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If You Think New Highs Are Bullish, Check This Out
Well before the U.S. stock market made its all-time high on a capitalization-weighted basis on March 24, 2000, we presented our case for the beginning of a secular bear market period, or what we quantify as a Supercycle Bear Market Period.1
The Supercycle Bear Market Period, which started before that stock market high point, is ongoing, since the risk-free rate of return continues to cumulatively outperform the total return (dividends reinvested) of the S&P 500 index, with returns of about 18% vs. -6%, respectively, since the market high in 2000. This 25% higher performance differential is especially significant, given the total return of 90-day Treasury bills has no drawdown or redemption risk, while the stock market is always highly volatile and has already had a drawdown of 50% during this period.
History shows that during Supercycle Bear Market Periods, an economic slowdown like the present one is not a “pause that refreshes,” as widely promoted by the bullishly-biased CNBC talking heads. Rather, it almost always turns into a full-fledged recession, which is typically twice as frequent and twice as severe (magnitude and duration), on average historically, as during Supercycle Bull Market Periods. This record is demonstrated by our 110-year stock market and economic timing model, SMECT:
model
Furthermore, our work shows the current Supercycle Bear Market Period – the fifth since 1870 -- is only about half over, with the worst psychological impact on investors yet to come when the stock market makes lower lows. This is because the current consensus mood of investors, which has been bullish and complacent, especially at the recent stock market highs, has been fueled by the financial media featuring facts-of-the-day supporting that mood. For example, it recently was widely featured that the first-quarter 2006 performance of the U.S. stock market was the best in seven years. But that is a cherry-picked and meaningless statistic designed to hype investors, as the following chart makes clear:
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Here is quite a different statement of facts that the financial media will not point out because it does not support today’s bullish and complacent consensus attitude of investors:
In the longest such stretch since the 10 years it took to make new highs from early 1973 to early 1983, and the 25 years it took from late 1929 to late 1954, the capitalization-weighted index of the stock market has closed below its March 24, 2000 all-time high for more than: six straight trading years; 24 straight trading quarters; 73 straight trading months; 317 straight trading weeks; and 1,520 straight trading days!
Over the next eight years or so, as we complete this Supercycle Bear Market Period, we fully expect the consensus mood to completely reverse and become extremely bearish. We expect the financial media will then broadcast data that match investors’ widespread and entirely predictable bearishness and disdain for investing in the stock market.
During recent weeks, the financial media has been pushing a bullish story of stock market indexes hitting five- and six-year new highs. However, not only are such new highs absolutely consistent with a continuing Supercycle Bear Market Period, but as we’ve have been continuously warning, they have broadly indicated the start of the most psychologically devastating second downleg of the Supercycle Bear Market, the largest bear market in a Supercycle Bear Market Period.
The chart below shows we are in the fifth Supercycle and the tenth Supercycle Period since 1870. The years of the nine turning points for these Supercycle Bull (red) and Bear (green) Market Periods are: 1881, 1896, 1906, 1921, 1929, 1949, 1966, 1982 and 2000.
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Supercycle Bear Market Periods have a start and a finish, and a high and a low, although these four points can only be well-agreed upon in hindsight.2 Their duration is about four Kitchin
Cycles3, starting from a fundamental overvaluation peak and ending with a fundamental undervaluation trough.4
Because of the doubly-increased frequency and severity of these stock market-led, political-business Kitchin cycles, corporate profits cumulatively grow at half or less of their average growth rate – especially during K-Cycle Winters, or the deflationary economic Supercycle Bear Market Periods5
-- and thus the stock market P/E ratio collapses.
Keep in mind that GAAP-reported corporate earnings will also have to be reduced several hundred billion dollars for the present-value costs of retirement plan and healthcare benefit obligations, which we’ll hear more about later this year.
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A devastating Supercycle Bear Market, which is the most severe bear-bull-bear sequence of the typical four bull and bear market cycles during a Supercycle Bear Market Period, defines the stock market high and low of that period.
The Supercycle Bear Market starts from the stock market’s mania price peak and develops a down-up-down, ABC pattern. The first downleg (A) is followed by a rebound upleg (B), which leads to an “echo-mania” stock market price peak that may be either lower or slightly higher than the initial mania price peak. The “echo-mania” is similar in investor mood to the original mania, which led to the peak in the previous Supercycle Bull Market Period.
(At the end of this report we summarize some independent theoretical work in behavioral finance, which supports our observation that the pairing of manias and follow-on echo-manias causes these patterns.)
Then the ultimately most devastating, second downleg (C) usually declines to the lowest low of the entire Supercycle Bear Market Period – and thus usually to a lower low than the bottom of the first downleg (A).
The manifestation of the mania and echo-mania pattern is consistent with the financial-sector stock bubble having burst first, followed by a bust of the bubble in the non-financial housing sector. Compared to the high-tech, or dot.com, equity bust, a bust in housing would have about twice the negative economic wealth effect on consumer spending, which drives 70% of the U.S. economy.
