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Stocks Secular Bear Market New Downleg Has Begun

Stock-Markets / Stocks Bear Market Jun 13, 2008 - 12:24 PM GMT

By: Zeal_LLC

Stock-Markets

Best Financial Markets Analysis ArticleThe early summer weeks of June have not been kind to the US stock markets. Across June's initial 8 trading days, the flagship S&P 500 stock index lost 4.6% of its value. This is not a trivial move for America 's biggest and best elite companies, so stock traders are starting to sweat a bit.

As usual, Wall Street is generally pretty bullish despite the recent selling. It is largely perceived as a minor pullback within a big new bull upleg, a stellar buy-the-dips opportunity. But what if this is not the case? An alternative, and far-more ominous, interpretation of this past month's weakness suggests we could really be witnessing an awakening bear .


If you aren't a contrarian or haven't studied financial-market history, the notion of a new bear probably seems preposterous. I am not happy with this thesis either, as bear markets are much more challenging to thrive in than bull markets. Nevertheless, the case for a new bear is getting pretty compelling. And if a bear is indeed stirring, it is far more prudent to prepare for it instead of burying our heads in the sand.

The case for this new bear begins with stock-market technicals. The average price action in the 500 individual stocks comprising the S&P 500 (SPX) has been growing increasingly negative. With this index trending lower, the supplies of component shares offered by sellers are generally exceeding buy-side demand. Sellers outnumbering and overpowering buyers is one of the core bear-market attributes.

A year ago, the SPX technicals still looked bullish. In July it hit a new all-time high of 1553 within weeks of finally surpassing its old high-water mark of 1527 from way back in March 2000. There was a sharp selloff soon after this top as the initial subprime scare hit, but the SPX soon recovered. By early October it again hit fresh all-time highs near 1565. Together this pair of highs now looks like a secular double top.

At its apex early last autumn, the SPX was up an awesome 95.5% in a mighty bull run that started way back in March 2003. Over this entire 4.5-year span, the general US stock markets as represented by the SPX never experienced a single major correction. Such a long span of time with a unidirectional prevailing trend is rare, as stock-market action is usually fairly cyclical. Corrections follow uplegs and bears follow bulls.

While the SPX bull was certainly quite long in the tooth by its October high, technically there was no real evidence of bear-market action until late November. That is when the SPX finally broke materially under its key 200-day moving average. 200dmas generally provide strong support in ongoing bull markets. Any pullbacks or corrections usually bounce at or slightly below the 200dma if the bull uptrend remains intact.

But in late November, the SPX briefly fell under 0.95x its 200dma. Such levels had not been witnessed since early 2003, the last time the SPX was in primary bear mode. Its 200dma was failing as support, a key sign of an aging bull starting to give up its ghost. If you are a Zeal subscriber, you can see this for yourself on our long-term Relative SPX chart located in our private charts section under General Stock Markets.

In early December the SPX surged above its 200dma once again, but this recovery attempt was half-hearted. The selling soon overwhelmed buying again and the index headed south. By early January the SPX had broken decisively below its 200dma and the 200dma itself was rolling over. Since a 200dma usually runs parallel with a price's primary trend, this was another clue that the long bull since 2003 was in serious trouble.

By mid-January the SPX was freefalling along with stock markets across the globe. I explained the factors driving this wickedly-steep mini-panic in depth in the February issue of our Zeal Intelligence newsletter, which is now in our web archives for subscribers. Technically this particular selloff defined the downtrend labeled “bear downleg” in the chart above. The SPX's 200dma had totally failed, something that does not happen within ongoing bull markets. Traveling for long under a 200dma is bear-market behavior.

From its early October high to its latest mid-March low, the SPX lost 18.6% of its value. This is such a big and fast decline that it looks vastly more bear-downleg-like than bull-correction-like. For instance in one of the SPX's biggest selloffs within its March-2003-to-October-2007 bull, the SPX fell 7.7% in mid-2006. Another big one in 2004 fell 8.2%. Mid-bull pullbacks in the SPX are usually less than 10%, minor.

Within bears though, individual downlegs can easily push 20%+. In early 2001 during its last bear market, the SPX fell 19.7% in a single quick (just over 2 months) downleg. The far-more-brutal downleg ending in July 2002 witnessed a 31.8% SPX decline in just 4 months! So SPX declines approaching 20% like our recent one did are something seen in primary bears , not primary bulls which usually only see sub-10% pullbacks.

By mid-March, fear was so extreme as measured by technicals and key fear gauges like the implied-volatility indexes that a major rally looked imminent. In the March 11th Zeal Speculator regarding the SPX I wrote, “Even if we are in a new bear, we need to see fear abate periodically to rebalance sentiment. New downlegs launch out of greed, not fear. Only a strong rally will dissipate all of the excessive fear today and bring back greed. Thus I still think we have a good chance of seeing the SPX rally up to its 200dma.”

