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Earlier
this week, a friend asked me if I thought this stock bear was over. My first thought was “which
bear?”, for there isn’t just one. The stock-market action over the last
couple years has been a tale of two
bears. Investors who’ve
failed to understand this critical truth are very confused on what to expect
from stocks going forward.
You’ve
certainly heard both sides of the bear argument. The bulls say of course the bear is
over, the S&P 500 (SPX) has rallied 40% since March and 20%+ is
officially bull territory. But
the bears claim those lows won’t hold, that a retest is coming due to
the slow economy and valuations remaining too high for a classic bear bottom
in early March. Who is
right? Both and neither at the
same time!
The key
to understanding stock-bear cycles is to realize that there are a pair of
concurrent cycles, a tale of two bears.
They operate like those Russian Matryoshka nesting dolls, a smaller
bear cycle existing within a larger bear cycle. The larger bear cycle is measured in
decades, while the smaller one nesting within is measured in years. The larger bears are known as secular
bears while the smaller ones are cyclical bears.
Making
this secular/cyclical distinction is absolutely crucial when using the word
“bear”. If the type
of bear being discussed is not explicitly specified, confusion is the
inevitable result. And confusion
invariably leads to poor investing decisions and loss of capital, both in a literal
sense and in the opportunity-cost sense.
So we need to start by defining each type of bear.
The word
“secular” means long periods of time, and indeed the secular bear
is well-deserving of this moniker.
Throughout history, secular bears have had average durations of 17 years each! These great bears follow great bulls,
which also happen to average 17 years.
One complete secular-bull-to-secular-bear cycle runs 34 years, a third
of a century. I highly encourage
you to read my latest Long Valuation Waves essay if you are not familiar with these great stock-market cycles. They are crucial to understand.
Meanwhile
the smaller cyclical bears are much shorter and occur within secular bulls and secular bears alike. Typically a cyclical bear will average
a couple years in duration. While
secular bears are driven by valuations, cyclical bears are usually driven by
sentiment. The former start at
very overvalued levels, while the latter start at very overbought
levels. This distinction may seem
subtle, but it is important.
Our
current secular bear started back in early 2000 because stock valuations were
extreme. The US
stock markets were trading at staggering prices relative to the underlying
profits of the corporations the stocks represented. While the long-term average
price-to-earnings ratio of the general stock markets is 14x (14 times), as
this secular bear dawned the SPX was nearly triple that at 44x! This disconnect had to be addressed.
And the
17-year secular bear is the naturally-occurring market mechanism that
remedies extreme overvaluation. Stocks
don’t fall for 17 years, but grind
sideways for 17 years. This
gives earnings time to slowly catch up with the high stock prices. As discussed in depth in my LVW research, this secular bear won’t end until stocks reach deeply
undervalued levels (7x earnings, half the average) out in 2016 or so.
So from
a valuation perspective, today’s secular bear is indeed only half
over. Over the next 8 years, the
stock markets are very unlikely to get materially higher than their early
2000 and late 2007 levels at best.
This is around 1550 on the SPX.
Investors are indeed wise and prudent to respect this secular bear and
trade accordingly. But an
overarching 17-year sideways grind certainly doesn’t mean they should
totally avoid stocks in a secular bear.
We
mortal humans really don’t live very long. And our useful investing lifespan is
considerably shorter than our natural ones. To invest, first surplus income has to
be generated. For most people
this starts happening a few years after college, say at 25 years old. Investment can continue as long as
someone can live below their means and keep plowing surplus income into the
markets. But once retirement
arrives, say at 65, working income stops so investments must then be
gradually sold to finance life.
With an
average investing lifespan of just 40 years, investors can’t afford to
let their surplus labors sit in idle cash for 17 years. This is especially true in the
Fed’s fiat-currency regime where dollar inflation is constantly eroding our saved purchasing power. Thus a good steward of his assets
invests all the time, not just when the sun is shining. While it is much harder in a secular
bear, investing can still bear great fruit.
