Back in early October when the benchmark S&P 500
stock index was hitting all-time highs, “bear” was a heretical
four-letter word. Merely letting it roll off your tongue or spill from
your pen offered a fast track to pariah status. In the best of times,
people tend to forget that the worst of times are even possible anymore.
But after the most brutal new-year selloff in market history, investors and speculators are
far more receptive to the usually taboo topic of stock bears. Most on
Wall Street consider a bear market a 20% decline from the latest interim
high. This week we came pretty darned close to a 20% slide in S&P
500 (SPX) terms.
On a closing basis from early October to this week,
the SPX slid 16.3%. Fully 2/3rds of these losses ballooned in January
alone, which explains why this month feels so awful. On an intraday
basis, the SPX had corrected 19.4% at worst before Wednesday’s sharp
bounce. The formal 20% bear in the best measure of US stocks was within
spitting distance.
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% 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 theory 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.
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 this SPX chart above, it is quite
different. Despite languishing in an indisputable secular bear in the
1970s, the SPX exhibited periodic higher tops! 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.
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 precedent 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 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 like 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.
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 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 is hardly
noticeable at the time. By boiling the water slowly, 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 a total anomaly. 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!
At Zeal we’ve been trading gold and silver
stocks since late 2000 when their secular bulls stealthily began. We
are constantly researching individual PM stocks and timing specific PM uplegs. You can profit from our hard-won experience. Subscribe today to our acclaimed monthly newsletter and start thriving in this overlooked sector. 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
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 a bear.
Adam Hamilton, CPA
Zealllc.com
January
25, 2007
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comments, or flames? Fire away at
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