by David Stanowski
10 July 2009
In the aftermath of the biggest stock market decline in decades, everyone who owns stocks or stock-market mutual funds will have to make a critical decision fairly soon; is the primary trend still down, or has a new Bull Market begun. This choice will determine each individual's investment strategy, and ultimately their financial well being. There are two very different types of stock market analysts. Knowing which type to rely on will be critical to avoiding financial ruin!
Since 1932, the stock market has been in a strong uptrend punctuated by occasional Bear Markets. This is the only history and experience that most people living today know. This has been the "normal" state of affairs for the last 75 years. Therefore, most economists, stock brokers, stock-market analysts, financial media, and anyone else who predicts what they think the stock market is going to do understand that the safest approach is to be permanently Bullish, i.e. a PermaBull. Since they believe that no one can time the market, PermaBulls have no other choice than to advocate the buy-and-hold approach to investing.
Being a PermaBull makes you one of the good guys who is always optimistic and hopeful about the future, so there doesn't seem to be any downside to joining their ranks. However, every few years, those who follow their advice lose quite a bit money in a Bear Market, but the PermaBulls calmly explain that no one can time the market, so the only choice is to ride out the Bear Markets, and "eventually" investors will recoup their losses, and be making big profits again.
Many of the PermaBulls also profit from their forecasts, because investors use their services much more in Bull Markets, so when the market seems to be forming a top, Bearish forecasts would be good for their clients, but bad for their business. PermaBulls adjust to changing conditions in the stock market by altering their recommended percentage allocation to stocks, or moving their clients into "defensive sectors", but they never advise them to get out of the market, because "no one can time the market". PermaBulls loose a lot of clients in Bear Markets, because nearly everyone gets disgusted and sells their stocks for big losses long before the new Bull Market bails them out, but since most people have short memories, the long-term uptrend eventually pulls them back in, which has allowed the PermaBulls to dominate the industry, and do quite well for themselves. However, when a stock market crash occasionally comes along, the PermaBulls will remain fully invested, looking for another rally to bail them out, but eventually their clients will be wiped out.
PermaBulls have been successful in the post-WWII era where down trends were not as frequent or severe as in earlier times, but in "Secular Market Trends" Michael Alexander revealed that from 1800 to 2000, the U.S. stock market spent 95 years (48% of the time) in Secular Bear Markets, so the PermaBull strategy hasn't done nearly as well during other time periods.
Maybe ten percent of those who develop forecasts for the stock market are the crazy mavericks who actually realize that the market goes in two directions; up AND down. These BullBears are well aware that timing the market precisely is nearly impossible, but buying and selling based on valuation and sentiment allows them to define buying and selling zones that shift the odds greatly in favor of their clients. The foundation of this approach to investing is using dividend yields and P/E ratios to compare current valuations to past benchmarks, and measuring investor sentiment, in a variety of ways. Many also add more esoteric techniques such as Gann Lines, Dow Theory, Elliott Waves, and cycles. BullBears are often wrong in their forecasts, but since they acknowledge that the market doesn't only go up, they are much less likely to lead their clients to financial ruin, by advising them to ride out steep declines.
There are only a few advisers who might qualify as permanently bearish, i.e. PermaBears. Late in the 16-year Bear Market from 1966-1982, some of the Gold Bugs were true PermaBears, on the stock market, but they are long since gone. There may be a handful of new faces at this time, but they get little attention from the press, or the public. Any time that BullBears become Bearish for a long period of time, the PermaBulls often accuse them of being PermaBears, but if they are willing to become Bullish, when conditions warrant, they haven't become one-dimensional like their critics.
How have PermaBulls fared versus BullBears over the last 75 years?
There is no way to answer this question in specific terms, so a more general approach will have to suffice. In recent years, there is no question that the financial press and the public have been more inclined to embrace the views of PermaBulls rather than the more objective approach of the BullBears. A Bullish forecast is optimistic and hopeful, so even when its wrong there is very little criticism of the forecaster, because at least he was politically correct. However, when a BullBear releases a Bearish forecast, he is an outcast, a killjoy, and a pariah. Even if he is correct, he is rarely given any praise for saving his clients millions of Dollars. When a Bearish forecast is wrong, the response is "we told you so"; "you are just too negative"!