One of our favorite indicators reflects the timing connection between these two asset classes. This home building indicator typically leads the stock market and argues that a huge drop in the stock market is imminent:
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Here’s a table detailing the stock market6 ABC patterns of Supercycle Bear Markets in the current and previous four Supercycle Bear Market Periods:
To more easily recognize the ABC pattern for each of the previous four Supercycle bear markets, as well as the consistently alternating new-highs pattern7, we’ve scaled each, from the month before the top to the month after the bottom, in equally-sized (in magnitude as well as duration), log-scaled monthly charts.8
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In the Supercycle Bear Market from December 1968 through October 1974, as seen in the chart below, the stock market made “all-time new highs” at the top of its echo-mania (B)
cycle-trend.
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In the Supercycle Bear Market from September 1929 through April 1942, as seen in the chart below, the stock market made “six-year new highs” at the top of its echo-mania (B)
cycle-trend.
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In the Supercycle Bear Market from December 1906 through August 1921, as seen in the chart below, the stock market made “four-year new highs” at the top of its echo-mania B
cycle-trend.
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In the Supercycle Bear Market from June 1881 through August 1896, as seen in the chart below, the stock market made “all-time new highs” at the top of its echo-mania (B)
cycle-trend.
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In the chart below, all four previous Supercycle Bear Markets are overlaid on an equally-sized basis, along with the current (fifth) one in blue dots, illustrating the three-legged, down-up-down, or bear-bull-bear, ABC pattern. As you can see, the stock market is making its upleg B highs consistent with the median timing of the previous four Supercycle Bear Market echo-mania highs.
The chart below shows the parallel in the timing of World Wars I and II in their respective Supercycle Bear Markets. For comparison, we have overlaid the current Supercycle Bear Market (blue dotted line):
Despite the tremendous fiscal stimulus in the form of military spending during World War I, the stock market still made lower lows in August 1921, during the second downleg (C) at the very end of the 1906-1921 Supercycle Bear Market.
The 1929-42 Supercycle Bear Market containing WW II did not ultimately make new lows in the second downleg (C) because the first downleg (A) was the devastating decline of more than 85% from 9/3/29 to 7/8/32 in the 1929 Crash, which pre-empted much of downleg C. If not for the huge mistakes in monetary and fiscal policy intervention during 1930-32, which have been well documented by economic historians, a smaller first downleg (A) would likely have been followed by a much larger second downleg (C), making lower lows in keeping with the typical Supercycle Bear Market pattern. (See the attached exhibit at the end of this report reconciling this price-time geometry.)
In a parallel to the magnitude of the 1929-32 cascade decline of 89% by the Dow Jones Industrials, which was the high-tech sector of that time, the tech-laden NASDAQ declined 78% during the first downleg (A) of the current Supercycle Bear Market. To continue that parallel, the NASDAQ Composite Index might not make a lower low in its coming downleg (C) because its initial decline of 78% in downleg A pre-empted much of downleg C, though we fully expect at least a 50% decline in the NASDAQ.
However, the NYSE Composite, which is several times larger than the NASDAQ and comprises the rest of the stock market, declined only 38% during its first downleg (A). So, for many fundamental reasons as well, we expect the NYSE Composite to have a bigger decline during its second downleg (C) than the NASDAQ, such that the total market will make significantly lower lows. This will conform to the lower-low pattern
in the other Supercycle Bear Markets, regardless of the further economic stimulus from military spending in a highly probable expansion of the War on Terrorism, due to the Iranian nuclear weapons issue.
Incidentally, here’s what we said (see the two charts below) in early 2001, several months before the 9/11 terrorist attack, about our expectations for a War on Islamic Terrorism:
The chart below shows the other two Supercycle Bear Markets, which had “lesser” wars (the Spanish-American War of 1898 and Vietnam from ~1965 to ~1973), in both of which the devastating second downleg (C) made new lows, as we fully expect the current one will do over the next several years:
Again, notice the pattern alternation (see footnote 7 again) from the “four-year new highs” in May 1887 to the “all-time new highs” in January 1973, to what we expect will be only “five- to six-year new highs” this time. In both these non-World War Supercycle Bear Market cases, the second downleg (C) eventually made lower lows than the first downleg (A).
Thus, Supercycle war history suggests it is most likely that the coming second downleg (C) will ultimately decline more than 50%, breaking the October 10, 2002 lows, no matter how much fiscal stimulus might occur because of additional military spending in an expansion of the War on Terrorism.
Bob Bronson May 5, 2006
Bronson Capital Markets Research S&P 500: 1326
http://www.financialsense.com/editorials/bronson/main.html
ABC Patterns Result From Intrinsic Bubble
Behavior Of Manias And Echo-Mania Pairs
The reasons behind the investor psychology of an “echo-mania” are the stuff of the field of behavioral finance. Quite simply, investors haven’t had enough of the easy money made in the original mania, even though much, if not all, of that money was lost in the first downleg (A) of the Supercycle Bear Market. The eagerness for quick riches is hard to squelch, and so they rush in to buy all over again, creating a second, or “echo” bubble.
