By Adam Hamilton
With the US stock markets challenging a major multi-year high, investors are feeling pretty complacent these days. But unseen below the placid surface, a serious risk is arising from the depths. With each passing day, the odds grow that a new stock bear is imminent. As these merciless beasts typically maul the markets until stock prices are cut in half, they are dangerous threats that cannot be taken lightly.
The stock markets perpetually march forwards in great bull-bear cycles. All bull markets eventually mature and top when greed and complacency grow excessive and everyone willing to buy has already bought. Then bear markets are born, which don’t run their course until fear reigns and everyone susceptible to being scared into selling has already sold. And then this endless cycle begins anew, bull bear bull bear.
The problem today is our current bull market is long in the tooth, running longer and higher than average. And the older any trend in the markets gets, the greater the odds of an impending major reversal. After a bull market, a bear is absolutely inevitable. The only question is when it will awaken from hibernation. And thanks to our position in the bull-bear cycles today, probabilities favor that tipping point being soon.
Understanding these bull-bear cycles is crucial for investors and speculators. If you wrongly buy near the top of a bull, or sell near the bottom of a bear, it will derail your wealth-building progress for years. There are two distinct species of bulls and bears, secular and cyclical. The secular ones persist for the better part of two decades, while the shorter cyclical ones alternate every few years within the secular ones.
A full secular bull-bear cycle lasts a third of a century, or about 17 years each for the bull phase and bear phase. To get up to speed on this essential strategic context, read one of my essays on Long Valuation Waves. Our current full secular-bull-bear cycle began way back in August 1982, but the second secular-bear half started in March 2000. We are now 12 years into this phase, which again is likely to last 17 years.
There is a widespread misconception that secular bears drive stock prices lower like shorter cyclical bears, but this isn’t true. A secular bear is a giant sideways grind, a nearly-multi-decade consolidation. Stock prices are driven way too high relative to underlying corporate earnings power in secular bulls, so in secular bears they simply drift sideways long enough for earnings to catch up with stock prices.
Within these mighty sideways-grinding secular bears, there are shorter cyclical bears and bulls. The bears tend to cut general stock prices in half over a couple years, while the bulls tend to double them again over the next few. The net effect is a gigantic trading range running from the preceding secular-bull highs to halfway below them. High in its range now, today’s cyclical bull is running out of room to run.
All this secular-cyclical stuff is a lot easier to comprehend when seen visually. This first chart compares the last two secular bears, today’s that started in early 2000 (blue) and the previous one before that running from 1966 to 1982 (red). Both of these secular sideways grinds were formed by a series of oscillating cyclical bears and bulls. And today’s cyclical bull is likely nearing the end of its road.
After the secular bull of the 1980s and 1990s topped in early 2000, the first cyclical bear of this secular bear cut the stock markets in half. The flagship S&P 500 stock index fell 49.1% over 2.6 years. But out of that fear and despair a new cyclical bull was born, which propelled the SPX 101.5% higher over 5.0 years. That was followed by a cyclical bear which climaxed after 2008’s stock panic, a 56.8% drop over 1.4 years.
And out of those secondary lows after that once-in-a-lifetime fear superstorm, today’s cyclical bull was born. By its latest interim high in early April 2012, it had powered 109.7% higher over 3.1 years. Note above that these alternating cyclical bears and bulls within the greater secular bear have indeed formed a giant trading range. It runs between roughly 1500 on the upside to half that on the low end, 750.
Today’s cyclical bull is nearing that secular resistance. The higher the SPX travels within this trading range, the greater the odds its cyclical bull is due to fail and roll over into the next cyclical bear. While we’re not at 1500 yet, realize mid-secular-bear cyclical bulls certainly don’t have to hit resistance before giving up their ghosts. Back in the 1970s secular bear, cyclical bears often began well under resistance.
Towards the end of our last cyclical bull that climaxed in October 2007, the SPX remained above 1400 for over a year. So why start fearing a new cyclical bear now since we are just starting to peek over 1400 again? Remember that 2007 was a wildly-different environment from 2012. The US housing market, China, and commodities were booming. Meanwhile the European debt crisis and Washington’s inability to make any progress whatsoever hadn’t yet begun.
The general market psychology today, with our many structural worries and intense anxiety, is far more conducive to birthing a bear than the halcyon pre-panic days of 2007. Unless a political miracle happens, Obama’s smothering regulations and staggering debt growth are somehow magically unwound quickly, it is hard to imagine today’s cyclical bull enjoying a 2007-style long drawn-out encore topping.
While the SPX’s high position in its giant secular trading range is important, it isn’t the primary reason why a new cyclical bear is increasingly likely. That honor falls to another perspective on these bull-bear cycles, how long they tend to last and how big they tend to grow. While the first chart had zeroed axes to highlight how cyclical bears cut prices in half, this second one zooms in to examine what births these fearsome beasts.