If the trend of the market was up 80% of the time, over the last 75 years, by default, the PermaBulls would have been correct 80% of the time, by always being Bullish, which seems like a very impressive record; but their clients still got crushed the other 20% of the time. How their clients actually fared over the entire time period will vary greatly depending on when they moved in and out of the market.
In contrast, suppose that a BullBear analyst forecast 8 Bull Markets, and 10 Bear Markets over this same period, and only 10 calls were correct. This analyst was accurate "only" 56% of the time which is not as good as the record of the PermaBulls; but there is more to it than that. For example, if the BullBear's clients avoided six Bear Markets, they may have fared far better than the clients of the PermaBulls who lost a lot of money during those declines. The difficulty of looking at simple accuracy rates is more obvious when the size of the gains and losses are included. PermaBulls leave their clients wide open for catastrophic losses where the BullBears usually do not.
To illustrate this point in another way, the following story has been modified to include the definitions used in this article:
Suppose that you eat at an outdoor cafe every day, but once every 100 days a terrorist will drive by and kill all the customers. PermaBulls have no tools to predict these occurrences, so they simply stay Bullish and tell you to keep lunching there. They are right 99 percent of the time, and wrong only 1 percent of the time. However, in that one instance, you will be killed!!
But the BullBears have some useful tools. They can predict which days have a high probability of a terrorist attack, but not the specific day, so they are forced to choose 11 days out of 100 on which you must be absent from the cafe in order to avoid the one day when the attack will occur. This means that the BullBears are wrong, about when eating is unsafe, a whopping 91 percent of the time, but you won't get killed!!
How can the PermaBulls be mostly right yet worthless, and the BullBears be mostly wrong yet invaluable? The statistics are clear, aren't they?
The true statistics, the ones that matter, are utterly different from those quoted above. When one defines the task as "keeping the customer alive", the PermaBulls are 0% successful, and the BullBears are 100% successful.
When consequences matter, difference in statistical inference can be a life and death issue. In the real world, investors need timely warnings, and they almost never get them from PermaBulls; they entirely missed the current historic downturn. To BullBears, the warning signs were legion. Would you rather suffer several false alarms, or get caught in Bear Market and go bankrupt? Focus on irrelevant statistics is one reason why PermaBulls have been improperly revered, and BullBears have been unfairly judged, during the long bull market. But the PermaBulls latest miss was so harmful to their clients that their reputation for forecasting isn't surviving it.
Robert Prechter, Elliott wave Theorist May 2009
How did these contrasting strategies play out during the topping process from 1992 to 2007?
The easiest way to look at this is by using dividend yields. BullBears know that over 100 years of stock market data has demonstrated that when yields are less than 3%, stocks are extremely overvalued, and the risk of holding them becomes excessive. They may not drop as soon as they hit this point, but history suggests that the heightened risk will eventually come home to roost. On the other hand, Bear Market bottoms rarely occur with dividend yields less than 6-7%. At the 08 July 1932 bottom, the dividend yield was 13.84%.
see The Case for a Super Bear Market
The dividend yield on the S&P 500 declined below 3% in February 1987, and that October, it suffered through a 35% crash. By January 1992, the dividend yield had pushed back below 3% again, and it continued to decline until it was below 2% in January 1997. Each BullBear adviser was forced to decide how to play the market during this five year stretch of high risk, but most exited sometime during this period. In doing so, they missed the final run to the March 2000 high. Since yields were in uncharted territory, BullBears could NOT be expected to call the ultimate high, but unlike the PermaBulls, they believed that a major top was forming.
