With the
election of a new President, it was an important week for the financial
markets. Whether you were part of the 53% of Americans who voted for Obama or
the 47% who voted against him, you've got to be thankful this bitter campaign
has ended. A peaceful regime change is a great blessing that should not be
overlooked.
The very
next morning it was back to business as usual for the financial markets. Countless
traders collated and analyzed all the information available to them to
continue trying to best-position their capital for the future they believe is
most probable. And prevailing sentiment was definitely morose. No matter who
won on Tuesday, today's serious market and economic problems were going to
linger.
The
pessimism and gloom is certainly justified. With the S&P 500's (SPX)
35.1% year-to-date loss, 2008 is heading for the record books as one of the
worst stock-market years ever. This bear has been brutal. In its first
year which ended October 9th, the SPX was down 41.9%! This was the largest
first-year loss in any bear since the one after the 1929 crash plunged 43.8%
during its first year. Things look and feel pretty bleak.
With
endless bearish arguments out there, many very logical and plausible, it is
easy to surrender to the pessimism and capitulate. But if you are a
contrarian, somewhere deep in your brain nagging doubts are gnawing away. If
virtually everyone is bearish and pessimistic, and almost everyone is
discounting Armageddon, shouldn't I fight the crowd and be bullish? When
better to buy low than when practically no one is brave enough to buy?
While it
is very hard to be bullish today, my inner contrarian keeps warning me that
today's excessive pessimism and bearishness isn't sustainable. Every time I
unmute CNBC in my office, 95% of the interviews are bearish and negative. Each
time I read financial news, a similar unbalanced negative worldview emerges. The
bearish trade is certainly extremely crowded today, highly in vogue.
All these
newly-minted weathervane bears are amusing to watch. The right time to be
bearish was back in the early 2000s, when everyone insisted on staying
bullish. Back in 2001 and 2002 I was
making the case for a 17-year secular stock bear based on market
history. This meant the stock markets were due to grind sideways for the
better part of two decades in a giant trading range. It was a heretical
thesis at the time.
While the
perma-bulls scoffed back then, they are not today. If you are not familiar
with the long cycles in the stock markets, my "Long
Valuation Waves 3" essay will quickly get you up to
speed. Understanding where we are in these long cycles is the single most
important piece of knowledge any long-term investor can possess. While most
naïve investors are crushed in these secular bears, prudent investors
can thrive.
I
continued this thread of research over the last 7 years, updating it
periodically. By January 2008 it was starting to look like we were
entering a cyclical bear (lasting a few years) within this 17-year secular
bear. While the SPX was still sojourning in the high 1300s I warned...
"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."
This
bear-within-a-bear concept is critical today, especially for contrarians. Cyclical
bears within secular bears tend to run for a couple years and cut headline
stock indexes in half. While our current cyclical bear has only run for half
as long, in terms of depth it has already neared the projected 50% decline. At
worst on a closing basis between October 2007 and October 2008, the SPX
plunged 45.8%!
Add to
this observation the fact that secular bears tend to have giant trading
ranges. If a given secular bull (like 1982 to 2000) peaks at an indexed level
of 100, after that it should gradually meander back and forth between roughly
100 and 50 for 17 years. The 100-to-50 declines are the 50% cyclical bears
within the secular bear. And the 50-to-100 increases are the 100% cyclical
bulls within the secular bear.
Well,
believe it or not, despite the rampant pessimism today our current secular
bear's trading range suggests we could be nearing the beginning of one
of these 100% cyclical bulls. And even if our current cyclical bear persists
for another year first, its remaining downside should be modest. Since its
first year witnessed such an extreme decline, it is likely too low in its
secular trading range to fall much farther.
This
first chart compares our current secular bear with the previous one that
straddled the 1970s. Lest you think this is a new idea today driven by
bearishness being fashionable, it's not. I started researching and writing
about this concept in early 2002 and first built this particular
chart in early
2005. The SPX since 2000 is rendered in blue and slaved to
the right axis. The 1970s SPX is rendered in red to the left.
The
yellow and white numbers note this flagship index's P/E ratios at various points
in these secular bears. The whole purpose for a 17-year secular bear is a valuation
mean reversion. At the ends of secular bulls like in 2000,
stock prices are bid way too high relative to their underlying earnings. By
drifting sideways on balance for 17 years, earnings are given time to
gradually catch up with the high-flying stocks. So valuations slowly but
surely drop throughout a secular bear.
This
chart may look complicated at first glance, but it is really pretty simple. First,
focus exclusively on the red line tracing the SPX's meanderings between 1966
and 1982 in its last secular bear. Note that even though the SPX drifted
sideways on balance for 17 years, there were still plenty of giant tradable
swings. These big moves within a secular bear are cyclical bulls and cyclical
bears.