And this
is where cyclical bulls and bears come in. Within the 17-year secular trends,
every few years or so the short-term trend changes from bull to bear or
back. These cyclical swings can
be wildly profitable. Within a
secular bear for example, a cyclical bull often leads to a 100% gain in a few
years or so. Then the subsequent
cyclical bear often leads to a 50% loss over a similar span. These big moves are very tradable.
This
first chart illuminates the stock-bear cycles by examining our current
secular bear compared to the last one that straddled the 1970s. Within both secular bears, 17-year
sideways grinds, major cyclical bulls and cyclical bears erupted. The secular bears form giant sideways
trading ranges while the cyclical bulls and bears meander back and forth
within these ranges. Investors need to understand
this behavior.
The red
line follows the S&P 500 during the infamous secular bear from 1966 to
1982. Note that even though
stocks simply traded sideways on balance over this 17-year span, it
wasn’t randomly. Multi-year
cyclical bulls and bears emerged that were quite tradable by investors and
speculators alike. They could buy
low near the bottom of the secular trend and sell high a few years later near
the top. And instead of just
sitting out cyclical bears the speculators could actively short them, as
we’ve done at Zeal.
We’ve
seen similar behavior in our current secular bear, the blue line. Since 2000, the stock markets have
just ground sideways on balance. Yet
within this giant secular trading range mighty cyclical bulls and bears have
emerged. From March 2000 to
October 2002, the SPX fell 49% in a cyclical bear. But out of those oversold depths a new
cyclical bull emerged that carried this index 102% higher by October 2007.
Yet even
after such a strong cyclical bull, the SPX couldn’t materially exceed
its 2000 highs since it is stuck in a secular-bear trading range. So from its late 2007 heights another
cyclical bear emerged. This one
dragged the SPX down 57% by March 2009, once again carrying it to the bottom of
its secular trading range. These
doublings in cyclical bulls followed by halvings in cyclical bears are common
within secular bears, as these are the exact magnitudes of swings that keep
the giant secular trading range intact.
As I
argued right in the darkest days of the stock panic back in November, the SPX
being near its secular support strongly suggested a new stock bull was being born. Why? This is how secular bears work. They are not 17 years of falling
prices, but 17 years of sideways grinding punctuated by a serpentine
meandering cyclical-bull-then-cyclical-bear cycle. Companies and stock markets
don’t cease to exist just because people are scared, life and the
economy always march on.
One of
the primary arguments against the
new-cyclical-bull-within-secular-bear thesis at both the November and March
lows was valuations. How could
the stock bear be over when valuations were well above the 7x earnings
classic bear-low metric? This
really amused me, as I have been studying valuations since 2001 when I
predicted this secular bear. All
of a sudden 7 years later, valuation studies became the new rage. Yet sadly they were superficial and
usually misinterpreted.
This
next chart explores valuations in secular bears by zooming in to the same
span shown above and noting the SPX P/E ratios at key turning points. If you carefully study this chart, it
utterly shatters the popular notion among traders today that a stock bear
can’t end until we see 7x earnings. While a secular bear won’t end until such low valuations are seen,
cyclical bears can end regardless of where valuations happen to be because
valuations are not what drive these cyclical moves within secular trends.
In the
last secular bear that ended in 1982, general stock valuations did indeed
fall under a P/E ratio of 7x earnings.
But it didn’t happen until 17
years in! In October 1966,
the SPX bottomed at 18.8x earnings and then rallied 48% by November
1968. In May 1970 the SPX
bottomed again at 13.8x earnings, still way above the 7x metric. Yet out of those
“overvalued” lows a strong 74% cyclical bull emerged that ran
until January 1973. And this
pattern goes on and on if you follow the red line above.