And the SPX did indeed rally sharply off its V-bounce in March. Declines of many months suddenly steepening into a plunge, carving a V-shape, and then soaring are classical and common bear-market stuff. Such V-bounces are seen at the end of nearly every downleg in bears but only rarely in bulls after a huge exogenous shock like the Long-Term Capital Management hedge-fund implosion of 1998.

After this V-bounce, the SPX climbed fairly aggressively until mid-May. Its 12.0% bear rally was certainly weak by bear-market standards, but it still looked like a bear-market rally technically. In the four major bear rallies the SPX saw back in its 2001-to-2002 bear days, this index rose an average of 20.5%. But back then the stock markets weren't facing today's tremendous headwinds driven by a credit crunch coupled with an energy crisis.

And when this rally topped in mid-May, the specific technical level the SPX reached is very telling. It was repelled right at its 200dma. Just as 200dmas are major support in bull markets, they are major resistance in bear markets. Any student of market history will quickly learn that the highest-probability stopping point for any bear-market rally to run out of steam is near its 200dma. The bearish technical signs keep adding up.

After failing at the SPX's 200dma, the index started selling off again. It reached its 50dma by late May, an important level of support if this was bull-market action. While it bounced off its 50dma initially, this was an anemic bounce. If we were merely witnessing a pullback within a bull-market upleg, the 50dma would usually hold.

But in early June, actually last Friday during that giant $10 oil spike, the SPX broke decisively under its 50dma in a big 3.1% down day. Not only is a failing 50dma a telltale bear-market sign, but so are big down days. The great majority of the SPX's biggest daily swings of the last decade happened during its bear years. Bears see more extreme days than bulls in both directions, down and up.

So as you can see, all kinds of SPX technicals are now doing things that are usually only seen during primary bear markets. The price behavior we've seen since early October has been very bearish. While such action certainly doesn't prove we are in a new bear, it sure radically increases the odds that we are. When price action looks like a bear, feels like a bear, and acts like a bear, it just might be the real deal. If the SPX decisively breaks its critical support at its March lows in the coming months, a bear is upon us.

But until that happens, technicals alone are not enough to call an early-stage bear. Bears just don't erupt randomly, very specific conditions entice them out of hibernation. When stocks rise for too long without any material correction, and greed waxes extreme, bears emerge to rebalance sentiment. And per the sentiment gauges like the implied-volatility indexes and the put/call ratio, greed did indeed reign back in early October when the SPX peaked.

But there are also longer stock-market cycles that define bears. I call these Long Valuation Waves, or LVWs. Throughout stock-market history, great cycles exist covering a third of a century each. Great 17-year secular bulls are followed by 17-year secular bears, together making one LVW. Today we are in the secular-bear stage of our current LVW. If this is new or unclear to you, please read my latest LVW essay to get up to speed.

Within the second half of LVWs, their bear stage, stock markets generally grind sideways. This gives underlying stock earnings time to catch up with inflated stock prices from the top of the preceding bull stage (ending March 2000). Gradually this process reduces stock valuations (where stock prices are trading relative to their profits) to first normal and then ultimately undervalued levels by the end of the bear.

Since early 2000, the SPX action has been just as expected within such an overarching 17-year bear. Sure, stocks had a mighty run from early 2003 to late 2007, nearly doubling. But big cyclical bulls are common within great bears, they keep stock traders from getting scared out too early in the secular bear. Despite all the sound and fury of this massive SPX run though, by October 2007 the SPX was still only 2.5% above its March 2000 levels!

Thus the SPX was essentially dead flat over nearly 8 years, it just traded sideways! Investors who bought stocks in late 1999 or early 2000 along with the popular mania had just started breaking even again by late 2007. General stocks were terrible investments over this span. Overlaying this 2000s sideways action on top of the last great-bear grind from the 1970s is very revealing. The white and yellow numbers are SPX P/E ratios for their respective eras.

The blue line showing our current SPX looks quite similar to this same stage in the last LVW. If this chart interests you, I explained it in much more depth in an essay back in January when the SPX started to look bearish to me. But for today's purposes, just note that the SPX has traded sideways at best since early 2000 and that strong cyclical bulls and bears alike are common within these 17-year great-bear grinds.

The fact that the SPX just hit its secular resistance in late October radically increases the odds that we are in a new bear market. If the very same bearish technicals we have witnessed since October happened low in this trading range, like down under 1000 on the SPX, I wouldn't worry about them. But seeing so many bear-market signs emerge off the very top of a nearly-decade-long trading range demands we take them very seriously.

Even more provocative are the comparisons between today's LVW progress and this same stage in the last LVW in the mid-1970s. Near its recent peak, the SPX was only trading around 21x earnings. Many Wall Street analysts, and rightly so, said such valuations were nowhere near the 44x peak bubble extremes in 2000. To them, such relatively low valuations suggest this bull has plenty of room to run higher yet.

