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The Case for a
Super Bear Market

by David Stanowski
05 February 2009


Abstract:
The following article will explore five separate and independent market evaluation methods that are all pointing to a Bear Market in stocks and an economic Depression that will rival the conditions of the 1920's and 1930's.

Although no one can foretell the future with any great certainty, two forecasting techniques draw on over 100 years of data to reach this conclusion, so the message is very compelling!


Introduction:
When a hurricane approaches, the choices are either to prepare or hope that it will turn in another direction. Preparation requires the investment of time and money that will be wasted if it is a false alarm. Hoping that there is no real danger will seem the wiser choice, if nothing happens, but it opens up the possibility of catastrophic losses. 

Currently, there is a financial hurricane at loose on the world. Preparation may involve converting paper losses into real losses, and forgoing potential opportunities, but this must be weighed against the possibility of financial ruin.


Bear Markets:
There have been three major Bear Markets over the last 100 years. The prior two Bear Markets will be profiled to compare them to the current one.

1. 03 September 1929 - 08 July 1932
This rather simple Bear Market saw the DJIA crash 89% in 34 months.

2. 09 February 1966 -  12 August 1982
This very complex Bear Market saw the DJIA drop as much as 45% within a broad trading range, featuring five highs and five lows, over a period of 197 months.

3. 14 January 2000 - ????
This complex Bear Market saw the DJIA drop 39% into a low on 09 October 2002, it rallied to a new high on 11 October 2007, and then fell 48% into its most recent low on 21 November 2008.

This Bear Market could combine the depth of the 1929-1932 market with the duration of the 1966-1982 Bear.  



Market Evaluation Methods

 
1. Valuation
The goal of every investor is to "Buy low and sell high"; but that is easier said than done! The problem is how to reliably determine when prices are actually "low" or "high", as the case may be. Two valuation methodologies offer an objective way to determine when prices are historically high or low. Furthermore, when prices are extremely high, a Bear Market can be expected to begin; when they are very low, a Bull Market is in the offing.

Dividend Yield:
The most reliable way to determine Stock Market valuations is by using the Dividend Yield of the major indexes. This is because there is only one way to quantify dividends, but many methods to estimate earnings when computing the P/E ratio.

Looking back at over 100 years of data for the S&P 500, it is clear that stocks become over valued, i.e. too expensive, when their Dividend Yields were 3% or less, and they are under valued, i.e. cheap, at 6% or more. However, it should be noted that the 1921, 1938, 1942 and 1949 bottoms were made at Dividends Yields of 7.39%, 7.75%, 8.67% and 7.30%, so yields greater than 6% are common at major bottoms.

Markets act like a pendulum as they swing from one extreme in valuation to the other. This means that they usually reverse at levels of extreme valuation, move towards the mid point in Dividend Yields, but then over shoot the mid point until they reach extreme valuation in the other direction. Therefore, when Dividend Yields reach 3% or less, they usually reverse, but they normally do not stop at 4.5%; they move up to at least 6%.



Bull Market Highs - Start of Bear Markets
Dates 1929 1966 2000
Dividend Yield 3.00% 2.94% 1.11%
Source: Robert Shiller

Even after a 48% decline in the market, as of December 2008, the Dividend Yield still stood at a meager 3.24%; much closer to the levels of previous major tops than previous major lows; implying a lot of downside potential!

Bear Market Lows - Start of Bull Markets
Dates 1932 1982 2012 ?
Dividend Yield 13.84% 6.24% 6.24 to 13.84% ?
Source: Robert Shiller

Since the over valuation at the 2000 top was 62-63% more extreme than at the 1929 and 1966 tops, the Dividend Yield should rise to at least the level reached at the 1982 bottom. If dividends were to remain constant at December 2008 levels, this would require a drop in the market of an additional 48%! If Dividend Yields push beyond 6.24%, or if dividends fall, which is very likely in this economic collapse; the down side projections become even more extreme!


Price Earnings (P/E) Ratio:
The classic way to compare today's stock prices with levels of known value is to compute a P/E ratio of the major indexes. Investors always look for investments with low P/E ratios, because it represents how many dollars that they have to pay to receive one dollar in earnings. Speculators ignore high P/E ratios, because they are betting on price appreciation instead of looking for income. However, when prices stall in their upward movement, speculators usually bail out, and prices collapse to levels that bring the P/Es in line with historical norms.

