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Stock Bull Market Being Born?

Stock-Markets / US Stock Markets Nov 08, 2008 - 02:40 AM GMT

By: Zeal_LLC


Diamond Rated - Best Financial Markets Analysis ArticleWith 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.

At Zeal this month we added 4 new elite long-term investments simultaneously for the first time ever. The incredibly beaten-down prices in world-class commodities producers were too attractive to pass up. And if this cyclical-bull theory proves correct, commodities stocks will be among the greatest gainers. All of our new investments and rally trades are profiled in the hot new November 2008 Zeal Intelligence . Subscribe today to buy these bargains before it is too late!

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.

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 …

Questions for Adam? I would be more than happy to address them through my private consulting business. Please visit for more information.

Thoughts, comments, or flames? Fire away at . 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!

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