The last secular bear running 16.5 years between 1966 and 1982 enjoyed four cyclical bulls, while today’s 12-year-old secular bear starting in 2000 has seen two so far. Since we are trying to game when today’s is likely to fail, it is best to exclude it from the averages. Before it in the entire modern history of cyclical bulls within secular bears, their average duration is 34.8 months. And this is even skewed high.
Thanks to that housing bubble in 2007 and the massive economic impact of the Fed’s inflation and cash-out refinancings, the previous cyclical bull lasted much longer than they generally do (60 months). If you just include the 1970s cyclical bulls, the average drops dramatically to 28.5 months. The general rule of thumb for the lifespan of a cyclical bull within a secular bear is a few years. Today’s cyclical bull is beyond all of these.
It was born in March 2009 at the secondary panic lows, which made it 36.8 months old at its latest high in early April 2012. But as of this week, the SPX was within spitting distance of edging up to even better levels. If we see a new high soon, this cyclical bull is already 41.0 months old today. Thus this bull is long in the tooth, well past mature by any mid-secular-bear cyclical-bull-lifespan metric you want to use.
But even that may be conservative. Remember that the last cyclical bear climaxed in 2008’s stock panic. Such epic fear maelstroms are so exceedingly brutal that secondary lows are unheard of. Yet we had two secondary lows after that panic’s initial lows. They were both driven by political fears, by the rise of a man who won the US Presidency on a scary platform of Marxism (class warfare) and Socialism (theft via taxation).
In a single month in the heart of the stock panic, the SPX had plummeted 30.0% by late October 2008! A third of Americans’ vast stock wealth had vaporized in weeks. And that should have been the ultimate low, the climax of both the stock panic and cyclical bear that spawned it. Indeed over the next 6 trading days, the SPX blasted 18.5% higher. All throughout history, a singular decisive low like this ended every panic.
But the day that post-panic bounce reached its peak was Election Day. And after the results came in that night and investors learned Americans had inexplicably chosen to elect a Marxist and Socialist, the markets tanked. Investors were terrified of Obama’s campaign threats of higher taxes, crushing regulations, ballooning big government, and job-destroying class-warfare rhetoric. So the SPX plummeted 25.2% over the next 12 trading days immediately after Obama won!
That too should have been the ultimate panic low, 11.4% below the initial one several weeks earlier. And that November 2008 low was when fear peaked, the VXO fear gauge hitting a staggering 87.2 on close compared to 86.0 at the October low. But there was one more secondary low, much later in March 2009. That was a political anomaly as well. Obama certainly didn’t shift to the middle after winning like many on Wall Street somehow expected.
Right after his Administration took office in late January 2009, the toxic class-warfare rhetoric exploded. Obama railed against investors, saying our already-high taxes were far too low. He wanted the biggest tax hike on investors in the history of this nation, and socialized medicine, and endless new regulations. So the stock markets slumped in despair into early March 2009. The SPX fell another 10.1% under November’s secondary low.
But it is fear that marks the climaxes of stock panics and cyclical bears, and the VXO fear gauge merely hit 51.5 at that March 2009 low (54.0 a couple trading days earlier). This was a far cry from the unprecedented high-80s reads seen during the stock panic! So there is a strong academic case to be made that the true stock-market bottom should have been October 2008’s, the original decisive fear climax before Obama’s awful anti-American politics hammered the markets further.
So it is entirely reasonable to consider October 2008 the end of the previous cyclical bear instead of March 2009. This rendering makes the current cyclical bull 41.2 months old at its recent April 2012 peak and 45.4 months old today. Once again this is well beyond the average lifespan of the rest of the mid-secular-bear cyclical bulls of modern times (34.8 months). Today’s bull has already enjoyed a long and full life.
And boy, has it been fruitful too! Remember that cyclical bulls tend to double stock prices back up to the preceding secular bull’s highs. This isn’t as readily apparent in the 1970s secular bear above because I used SPX data for comparability, and this index wasn’t prominent back then. But if you look at the main stock index of the time, the classic Dow 30, the cyclical bulls were closer to doublings back then too.
In today’s secular bear, the last cyclical bull climaxing in October 2007 ran 101.5% higher, a perfect doubling. Meanwhile today’s cyclical bull had already climbed a whopping 109.7% higher by its early-April high! It is already the biggest mid-secular-bear cyclical bull in modern history, and could get even bigger if the SPX edges to marginal new bull highs soon. A cyclical bull this big is unprecedented.
