made from time to time. Today's SPX could briefly climb 15%, 30%, or even higher above its March 2000 top. But since that bull top was so long ago, these marginally higher highs cannot even entertain the notion of negating today's ongoing secular bear.
If the US stock markets continue trading sideways on balance until 2016, at which point stocks will be a once-in-a-trading-lifetime bargain at 7x earnings, are we now due for a cyclical bear to keep the SPX within its secular trading range? This chart zooms in to compare today's mighty SPX cyclical bull since 2003 with the equivalent period during the last secular bear.
Click Here, or on the image, to see a larger, undistorted image.
From May 1970 to January 1973, the SPX powered 73.5% higher in a mighty cyclical bull within its secular bear. Its technical behavior and chart pattern is fairly similar to the SPX's latest mighty cyclical bull between March 2003 and October 2007, a massive 95.5% run higher. By early 1973, like in late 2007, investors who hadn't studied LVW market history thought a glorious new bull had begun.
After years of rallying, traders [[including Bob Brinker!?!: normxxx]] largely forget that bear markets are even possible. By biding its time, a secular bear builds up a great surplus of optimism that will keep investors fully invested long into the next cyclical bear. Right after that early 1973 high, the SPX entered its worst cyclical bear of the 1970s. In 1973 and 1974, this flagship American stock index fell 48.2%. Half of the capital invested in American stocks was obliterated in less than two years!
Today's SPX is near the same point in today's LVW where the notorious 1973-1974 bear erupted in the last LVW. So could a new cyclical bear be looming? Absolutely, and you'd better be prepared just in case. And lest you think a 50% decline in today's stock markets is impossible thanks to the Fed's perpetual inflation and Washington's incessant meddling, think again. From March 2000 to October 2002 the SPX lost 49.1% of its value despite a similar inflationary Fed and the same Keynesian regime in Washington.
Also, note that even the worst cyclical bears are slow and boring. The average daily SPX decline in its mid-1970s bear was just 0.11% per day. This is such a lethargic rate that it was hardly noticeable at the time. By boiling the water slowly (so the drowsy frog doesn't notice), bears keep investors invested as long as possible. They don't notice their peril until they are already cooked. So realize that early January 2008's decline, 7x faster at 0.77% per day, is exceptional. Even within the worst cyclical bears within secular bears, such fast declines are rare and short-lived.
Like you, I hate secular and cyclical stock bears too. It is vastly easier to multiply your capital in bulls than in bears. Nevertheless as prudent traders we must recognize prevailing market conditions, which we are powerless to change, and trade accordingly. As such, much of our trading at Zeal has been focused on a scorned sector that thrives during both secular and cyclical bears, precious metals.
The massive gold and silver bulls of the 1970s are the stuff of legend. Since 2000, these precious metals have also performed extremely well. And during the brutal 1973-to-1974 stock bear, gold more than tripled! Gold stocks follow gold most of the time, regardless of general-market bull or bear. The headline HUI gold-stock index more than quadrupled within the wicked 49% stock bear of 2000 to 2002. So if you want to multiply your capital within secular and cyclical SPX bears, look to gold, silver, and their miners.
The opposing SPX and HUI behavior in recent months is a great tactical illustration of this awesome negative beta. In January 2008 prior to this week's bounce, the SPX fell 10.8% while the HUI rose 9.8% in extremely hostile market conditions. While the SPX fell 16.3% from its early October high, the HUI rose 12.8% to the very day. Since the mid-August lows, the SPX was down 6.8% while the HUI soared 49.7% as of the SPX's worst close in January! Stock bear or not, gold and silver are in strong fundamentally-driven global bulls and their miners and explorers are earning fortunes for investors and speculators.
The bottom line is the US stock markets are still mired deep within the secular bear that started in early 2000. These 17-year bear markets are defined by valuation reversions, not high-to-high comparisons. As the SPX in the 1970s clearly illustrated, new interim (nominal, NOT inflation adjusted) highs are probable from time to time even within the worst secular bears. So watch the valuations and avoid placing your faith solely in new index highs!
Within these secular bears, large cyclical bulls and bears are probable. The bulls can witness 100% gains while the bears can destroy 50% of the stock markets' value. After five years of a massive cyclical bull, unfortunately today the odds are swinging in favor of a big multi-year cyclical bear in the SPX. If such an event comes to pass, precious-metals stocks are one of the few sectors that should thrive despite the bear.
M O R E. . .
Normxxx
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