During these years of over valuation, the PermaBulls laughed at the idea that dividend yields had any forecasting ability, and stuck to their usual buy-and-hold approach. Those who followed their advice accrued significant unrealized gains during the rally, but gave much of it back when their portfolios declined 51%, if they were in the S&P 500 stocks, from March 2000 to October 2002; or 78% if they were primarily in NASDAQ stocks. Clients of the BullBears got out too early and missed a lot of "paper profits", but the PermaBulls were forced to ride out a big collapse. Many of their clients got out once the losses became too painful, so they didn't catch the beginning of the next up move.
Near the 2002 lows, the dividend yield only rose to 1.93% which was still indicating a high risk of owning stocks. BullBears generally didn't know what to do in this high risk environment, and many simply stayed out of the 2002 to 2007 run to the top where the final 1.72% yield continued to flash strong warning signs. It was no surprise to the BullBears when the market finally rolled over and dropped 58% into the recent March 06 low.
It is impossible to compute direct comparisons of these two approaches to market forecasting. Every analyst would give somewhat different advice, and every client would act on it differently. In addition, some BullBears would not just advise selling stocks, when they became overvalued, they would suggest short selling, too. However, most advisers and their clients are going to either own stocks, or sell them, and get out.
It should be clear that BullBears are always going to miss some upside moves, but they are usually going to protect their clients from major losses. It's much like reacting to the signs on a curving mountain road listing the speed limit as 35 mph, because of the obvious danger of higher speeds. Some will race down the road at 70 mph, and arrive safely at their destination. However, the probability is very high that one day drivers who travel this road at high speeds will lose control, smash through the guard rail, and end up in a fiery crash. From the mid 1990's until early 2008, the PermaBulls sped past the BullBears using their total disregard for the high risk involved, and recorded many years of high returns. However, how much of those profits did they hold onto after the crash?
The Case for a Super Bear Market
Did the excess risk payoff for the PermaBulls?
As of June, the total return on the safest investment in the world, U.S. Treasury Bills, was 3% higher than the total return for the S&P 500 (appreciation + dividends) since December 1996! In other words, those who took the excessive risk of holding the S&P 500 during a time of extreme over valuation, over the last 12 years, were penalized with a return 3% less than TBills! They endured two market declines of over 50%, and have nothing to show for it!
Investors who bought CDs enjoyed a higher total return than the S&P 500 all the way back to 1994! In fact, they earned $29,256 more than stock investors between 1994 and 2008!
A new study, "Bonds: Why Bother?", by Robert Arnott, shows that safe, boring U.S. Treasury Bonds outperformed the S&P 500 since 1969; i.e. for the last 40 years! Investors in higher yielding bonds could be much further ahead.
These three comparisons should provide a new appreciation for the strategy of only buying stocks during periods of undervaluation, and avoiding them during periods of over valuation; something that the PermaBulls do not understand. The higher potential returns available from stocks are rarely realized when they are held through periods of over valuation, and the Bear Markets that they usually trigger.
What do the BullBears see ahead?
This question was posed in this way, because by definition, PermaBulls will remain Bullish no matter what happens, so their forecasts are obvious. They believe that a new Bull Market started at the 06 March lows, and new highs will be forthcoming in the next year or two.
BullBears see things quite differently. After a 58% collapse in the S&P 500, and a 43% rally; the dividend yield currently stands at an all-time low of 0.77%!! This is because companies are cutting dividends which is pushing yields even lower.
"According to the latest data from Standard & Poor's, the second quarter of 2009 saw just 233 dividend increases.
How does that stack up historically?
Well, it's the worst second quarter on record since 1958 (51 years)!
Even worse, S&P says the first half of 2009 along with the 12 months ending in June both hold the most dividend decreases and fewest increases since records began back in 1956 (53 years).
This trend marks a sharp departure from the kind of dividend activity that we saw over the previous couple of years. Consider that in the second quarter of 2008 there were 455 positive dividend actions vs. 97 negative ones. And in 2007, the numbers were 542 hikes vs. just 18 decreases."
"Money and Markets" 07 July 2009
During the long top building process from 1992 to 2007, the PermaBulls argued that dividend yield no longer had any relevance. However, after the 51% decline in the S&P 500 and 78% crash in the NASDAQ from 2000 to 2002; and then the 58% plunge in the S&P 500 and 56% decline in the NASDAQ from October 2007 to March 2009; it has made a very strong case for its continued importance!