Looking back at over 100 years of data for the S&P 500, it is clear that stocks become over valued, i.e. too expensive, when their P/E ratios reach 21 or more, and they are
undervalued, i.e. cheap, at 7 or less

When P/E Ratios reach 21 or more, they usually reverse, but they normally do not stop at the mid point, they move down to at least 7.



Bull Market Highs - Start of Bear Markets
Dates 1929 1966 2000
P/E Ratio 32.56 24.06 42.87
Source: Robert Shiller

Even after a 48% decline in the market, as of December 2008, the P/E Ratio still stood somewhere between 15 and 22 (depending on how it is calculated); much closer to the levels of previous major tops than previous major lows; implying a lot of downside potential!

Bear Market Lows - Start of Bull Markets
Dates 1932 1982 2012 ?
P/E Ratio 5.57 6.64 5.57 to 6.64 ?
Source: Robert Shiller

Since the over valuation at the 2000 top was 32-78% more extreme than at the 1929 and 1966 tops, P/E Ratios should fall to at least the levels reached at the 1932 and 1982 bottoms. If earnings were to remain constant at December 2008 levels, this would require a drop in the market of an additional 70%! If earnings fall, which is very likely in this economic collapse; the projections become even more extreme!

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2. Stocks/GDP
This study simply takes the total dollar value of all U.S. stocks and divides it by GDP to get another take on whether stocks are historically expensive or cheap.

Looking back at over 100 years of data, it is clear that stocks become over valued, i.e. too expensive, when the Stock/GDP ratio reaches 75% or more, and they are undervalued, i.e. cheap, at 40% or less

When the Stock/GDP Ratio reaches 75% or more, stocks usually reverse, but they normally do not stop at the mid point, they move down to at least 40%.




Bull Market Highs - Start of Bear Markets
Dates 1929 1966 2000
Stocks/GDP Ratio 75% 85% 190%
Source: Fortune Magazine

Even after a 48% decline in the market, as of December 2008, the Stocks/GDP Ratio still stood at 75%; much closer to the levels of previous major tops than previous major lows; implying a lot of downside potential!

Bear Market Lows - Start of Bull Markets
Dates 1932 1982 2012 ?
Stocks/GDP Ratio 40% 40% 40%?
Source: Fortune Magazine

Since the over valuation at the 2000 top was 123-153% more extreme than at the 1929 and 1966 tops, the Stocks/GDP Ratio should fall to at least the levels reached at the 1932 and 1982 bottoms. If GDP remains constant at December 2008 levels, this would require a drop in the market of an additional 35%! If GDP falls, which is very likely in this economic collapse; the projections become even more extreme!


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3. Sentiment
Sentiment is a contrary indicator. The idea is that when the majority of investors have been extremely bullish for a long time, everyone who is going to buy is in the market, so there is no place else to go but down. There are several ways to measure sentiment, but one of the most reliable is the percentage of Stock Mutual Fund Cash.

Stock Mutual Fund Cash:
This method has clearly shown that when stock-market-mutual-fund managers are bullish, they reduce the percentage of their funds that they are holding in cash, and visa versa.
When stocks are near major tops, Stock Market Mutual Fund Cash drops to 5% or less, and near major bottoms it moves to 11% or more 



Bull Market Highs - Start of Bear Markets
Dates 1929 1966 2000
Stock Mutual Fund Cash N/A 5.5% 4.0%
Source: Investment Company Institute

Stock-Mutual-Fund Cash made an all-time low at the 2000 high, but then pushed to a new all-time low of 3.4% at the 2007 high! Even after a 48% decline in the market, as of December 2008,  Stock-Mutual-Fund Cash still stood at 5.0%; much closer to the levels of previous major tops than previous major lows; implying a lot of downside potential!

Bear Market Lows - Start of Bull Markets
Dates 1932 1982 2012 ?
Stock Mutual Fund Cash N/A 12.0% 12.0%?
Source: Investment Company Institute

Since the over valuation at the 2000 top was 38% more extreme than at the 1966 top, Stock-Mutual-Fund Cash should rise to at least the level at the 1982 bottom. This would require a drop in the market of an additional 58%!

There are other measures of sentiment such as surveys of bullishness that date back to the 1960's. Most of them reached extremes during the run up into the 2000 and 2007 tops that far exceeded the levels reached at the 1966-1982 tops. However, the real shift in sentiment that should occur before the ultimate bottom is reached, in this Bear Market, is a mind set that most people will never again invest in stocks, because they are so upset with the losses that they ultimately suffer. We are a long way from that point.