The stock panic explains much of this outsized gain, since the extreme secondary lows driven by Obama’s scary politics pushed the SPX below its 750 secular support. Provocatively at the November 2008 panic low just after the elections, the SPX bounced at 752 right on this line. The lower the starting point for a cyclical bull, the easier it is to get outsized gains. I even predicted a bigger-than-average cyclical bull just months after the panic.
But this still doesn’t change the fact that the recent years’ cyclical bull is considerably bigger than anything else seen in modern times. The longer a cyclical bull powers higher, and the greater its gains grow, the higher the odds it is due to roll over. At some point greed and complacency peak, all available buyers have already bought which leaves only sellers. And then the bull gives up its ghost to yield to the subsequent bear.
Could this analysis be all wrong? Could the 2000s secular bear finally be over? Highly unlikely. The Long Valuation Waves that encompass full secular bulls and bears are remarkably consistent in their third-of-a-century duration, as are secular bears which run for the second halves of these waves. The previous two secular bears ran 16.5 years (1960s) and 19.8 years (1930s). Today’s is only 12.4 years old.
So the averages suggest we have the better part of five years left, and even in a best-case scenario there should be a few more. I suspect that one more cyclical bear will take us back down near secular support (750 SPX) over the next couple years or so. And then the subsequent cyclical bull will once again eventually regain resistance (1500) over the following three years. And then this secular bear will end.
Also realize that the primary reason secular bears exist is valuations. Valuations, or how high stock prices trade relative to the underlying earnings their companies can generate, are propelled to unsustainable bubble extremes late in secular bulls. The mighty companies of the SPX were trading at an astounding 43.8x earnings back in early 2000 when today’s secular bear was stealthily born!
Secular bears typically don’t end until the general-market price-to-earnings ratio falls back down near 7x earnings, half the historical average of 14x. The 1970s secular bear didn’t end until the SPX was trading at 6.6x, way after it started at roughly the same SPX level 16 years earlier but then priced at 24.1x. If the SPX’s P/E ratio was down under 10x today, then we could consider the possibility of this secular bear ending early.
But it’s been nowhere close. Near the SPX’s latest cyclical-bull high in early April, the elite component stocks of this flagship index were collectively trading at 19.4x earnings. There is no way a secular bear, which exists to force stocks sideways from extreme overvaluation to extreme undervaluation, would end on such a high metric. This bear’s valuation work is only about half done so far, with lots of drifting left to go.
And not even that crazy stock panic or the Obama scares afterwards pushed the SPX to secular-bear-ending territory. Its P/E ratio was still 11.6x heading into the March 2009 secondary low, and was 13.0x at the end of October 2008. Secular bears are a valuation thing, and valuations have never been anywhere close to levels that could send this decade-plus bear back into hibernation early.
In light of all this, the risk that a new cyclical stock bear will soon be upon us is high and growing. This has enormous implications for investors on multiple fronts. If you want to plow new surplus capital into stocks, late in a cyclical bull is the wrong time to do it. After the subsequent cyclical bear cuts the markets in half again, the same cash will buy twice as many shares at very cheap prices. Don’t buy high late in a bull.
If you are going to need to sell significant stock positions to raise cash anytime in the next five years or so, it is prudent to do it soon while the SPX is still high in its secular trading range. I say five years because a cyclical bear can run for two and then a cyclical bull for another three before we get back up near resistance again. As an added bonus, capital-gains tax rates remain low for the rest of 2012.
Provocatively not every sector gets sucked into cyclical bears, there are isolated areas that thrive when the rest of the markets are selling off. Chief among them is gold, and therefore its leveraged subsidiary plays of silver and the precious-metals miners. In the last cyclical bear when the SPX lost 56.8%, gold rallied 24.8% over that exact span! In the one before that when the SPX lost 49.1%, gold climbed 12.6% even though its secular bull didn’t start until the middle.
So at Zeal, we’ve been exiting our general commodities-stock positions that leverage stock-market downside and migrating back into elite precious-metals stocks which leverage gold’s upside. Even if the stock bear somehow tarries, the setup in gold and silver today for massive autumn rallies is amazing. With the stock-bear risk high and growing, the oversold and unloved precious metals are a fantastic contrarian play.
The bottom line is the stock markets’ cyclical bull of recent years is getting long in the tooth. It has both lasted longer than the average mid-secular-bear cyclical bull and powered considerably higher. Greed and especially complacency run high, with the flagship S&P 500 stock index nearing the top of its giant secular-bear trading range. All of this is increasing the odds a new cyclical bear will be born anytime now.
These dangerous beasts are not to be trifled with, as they tend to cut the stock markets in half. The losses in popular high-beta sectors are even greater. The surest defense is boring old cash, as falling stock prices greatly increase its purchasing power. But a far-more-profitable and exciting alternative is gold, which has continued rallying through each previous cyclical bear of this long secular bear.
Adam Hamilton, CPA
August 10, 2012