But back at this stage in the 1970s LVW, valuations had moderated too. The SPX was trading near 19x earnings as 1973 dawned, a better value than the 21x of October 2007. Yet despite this, the index still got sucked down in one of the most brutal bears of the modern era in 1973 and 1974. As this next chart which zooms in on the cross-LVW comparison around this time shows, the SPX still lost nearly half its value!

From early 1973 to late 1974, less than 2 years, the mighty flagship SPX full of elite American companies fell by a devastating 48.2%! It was horrifying. Much like last autumn, the stock markets simply started selling off after a strong multi-year bull. In the early-1970s equivalent to our recent 2003-to-2007 bull, the SPX gained an outstanding 73.5%. The myriad parallels between then and now are ominous.

We are at the same stage in our current LVW now as we were early in the 1973-to-1974 bear in the last LVW. That bear started at 19x earnings while our latest SPX top was at 21x earnings. That bear started just above the top of the SPX's secular trading range, just like our current technical weakness. And back then, just like now, spiraling oil prices and inflationary expectations were really weighing on Americans and hence the US economy and stock markets.

So the bearish SPX technicals we've seen since early October should be placed within the strategic context of our current position within our Long Valuation Wave. They are not happening in a vacuum where we can blissfully ignore them. Similar conditions in the last LVW, at this very time within it, sparked a terrible bear that cut the SPX in half in less than 2 years. These are dire tidings indeed, no fun at all.

Obviously I don't know for sure if we are indeed in a young bear, but the more SPX action I see since October 2007 the more bearish things look. In light of all this, which I have barely brushed upon in this essay, it would not surprise me one bit to see the SPX down near 800 by autumn 2009! It sounds crazy, but this is what historical precedent suggests is not only possible but probable. Investors should really be cautious here.

And one of the worst things about all this is bear markets are so darned devious. A bear wants to maul as many investors as possible, so it has to obscure its existence as long as possible. Thus any steep declines like we've seen recently are soon followed by sharp rallies. The biggest stock-market up days ever witnessed in history happen during bear-market rallies. These fast bear-market rallies quickly calm fears and convince investors that “this couldn't possibly be a bear”.

So even if the SPX is whittled down to half its October 2007 peak, near 800, for most of the journey down Wall Street will insist everything is fine and a major bull is just beginning. It always works this way. General psychology doesn't actually get bearish until the terminal stages of bears when investors realize they've been played for fools. So recognize that sentiment and feelings don't betray a bear until far too late.

On an averages basis, bears are boring too. The average daily decline in the wicked 1973-to-1974 bear, still remembered as one of the worst, was merely 0.1% per day. This is nothing! Like the proverbial turning up the heat to boil a frog slowly, bears gradually boil investors before they realize it. Most of the time bears just barely grind lower. Big down days are rare, usually only seen late in downlegs. And big up days out of those lows are common. Bear markets are so Machiavellian in the way they subtly unfold.

Investors looking for a bear in day-to-day action or short-term charts won't find one. Even on charts running a month or two back, most of the time in a major bear that particular slice of time won't look too bearish in isolation. Only traders who can keep the long-term strategic picture in clear focus can hope to identify a bear early enough to avoid the worst of its ravages.

At Zeal, we actively traded the last major SPX bear, which was primarily in 2001 and 2002, to outstanding success. In 2001, the SPX fell 13.0%. That year all our realized stock trades recommended in our monthly newsletter gained an average of 10.1% absolute, or 29.3% annualized since our trades virtually always run less than a year. In 2002, the SPX fell 23.4% . That year our stock trades gained 40.5% absolute or 129.1% annualized! Bear markets can indeed be traded successfully by battle-hardened traders.

So if you want to make this next probable bear-market journey with traders who have thrived in just such a hostile environment in the past, join us. We publish an acclaimed monthly newsletter analyzing the markets and launching real-world trades based on our research. And we publish a separate weekly newsletter doing the same for more-active speculators. We will continue to actively trade, and hunt for profits, even in a bear. Subscribe today!

The bottom line is recent technical action in the US stock markets is looking increasingly like we are already in a new cyclical bear. Sellers are overpowering buyers with increasing ease and stock prices are falling on balance. If such a bear follows historical precedent, it is not unreasonable at all to expect the major US stock indexes to fall to half the levels of their early-October highs before this bear fully runs its course!

Merely knowing that we may be in a new bear will give you a huge psychological edge over the majority of investors who will remain clueless until near the very end. While bears are much tougher trading environments than bulls, they can still be traded profitably by the prudent. Remain wary and keep the big picture in focus, refusing to be seduced into unbelief by the big up days so common in bears.

By Adam Hamilton, CPA

So how can you profit from this information? We publish an acclaimed monthly newsletter, Zeal Intelligence , that details exactly what we are doing in terms of actual stock and options trading based on all the lessons we have learned in our market research. Please consider joining us each month for tactical trading details and more in our premium Zeal Intelligence service at … www.zealllc.com/subscribe.htm

Questions for Adam? I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/adam.htm for more information.

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com . Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

Copyright 2000 - 2008 Zeal Research ( www.ZealLLC.com )

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