The key
point is that cyclical-bear bottoms within secular bears don’t require
any certain P/E-ratio level. That
is a misleading myth propagated by sloppy analysts too lazy to actually study
market history. Cyclical bears
bottom when stocks get too oversold near the bottom of their secular-bear
trading range, it has nothing to do with valuations. The best example of this ironclad
truth is from our current secular bear.
Back in
October 2002, the SPX was down 49% in its first brutal cyclical bear of this
secular bear. Trading near 775,
it wasn’t much higher than we saw during the recent stock panic. It was this late 2002 low that
established the secular trading range that the SPX has largely stuck to ever
since. But note that at those
2002 lows, the stock markets were still trading at 25.5x earnings. These are very high valuations, almost into classical bubble territory of
28x (twice 14x fair value)! Yet
the next cyclical bull was still born.
Between
October 9th, 2002 and October 9th, 2007, the SPX blasted 102% higher in one
of the longest cyclical bulls I’ve ever come across. Yet after this run, after more than
doubling in exactly 5 years, the valuations at the late 2007 top (21.3x) were
substantially lower than at the
late 2002 bottom. This is about
1/6th lower even though the SPX was over twice as high! This illustrates an extremely
important point.
Time is the primary weapon
secular bears use to revert prevailing valuations back from very overvalued
levels at the start of the secular bear to very undervalued levels at its
end. As the years pass by,
corporate earnings naturally grow.
And since stock prices are trading sideways on balance, the P/E ratios
naturally gradually contract. Like
a child growing into shoes that are still too large, earnings grow into
prevailing stock prices. Big
cyclical bulls and bears within secular bears do not short-circuit this
overriding strategic valuation-mean-reversion trend.
The
farther you progress into a secular bear, the more valuations moderate at
both cyclical tops and bottoms. If
you look at the peak-to-peak or trough-to-trough P/E-ratio comparisons above,
in either secular bear, you will note they are always contracting over
years. But at any given cyclical
top or bottom, they can be anywhere.
Like stock prices, earnings are in constant flux over the short term
which leads to occasional valuation anomalies. But over time, the secular bear will
force P/E-ratio contraction.
Realize
that today’s bearish arguments stating that 7x earnings wasn’t
hit in March, so therefore today’s stock markets can’t be in a
new bull, are totally specious. Anyone
advancing this 7x thesis does not understand stock bears and has not studied
them. Major and very profitable
cyclical bulls can erupt within secular bears from all kinds of valuation
levels. 7x earnings are not seen
until the very end of a secular
bear!
Out of
extremely oversold (a function of sentiment, not valuation) lows, near the
bottom of the secular-bear trading range, massive cyclical bulls erupt. Prudent investors can ride these to
100%+ gains in the general stock markets and much bigger gains in sectors
outperforming fundamentally like commodities stocks. Despite remaining in a
secular bear today, we are due for a huge cyclical bull that should run for
several years or so. Valuations
are irrelevant for this already-underway surge higher.
To get a
better understanding of the kinds of speed and magnitude a young cyclical
bull can command out of the bottom of a secular trading range, consider the
1974 and 1975 example. This next
chart zooms in to the early 1970s and compares it to the matching years in
our current secular bear. Occurring
at the exact same point in two separate secular bears separated by an entire
34-year LVW cycle, the similarities between 2008 and 1974 are uncanny.
While
2008 was the first full-blown stock panic in 101 years, 1974 was certainly no picnic.
Instead of plunging 27.1% in less than 4 weeks like the SPX did in
October 2008 at the worst stage of our recent panic, the SPX plunged 24.6% in
8 weeks leading into October 1974.
That selloff wasn’t quite at panic-type speeds, but it was
certainly of panic-type magnitudes.
Investors were terrified in late 1974 just like they were in late 2008.
And the
economy wasn’t looking so hot then either. Today investors worry about a simple
mean-reversion in house prices from bubble-like highs, but back then there
were gasoline lines and rationing.