The fact that the dividend yield on the S&P 500 was less than 3% for 191 straight months, i.e. 16 straight years, (November 1992 to October 2008) could mean that the duration of the over valuation combined with the degree of over valuation is pointing to the very high probability that this Bear Market will be of unprecedented severity and duration. In other words, if there is any kind of symmetry, or reversion to the mean, this Bear Market could last for 16 years (beginning in 2000) and produce a maximum dividend yield well in excess of the typical value of 6-7% at Bear Market lows.
If dividends stay constant, the S&P 500 would have to fall another 50-60% (450 to 375) to push the yields up to 6-7%. However, if dividends fall, or yields hit 10-12%; the index might have to drop 70-80% from here!
America's Great Bear Markets.
Using Elliott Wave classifications, there have been three Great Bear Markets, and their resulting economic depressions, in U.S. history.
1. The South Sea Bubble caused a huge run up in British stock prices from 1719-1720, the market crashed 98% into 1722, and then traded sideways, at this extremely low level, for 62 years, until 1784. As a British colony, the American economy followed a similar path. This 64-year-long Bear Market caused a six-decade-long economic depression. The unrest due to these economic conditions eventually lead to the American Revolution.
2. U.S. stock prices plunged 78% from 1835 to 1842, and the economy went into a depression. There was a strong rebound into 1853, and then another drop into 1857. These back-to-back depressions created the conditions that pushed the South to secede which lead to the Civil War.
3. The DJIA crashed 90% from 1929 to 1932, and the economy plunged into the Great Depression that lasted 16-20 years, depending on how its end point is measured. The economic conditions of the 1930's lead to WWII.
These critical periods in our history are depicted on the graph below.
With the dividend yield and P/E ratio during the 1992-2007 topping process exceeding the levels reached in 1929 in both the duration and degree, the most logical conclusion is that what is currently unfolding will eventually be recognized as America's fourth Great Bear Market. Unfortunately, the financial and economic condition of this country is far worse than it was in 1835 or 1929 which means that this downturn will probably generate conditions at least as bad as the three Great Bear Markets that preceded it! Current debt levels are far worse than during the previous examples, and our manufacturing base is so depleted that it will be much more difficult to sustain ourselves through the downturn and mount a vigorous recovery.
The Foundation For the Study of Cycles puts the most likely bottom for this Bear Market in 2012, and using the dividend yield projections performed earlier, prices could easily drop another 50-70%.
Note the duration and extent of over valuation, as measured by dividend yield, (shown in turquoise) compared to past history, in the following graph.
The Dividend Yield currently stands at an all-time record low 0.77%; which is not shown on the graph above.
Bear Market Lows - Start of Bull Markets
Note the duration and extent of over valuation, as measured by the P/E ratio, (shown in turquoise) compared to past history, in the following graph.
The P/E Ratio currently stands at an all-time record high somewhere between 60 and 131; depending on certain assumptions; which is not shown on the graph above!
source: Elliott Wave Theorist
source: Chart of the Day
Bear Market Lows - Start of Bull Markets
The day of the PermaBulls and their unidirectional buy-and-hold strategy is over. That approach will work during long and robust Bull Markets, if investors hold their stocks all the way through Bear Markets, so that they are positioned to fully recoup their losses when the next Bull Market begins. Most investors intend to do this, but end up bailing out when losses get too painful. This is why most studies show that very few investors enjoy returns that are anywhere near what buying-and-holding the major indexes would yield.
There is no reason to believe that recent action is anything more than a Bear Market rally that will eventually give way to new lows, so it is time for investors to review the work of a variety of BullBear analysts to allow them to understand why it is so dangerous to own stocks in this market. In fact, stocks may currently be more overvalued that at any other time in the history of the U.S. markets. Down side risk is very high! The time to return to the stock market will occur when dividend yields are back up to at least 6-7%.
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