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4. Moving Averages
Another way to determine a baseline value of an investment, independent of earnings or dividends, is to compute a long-term moving average of its price. As the name implies, this "moving average" is the average price that investors have been willing to pay, over a reasonably long period of time, so it provides an approximation of a more stable "value" with which to compare current price levels. History shows that current prices are sometimes far removed from real value, which makes them vulnerable to a correction back towards the baseline.

When prices surge far above their moving average it is an indication that a major Bull Market Top may be forming, and a Bear Market is beginning, so a reversal of prices back towards the baseline value, and often below it becomes more and more probable. Likewise, when prices plunge far below their moving average, 
it is an indication that a major Bear Market Bottom may be forming, and a Bull Market is beginning, so a reversal of prices back towards the baseline value, and often above it becomes more and more probable.

For the purposes of this article, monthly closing prices of the DJIA were used to compute the 240-month (20-year) moving average. As this moving average is calculated each month, it represents the average price that investors were willing to pay for the DJIA, looking backward 20 years from that month.

Examining the following graph clearly shows that the period in question was dominated by a strong up trend that contained the three Bull and Bear Markets under study.

At the 1921 low, the DJIA (red line) dropped down to meet its 240-month MA (green line). From there, the DJIA surged into its 1929 high leaving its MA far behind. This wide differential signaled that conditions were ripe for a reversal into a Bear Market, and prices did drop so far that they ended up significantly below their MA, setting up a major bottom.

After the 1932 low, prices moved back and forth across their MA for many years setting up a base for a move into the 1966 Bull Market Top, which had a much smaller differential than the 1929 Top. As might be expected, the smaller differential at this top lead to a 16-year sideways Bear Market rather than a crash. Prices moved down to meet and their MA and crossed above and below it for several years until the 1982 bottom was formed. 

This bottom launched the 18-year run into the 2000 Bull Market Top, which featured a differential similar to the 1929 Top. However, prices did not fall nearly as much as they bottomed in 2002, and then rallied into 2007. Now they have dropped enough to where they will probably meet their MA in the near future.


The next chart shows the value of this technique much more clearly by plotting the percentage difference between the DJIA and its 240-month MA.

The first Bull-Bear Market cycle shows that the 255% difference at the 1929 top was so extreme that it created a plunge that lead to a -65% differential at the 1932 bottom!

The second Bull-Bear Market cycle shows a very different profile. The differential actually peaked in 1959, at 158%, and declined to 116% at the 1966 Top. With the rounded top, and less differential than in 1929, this top lead to a 16-year sideways Bear Market rather than a crash. Without a crash, the Bear Market extreme differential was established in 1974 at only -17%, and the sideways Bear Market ended in 1982 with a differential of -6%.

The current Bull-Bear Market cycle shows that the 250% difference at the 2000 top was so extreme that it lead to a sharp drop into the 2002 bottom, a rally to a new high in 2007, and currently finds prices 16% above their MA. While it is certainly possible that this Bear Market could be ending at or near its MA, if it continues to drop sharply, rather than going into a sideways pattern, prices would need to fall an additional 50-65% to create a differential similar to 1929-1932!



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5. The Elliott Wave Principle
The Elliott wave principle is a form of technical analysis that attempts to forecast trends in the financial markets and other collective activities. It is named after Ralph Nelson Elliott (1871–1948), an accountant who developed the concept in the 1930s: he proposed that market prices unfold in specific patterns, which practitioners today call Elliott waves.

Elliott published his views of market behavior in the book The Wave Principle (1938), in a series of articles in Financial World magazine in 1939, and most fully in his final major work, Nature’s Laws – The Secret of the Universe (1946). Elliott argued that because humans are themselves rhythmical, their activities and decisions could be predicted in rhythms, too. 

Elliott's market model relies heavily on looking at price charts. Practitioners study developing price moves to distinguish the waves and wave structures, and discern what prices may do next; thus the application of the wave principle is a form of pattern recognition.

The structures Elliott described also meet the common definition of a fractal (self-similar patterns appearing at every degree of trend). Elliott wave practitioners say that just as naturally-occurring fractals often expand and grow more complex over time, the model shows that collective human psychology develops in natural patterns, via buying and selling decisions reflected in market prices.

Robert Prechter came across Elliott's works while working as a market technician at Merrill Lynch. His fame as a forecaster during the bull market of the 1980s brought the greatest exposure to date to Elliott's theory, and today Prechter remains the most widely known Elliott analyst. Wikipedia



Elliott Waves unfold in sequences of five waves as shown below.