Between
1966 and 1982, the SPX's daily closes averaged exactly 100. It was a terrible
17-year span for buy-and-hold investors. Being flat for so long was bad
enough, and inflation slaughtered them with huge real
losses. But check out the very tradable cyclical bulls and bears during the
first half of this span that is analogous to our current SPX secular bear
since 2000. These big swings were very impressive.
From
October 1966 to November 1968, the SPX surged 48.0% higher in a cyclical
bull. Then it fell 36.1% by May 1970 in a cyclical bear. Then it soared 73.5%
higher in a cyclical bull by January 1973. And then it plunged 48.2% by
October 1974. Provocatively this particular cyclical bear, which cut the SPX
in half in the mid-1970s, matches up perfectly with today's cyclical bear in
our current Long Valuation Wave.
But did
the world end in October 1974 at the SPX's lows? Of course not, although
traders sure felt like it had. Nevertheless, by September 1976 the SPX had
surged 73.1% higher in another cyclical bull. You see the pattern here? Even
within a 17-year valuation-driven secular bear, waves of big swings wash
through. Big tradable cyclical bears are followed by big tradable cyclical
bulls. By buying aggressively late in bears when people are disgusted with
stocks, contrarian traders can make a fortune in the inevitable subsequent
cyclical bulls.
With the
last secular bear's profile in your mind, now consider the blue SPX line
showing today's stock markets. Yes, the SPX has drifted sideways on balance
for 8 years now, just as I forecasted in
2001. Since 2000, the SPX has averaged 1219 on close. Since
2000, inflation has killed long-term buy-and-hold investors just like it did
in the 1970s. But despite all this, check out this decade's sexy big swings!
From
March 2000 to October 2002, the SPX plunged 49.1% in a cyclical bear. But
right at those depths of despair a mighty new cyclical bull emerged that
ultimately carried the SPX 101.5% higher by October 2007. And since then, as
you know, we are down 45.8% in another cyclical bear. The pattern is
very clear. Cyclical bull, cyclical bear, cyclical bull, cyclical bear. And
if our current cyclical bear is indeed maturing, then what's next? A cyclical
bull!
In the
early years of today's secular bear, the SPX established a giant trading
range. Call it roughly 800 on the low side and 1525 on the high side. This is
rendered above. As you can see in the chart, at its 849 close on October
27th, 2008 the SPX wasn't far above that 800 secular support line at all. Of
course this doesn't guarantee 800 will hold again today as it did through
three major V-bounces in late 2002 and early 2003, but it is certainly
provocative.
In
addition to the SPX now being near the bottom of its secular trading range,
it has also fallen nearly as far as the 50% target in its current cyclical
bear. In the early 2000s cyclical bear the SPX lost 49.1% and in the mid-1970s
cyclical bear it lost 48.2%. Our current 45.8% isn't quite there yet, but it
is getting close. So although today's cyclical bear is way younger at 12
months compared to 30 months (early 2000s) and 21 months (mid-1970s), it has
still nearly lost enough to hit this epic-cyclical-bear 50% metric.
At very
least, this strongly implies the SPX has vastly more upside than downside
from here. At best, it implies this bear is over. As the 1970s secular bear
showed, the secular trading range is not precise but loose. So even though
800 wasn't hit yet on the SPX, October's lows could indeed have marked a
major interim bottom. Only time will tell if this bear is over or not, as it
could still grind sideways for awhile even if it doesn't fall a lot lower. But
probabilities for a big move higher are definitely far greater than for a big
move lower.
Before we
move on, take one final look at the P/E ratios for each secular bear. The
SPX's contracting valuation profile this decade is quite similar to the
valuation progression seen in the last secular bear. Even more importantly
though, note that the 1970s secular bear didn't end until the SPX fell under
7x earnings. Today's SPX was still 13.9x in late October, so this secular
bear still has many years left to run yet.
Sure, as
Wall Street often points out stocks are way cheaper today than in 2000. But
until they get to half fair value, 7x, odds are this secular bear has not
fully run its course. Secular bears overshoot on the valuation downside just
as much as secular bulls overshoot on the valuation upside. Think of a
pendulum. If you pull it way extreme in one direction and let it go, it is
going to swing way extreme in the opposite direction before it settles down
and starts swinging normally again.
This next
chart zooms in to highlight our last cyclical bull and cyclical bear in this
decade and compare it to the corresponding years during the last secular bear
of 1969 to 1975. This chart is provocative as well and should really make
contrarians think. It attacks today's immense prevailing bearishness, making
it look pretty foolish in light of the magnitude of the SPX's recent selloff
and the likely reaction going forward.
