SPX Bear Downleg
Adam Hamilton
Archives
Jun 13, 2008
The 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.
Adam Hamilton, CPA
June 13, 2008
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!
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