Elliott Waves

When using the Elliott Wave Principle, projections and forecasts are constantly refined and updated, but at this time, the Bear Market still seems to be trying to finish Wave 1. The ideal low on Wave 1 would be about 6,500 on the DJIA.

From there, a major Bear Market rally (Wave 2) should begin that would carry to about 9,500 on the DJIA over a period of 4-6 months. This Wave 2 rally should generate enough bullishness and optimism to convince most people that all the bailouts have worked, and the Bear Market is over.

However, if the Elliott Wave projections are correct, Wave 2 will end far below the all-time high in the DJIA and yield to another leg down in this Bear Market. This Wave 3 should be a crash to around 2,000 on the DJIA!

Finally, after another Bear Market rally in Wave 4, Wave 5 should carry the DJIA down to the starting point of the previous Bull Market, 577.60-776.92, in 2012.

The Elliott Wave Principle is certainly the most esoteric and controversial methodology presented in this article, but it is also the one that most clearly called the current Bear Market many months before most analysts even considered it a possibility, so its message is hard to ignore!




Lagniappe

Total Credit Market Debt as a % of GDP
:
There are many other metrics that can add more insight into the nature of the market at this time, but this is one of the most chilling! This data clearly shows that at the 2007 top, the total debt in this country, relative to the GDP, was more than double the amount at the 1929 top! The unwind of that amount of debt in 1929 produced a crash of 89% in the stock market. What is twice the amount of debt likely to do?

Bull Market Highs - Start of Bear Markets
Dates 1929 1966 2000
Total Credit Market Debt as a % of GDP 170% 147% 359%
Source: Federal Reserve; Flow of Funds; Table L.1, Line1
Source: Economagic

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10-Year Total Real Return:
This is an interesting study that computes the total return on the S&P 500, i.e, price appreciation + dividends, adjusted for inflation using the CPI, for the previous ten years.

This study begins in 1936, so the first cycle starts when the 10-Year Total Real Return dips slightly negative in 1946. From there, it pushes up to its all-time high of 19.1% in 1959, but drops to 10.2% at the 1966 High. This indicator goes negative in 1974, and remains mostly negative until the 1982 Low.

The next cycle starts by moving off the 1982 Low to reach 15.3% at the 2000 High, and just hit its all-time low last month at -5.1%! In other words, the most negative 10-year period since this data series began in 1936, was January 1999 to January 2009, which helps to put the magnitude of the current decline into perspective!

However, the most interesting pattern formed by this indicator is the 28 years of positive returns (1946-1974), followed by 8 years of mostly negative returns (1974-1982), which lead to another 26 years of positive returns (2008-1982). Will the pattern repeat with another 8 years of mostly negative returns (2008-2016)?

"Taking inflation and dividends into account, an investor who put money into the market any time after the end of 1996, and held on, now has less value than when he or she started."

 

Inflation-Adjusted Earnings:
"It has been said that earnings drive the market. That may be the case but as of late it's been all downhill. Today's chart illustrates that S&P 500 as-reported earnings have declined over 60% over the past 17 months, making this the largest decline on record (the data goes back to 1936). In fact, earnings are currently lower than they were back in the mid-1960s."

Also note, that as earnings drop, prices have to fall even further to get P/E ratios back into the long-term buying zone of 7 or less.



Previous Articles:

Conclusion:

Some people were aware of some or all of these arguments at the 2000 and 2007 market tops, but most did not take appropriate action. Their take on all this was that "it is different this time"; measures of valuation that had held up for more than 100 years, and other well-worn methodologies simply did not matter any more, because we were in a new age of ever rising prices. This is the same argument heard at the top of every market mania in history.

So far, those who did not heed the warning of these arguments have paid a very dear price. However, only time will tell whether the forecast of much deeper losses ahead will come to pass. Each individual must decide what they see in the message of these metrics. Those who are working with a financial adviser would be well advised to ask them to read this article and offer their thoughts on the validity of this thesis.   


Post Script:
The future could be hazardous to your financial health!

There are no realistic scenarios that hold out any hope of a strong and stable economy over
the next 5-7 years. Insolvency is rampant within the world's financial system, and will probably spread to more than a few local, state and national governments.

Virtually all government interventions and bailouts will only make matters worse, and prolong the suffering. This problem was caused by many things, but at the heart of the issue was too much borrowing and spending. The centerpiece of all government fixes is more borrowing and spending; in other words, their solution is to do more of what caused the problem in the first place!