Until
2008, the infamous 1973-1974 stock bear was the worst in modern memory. Old
timers still shudder thinking about how bad it was. The SPX plunged 48.2% in
21 months and there was much wailing and gnashing of teeth. While horrible in
aggregate, its average rate of descent at -0.11% per day over this span
wasn't excessive. Our current bear has been compressed into a shorter time
frame so its average decline of -0.17% per day is far more extreme. But both
nasty bears had similar end results.
While our
current bear is steeper, the terminal plunge in 1974 was pretty darned steep
as well. In this bear's last 2 months ending October 2008, the SPX plunged
34.7%. In that bear's final 2 months ending October 1974, the SPX plunged
22.6%. It takes incredibly extreme fear to drive such intense selling, and
the more intense a fear episode the sooner it will burn itself out. Extreme
fear is never sustainable.
And boy,
if you consider the fear and the
extremes it drove in October 2008, it is hard to
imagine selling intensifying from there. The reason intense fear rapidly
burns itself out is everyone remotely interested in selling is shaken into
selling by an extreme fear episode. As soon as those sellers are done dumping
their shares, only buyers are left. It doesn't take much buying pressure in
such an environment to drive a sharp rally.
And that
is indeed what happened after the legendary October 1974 lows. The SPX
rallied sharply in a V-bounce, up 16.8% in 7 trading days. Then the few
remaining holdout sellers sold in desperation, convinced the sharp rally was
a chance to get out before the crash. They were wrong of course, as when
everyone is bearish stocks don't crash. Crashes only happen off secular tops
when consensus is overwhelmingly bullish.
This
selling drove the SPX down again, but it remained higher than its October
lows. A secondary bottom was carved in early December 1974 just 4.4% above
the October 1974 bear low. After that, it was off to the races. By July 1975,
the SPX had soared 53.5% higher in a mighty cyclical bull. If you have been
following the SPX in 2008, you certainly already see the parallels here.
After
plummeting into October 2008, the SPX surged 18.5% higher in a sharp V-bounce
within just 6 trading days. Skeptical traders, succumbing to the prevailing
bearish sentiment, sold the rally aggressively this week. If the historical
pattern prevails, we should see a secondary stock bottom sometime in the
coming weeks that will hold. And then a new cyclical bull could very well
emerge from the ashes.
Now I
know no one wants to believe such a heretically bullish thesis today. There
are countless reasons why the stock markets ought to go lower, I hear them
every day. And virtually everyone believes stocks won't bottom until mid-2009
at the earliest. But the technical evidence here (magnitude of this cyclical
bear, bottom of secular bear's trading range) is pretty convincing. And the
lack of bulls out there today makes it even more compelling from a contrarian
standpoint.
Cyclical
bears maul stocks until fear reaches a high-enough level to pressure all the
weak hands into selling. And after a 45.8% SPX plunge in just over a year and
last month's stellar average VXO
level of 65.5, it is hard to argue that this bear wasn't
extreme enough and didn't generate enough fear. It was one of the most brutal
and swift bears ever witnessed in stock-market history. Now as always late in
bears, the great majority of traders have been conditioned to fully expect
this extreme selling to persist.
Sure, the
economy is a mess. But stock markets anticipate the economy. Investors
buy stocks looking for future profits growth, so almost always in market
history the stock markets turn around well before the underlying economy. So
even if this recession persists, as is likely, realize that this cyclical
bear is going to end and the next cyclical bull ignite many months before the
economic data seems to justify it.
Of course
as a mere mortal who can't see the future, I don't know for sure. But my
inner contrarian is sure squawking about conditions today looking just right
for a new cyclical bull to be born within this secular bear. Even a modest
cyclical bull could see a 50% gain in the SPX, and a big one could see an
epic 100% gain within a few years. Trading this thesis is very uncomfortable
and highly contrarian right now, but the case is pretty compelling.
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Also, if
you want my political take on the Obama victory and its likely impact on the
financial markets, I discussed it this week in Zeal Speculator. It will
probably offend you no matter how conservative or liberal you are. Politics
are highly divisive and inflammatory, but the election is over and life goes
on. Good riddance to this campaign! Great opportunities will emerge in the
markets no matter what Obama does.
The
bottom line is despite all the pessimism and fear today, there is a good
chance that a new cyclical bull is being born. The brutal cyclical bear over
the past year nearly cut the SPX in half and nearly drove it down to the
bottom of its secular trading range. And 2008's steep selloff paralleled the
1974 SPX action really well, the only comparable year in modern history. These
are perfect birthing conditions for a cyclical bull.
On top of
this, we have incredible levels of sustained fear never before witnessed. Everyone
is terrified and almost no one is bullish. If you ever wanted a highly
contrarian opportunity to bet against the crowd, this is it. Cyclical bulls
are born deep in despair when most investors and speculators have given up
hope of stocks ever rising again. It sure feels like that today.
Adam Hamilton, CPA
Zealllc.com
October 24, 2008
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