They tell themselves they’ve “learned a lesson” and “won’t make the same mistake twice” by holding on to their hot stocks too long. They think they’ll sell in time to avoid the next market collapse, but empirical evidence shows they don’t. In fact, their eventual “herding,” when the decline is well underway and they finally “getit” and decide to sell en masse, usually causes a more severe second downleg than the first.
Experiments conducted by George Mason University professor Vernon Smith, who shared in the 2002 Nobel Prize for economics, confirmed this behavior. Participants traded a dividend-paying “stock” with a very clear fundamental value. A bubble invariably forms, then bursts. If the experiment is repeated with the same people, a bubble forms again. The second time, though, participants think they will be able to sell their stock before trouble strikes. They then express surprise that, in fact, they weren’t able to get out before the second collapse, which leads to their total disdain for investing in stocks. This collective investor disillusionment is both a necessary and sufficient condition for bringing about the selling that results in the extreme fundamental undervaluation that finally ends the Supercycle Bear Market Period.
We have seen exactly this behavior at work since the stock market began its rebound from the October 2002 and March 2003 lows. We expect that the recent “echo-mania” will end like the original mania and like the good professor’s experiment: badly for the investors speculating once again on highly overvalued stock and believing they’re now a better-than-average investor.
1 A Bronson Asset Allocation Cycles (BAAC) Supercycle Bear Market Period is a 12- to 20-year period of stock market underperformance during which bear markets, anticipating economic recessions, as well as the recessions themselves typically are twice as frequent and severe (magnitude and duration) as during
Supercycle Bull Market Periods. Such a period begins when the return from money market funds sustainably exceeds the total return from equities, especially when downside-volatility-risk is taken into account.
We both fundamentally and technically defined such Supercycle Bull and Bear Market Periods using our forecasting model. Our forecasting model is formulated with four paired factor groups: monetary-economic, social-political, valuation-sentiment and inter- and intra-market technical over more that seven time horizons. Each factor group is a dynamic weighting of several dozen quantified indicators, which is periodically re-optimized as indicators are upgraded, created or deleted.
Our Supercycle Bear Market Period call report and further explanation of BAAC Supercycles and our forecasting model are available upon request.
2 After the Supercycle Bear Market is completed, which defines the highs and lows of the whole Supercycle Bear Market Period, a period of post-traumatic volatility follows until fundamental valuations reach extreme undervaluation, ending the entire Supercycle Bear Market Period. But during this highly volatile period, neither significant new highs nor new lows are made, as investors simply become belatedly disgusted with stock market investments, which is the investor mass sentiment condition necessary and sufficient for an extreme fundamental undervaluation to develop.
3 In 1923, Joseph Kitchin published in the Harvard University Press an article entitled, “Review of Economic Statistics,” outlining his discovery of a primarily inventory-driven, 40-month business cycle, based on his study of U.S. and U.K. financial instrument statistics from 1890-1922. The actual nomenclature “Kitchin cycle” was first used by economist Joseph A. Schumpeter (1883-1950). In our SMECT Model, reconciling the pattern of business and stock market cycles since 1896: model,
we demonstrate how the previous 40-month Kitchin business cycle has morphed into a 48-month political-business cycle.
4 Here we are referring to classical fundamental valuation metrics, such as the ratios of market price to corporate earnings (illustrate in this report with charts), corporate dividends, enterprise value (assets plus liabilities), book value (assets minus liabilities), and various cash flow measures.
5 Our SMECT model, referenced in footnote 4, explains the four economic seasons of the Kondratieff Cycle, which we quantify in Supercycle Bull and Bear Market Periods.
6 For the stock market we have developed a spliced index that incorporates: from April 2001 to the present, the Wilshire 5000 (capitalization-weighted index of all exchange-traded common stocks); from January 1956 to April 2001, the S&P 500 Index; from January 1926 to January 1956, the S&P 90 Index; from January 1871 to January 1926, data from the Cowles Foundation available on Robert J. Shiller’s website. Rather than Shiller’s monthly averaged daily data, we use month-end data where available and the intra-month highs and lows for major cycle turning points.
7 Historically, the echo-mania price peak has alternated between making a slightly higher “all-time” high and just making “4- to 6-year new highs,” each of which are highly touted by the financial media as they feed into the highly bullish and complacent mood of the day. If that higher-high-or-not pattern alternation were to continue, then the stock market would not make a new high this time, as seems the most likely outcome, because the broad, capitalization-weighted market indexes[5] made “all-time” highs at the previous echo-mania peak in 1973.
8 This is consistent with the proposition that capital markets exhibit fractal (self-similar) patterns proportional to their fundamental drivers.
© 2006 Bob Bronson
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