The Bush Administration, in concert with the Democratic Congress, accomplished absolutely nothing with their bailouts except to spread the losses from those who caused them to those who had nothing to do with the bad decisions that lead to the losses. This is the definition of crony capitalism where the well-connected are favored and bailed out at the expense of the public at large. The justification for their actions could best be described as the theory that it is less damaging for 1,000 people to lose $1,000 each than it is for one person to lose $1,000,000. Of course, nothing could be further from the truth. Rewarding losers and punishing winners increases risk which decreases economic activity.

As the leader of the current one-party system in Washington, the Obama Administration has  continued the crony capitalism, already in play, but it will go much further by creating more "socialist programs", like Social Security and Medicare, under the guise of economic stimulus. Many efforts by politicians to help their cronies will be temporary in nature, but socialist programs are meant to channel even more power to the federal government, on a permanent basis, which will also act as a permanent drag on an economy desperately trying to recover.

The greatest threat to the economy, and to our way of life, is massive unemployment. Almost everyone is going to lose some portion of their wealth in the years ahead, but massive unemployment can unleash very dangerous political forces. During the Great Depression, unemployment got as high as 25%. If the projections of these methodologies come to pass, total unemployment (as defined by U6) could easily exceed 30%!

Massive unemployment will almost certainly lead to widespread "civil unrest" (demonstrations and riots), as people vent their frustrations in very destructive ways. This turmoil has already started in Russia, China and Europe, so it will probably not take much longer to reach our shores.


Such conditions would enmesh the government in the task of caring for and controlling millions of formerly productive people, and they would demand unprecedented new powers in order to perform this function. Many of our remaining freedoms will be at stake.

Even though the techniques in this article focused exclusively on the stock market, their message is one of a Depression that would affect every corner of the economy. The U.S. residential real estate market lost $3.3 Trillion in value in 2008, and it has lost $6.1 Trillion since the top in 2005. If this scenario comes to pass, it  is very likely that residential real estate is only in its first wave down, too; with much more yet to come. Commercial real estate peaked after residential and has only just begun its decline.

News Corp chief executive Rupert Murdoch kicked off the World Economic Forum in Davos, Switzerland last week by warning that the atmosphere was worsening – despite global economic confidence plumbing the lowest depths on record. "The crisis is getting worse," he said.

The comment was also made that over the past five quarters 40% of the world's wealth has been destroyed! No data was offered to support this claim, but there is no doubt that a significant portion of the world's wealth has already disappeared, however, it is difficult to quantify it precisely.

Perhaps the most chilling piece of hard data comes from the Federal Reserve's most recent (3Q 2008) report showing that neither households nor non-financial corporations have even started deleveraging (decreasing debt), yet! This crisis is the result of too much leverage (debt), but households and non-financial corporations have not yet become scared or motivated enough to actually reduce their appetite for new borrowing! Just imagine what the stock and real estate markets might do when actual deleveraging begins!

NOW is the time to reevaluate your financial position and investments and start downsizing and deleveraging before the avalanche really begins! We are all going to have to figure out how we are going to make a living in a world that promises to be very different than the one that existed before this crisis began!
      
Is Your Money Safe?

DISCLAIMER:
THIS CONTENT IS FOR INFORMATIONAL and EDUCATIONAL PURPOSES ONLY, and is NOT INTENDED AS INVESTMENT ADVICE!


The information contained in this article reflects an analysis of market trends and conditions, and nothing contained in this article, or on this website should be interpreted as, or deemed to be, a recommendation to any investor, or category of investors to purchase, sell or hold any security.

Any investment decisions must in all cases be made by the reader, or by his or her investment adviser. Nothing contained on this website is intended as a solicitation for business of any kind, or for investment.

As a matter of law, INVESTMENT ADVICE may only emanate from members of the government-created monopoly of federally-registered brokers and investment advisers. The author falls into neither category.

In contrast, what you just read is simply INFORMATION, that was obtained from what are believed to be reliable sources. It is ALWAYS wise and prudent to undertake investment positions only after considering a wide variety of information and opinions, on the subject, and after consulting with those who are authorized to give INVESTMENT ADVICE, if so desired. Although consultation with "experts" may be helpful, everyone should do their own DUE DILIGENCE regarding ANYTHING that may affect their financial well being.

The author is an active participant in the markets, and may trade the securities that are discussed in this article, both before and after publication, and/or may have a long-term position in such securities. In other words, the author usually has a financial interest in the subject of the articles on this web site.


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