The Arabs were using oil as a weapon to try and punish Americans for US support of Israel
after Egypt and Syria
simultaneously invaded it to try and wipe out the Jews. In 1974, headline CPI inflation ran
12.3%! In the first quarter of
1975, the US
economy contracted at a sharp 4.8% annual rate. Things were a mess.
Despite
these huge economic problems that were far more disruptive than today’s
credit crunch, the stock markets still rallied out of those deeply oversold
October 1974 lows. By July 1975,
the SPX was already up 54%. And
by September 1976, this cyclical bull within a secular bear had carried it
73% higher. And as you can see
above, the sharp initial ascent of this cyclical bull in its first 9 months
or so was virtually identical to what we’ve seen in the SPX since March
2009. Cyclical bulls within
secular bears are awesome beasts!
And
provocatively, this particular cyclical bull we’ve entered today has
much greater potential than the one that erupted after the near-panic in
1974. The biggest up years ever
witnessed in stock-market history happen immediately after the biggest down
years. While 1974 was down 30%,
1975 rallied 32%. And
2008’s 38.5% SPX decline was the biggest calendar-year plunge in this
index’s entire history. So
over a century of stock-market history spanning panics and a depression strongly argues that 2009 is going
to be a huge up year. This post-panic reversion force will
probably make this cyclical bull much bigger and faster than normal.
As in
1975, the state of the economy today is largely irrelevant for this unfolding
stock bull. Stocks are not
rallying because they are fundamentally cheap, nor because the economy is
improving. They are rallying
simply because they were far too radically oversold in the stock panic. The SPX near 750 in late November or 675 in early March was
handicapping the end of the world, yet that obviously didn’t come to
pass. So stocks have to be bid back up to reasonable levels
reflecting a severe recession, not a depression. And of course sentiment has to be
rebalanced away from the extreme fear of the panic.
The secular bear that started in 2000 is
indeed alive and well. We are
only about halfway through its 17-year span. Still, coming out of the bottom of its
secular trading range a mighty cyclical
bull has erupted. This should
lead to a 100%+ total gain in the SPX over the coming years. There is absolutely no contradiction
in this cyclical-bull-within-a-secular-bear worldview. It is coherent, logical, and
historically sound.
At Zeal
we have been actively trading this thesis since the stock panic, to big
gains. As I mentioned last week
in my latest controversial inflation essay, our new long-term investments added in the heart of the stock panic
already have average unrealized gains over 100%. Our 29 open post-panic stock trades in
our monthly and weekly
subscription newsletters now have average unrealized gains approaching
50%. The opportunities are vast early in this cyclical bull. Can you afford to miss them after the
panic, to let inflation ravage your cash and your future lifestyle?
As
zealous students of the markets, we are dedicated to relentlessly studying
them and applying this research to recommending high-potential investments
and speculations to our subscribers who support our work. We called that latest brutal cyclical
stock bear in January 2008 when the SPX was at 1350.
We called this new cyclical stock bull in November 2008 in the heart of the panic.
If you want to grow your knowledge of the markets, and profit greatly
from it, subscribe today!
The
bottom line is there are two types of bears, secular and cyclical. While we are only halfway through a
17-year secular bear, the last cyclical
bear just gave up its ghost in early March. It wasn’t an undervaluation that
signaled this end, as that classic 7x earnings standard only applies to
secular bears. It was the extreme
oversoldness and extreme fear, which weren’t sustainable. Stocks were simply driven too low in the panic.
And they
are due to rally greatly because of this oversold anomaly. A new cyclical bull has been
born. There is no contradiction
at all in being long stocks during a cyclical bull within a secular
bear. It is actually the most
prudent course for growing capital.
But sadly only the investors and speculators who take the time to
learn about stock-bear cycles will be able to capitalize on these awesome
opportunities.
Adam
Hamilton, CPA
Zealllc.com
June 12,
2009
Read
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