Cult of the Bear, Part 2

Cult of the Bear, Part 2
The charts are aligned for a hard time for U.S. stocks., Jan 9, 2006




In part 1, we reviewed my forecasting process, and considered some reasons why — despite its bullish start — 2006 might be rocky for U.S. equities. Today, we go to the charts.

The 100-Year Dow

Humans are particularly bad at thinking about long periods of time. We have evolved with much shorter cycles: A daily sunrise, a monthly full moon, annual seasonal changes. Longer periods of time are outside of our personal experience. They create an analytical blind spot.When we look at the “long term,” we discover interesting things. Consider each “market” period in this 100-year chart.Regardless of how each one ends, every bull market over the past century has been followed by a significant refractory period. As the chart shows, it takes quite a while to recover from a crash. Some of this is due to the destruction of capital. At the end of bull markets, many industries end up with excess capacity (think optical fiber or telecom.) But do not overlook the large psychological component of the pain incurred by investors. The damage gets repaired when investors finally forget about the pain they suffered — or when a new crop of investors (without scars) finally appears.Today, market junkies have a new mistress: homes. Their former passion for stocks has been replaced. As we have seen, their equity wounds — plus 46-year low interest rates — has made real estate the new hottie. My guess is that nothing short of a large and sustained move upward (e.g. several quarters) will rekindle their love affair with equities.How likely is that? Is it possible that an 18-year bull market (1982-2000) could be followed by a two-and-a-half-year bear (March 2000 peak to October 2002 low), then followed by another multidecade (2003-2018) bull? Sure, anything is possible. But as the chart above shows, it would be historically unprecedented.

16-Year Trading Range

On the 100-year chart, take a close look at the bear market prior to the most recent bull. It’s the 1966-82 trading range. On the long-term chart, it looks like a fairly benign flat range. In reality, it was a volatile, dangerous period:

A Colorful History
Markets are correspondingly colored — green for bull, and red for bear — revealing their cycles
Source: Barry Ritholtz

Assuming we are, in fact, in a long, post-bull trading range, than this is year five (give or take) of what could be a 10- to-15 year secular bear market. As the 1966-82 experiences shows, we may be in for violent moves down and rapid blastoffs.

Ups and Downs; Mostly Downs
The 1966-82 experience says we may be in for violent moves down and rapid blastoffs
Source: Rydex Funds

If we are repeating the 1966-82 experience, I’d say we are somewhere around 1972-73. The similarities are imperfect — especially regarding interest rates — but an unpopular war, a potentially scandal-ridden second-term president with low poll numbers, and the end of a 20-year bull run five years prior are too similar to ignore. Compare the numbers: the Dow is up 45% from its October 2002 low and the S&P by about 60%. That parallels the Dow’s 67% gain from the 1970 low to the 1973 peak .

Four-Year Presidential Cycle

The next chart reveals what is known as the four-year, or presidential, cycle. The theory behind this is that U.S. markets have a tendency to make a low in the second year of a president’s term and a high in the fourth year. It has held up quite well historically, with the notable omission of 1986. Recall, however, what happened in 1987.The chart suggests that cyclicality is at play. Given the upward bias of markets over time, regular corrections of 20% or greater may be inevitable.What is truly astonishing is the very human propensity to downplay or even ignore these periodic dislocations. The classic example is the tendency of humans to build homes in earthquake zones, in flood plains, where tsunamis have previously hit — even near volcanoes (!). Investors have similar blind spots.

Hail to the Chief
The presidential cycle suggests trouble ahead
Source: BTR Capital Managment

P/E Ratios Are Not Cheap

The chart below covers the S&P 500 and its P/E ratio over the course of 1982-2000 bull market. Note that the P/Es started at 7 and rose to nearly 50. The median P/E went as high as 32.There are those who claim that P/E expansion isn’t all that significant to market performance; they argue it is a function of falling interest rates. A better explanation is psychology: Something shifted in investor sentiment that made them willing to pay more than $7 for a $1 of earnings — in fact, almost $50 per. That change is best explained by a sentiment shift related to perceived relative value.Most investors do not think about P/E expansion as the lion’s share of the market’s gains. Instead, they credit a robust economy, technological advances, productivity gains, and (of course!) earnings improvement.All those elements did have an obvious impact . By my calculations, they were responsible for about 25% of the gains.But the biggest contribution of these elements was not to the bottom line; rather, it was to investor sentiment. This “fantastic four” allowed investors to rationalize higher prices: Aren’t stocks worth more if the economy is doing well? Doesn’t technology make companies more efficient? If workers are more productive, then earnings will be all the more better.While rational, these are hardly easily quantifiable data points.

Multiple Expansion and Mean Reversion

So what does this have to do with this year’s market performance? Nearly everything.Do not forget that the process works in reverse, as well. Post-crash, there is an increasing unwillingness to pay more for a dollar of earnings. Indeed, that’s why we are seeing the market making so little progress, despite all the “good data.” Investors are unwilling to pay more for earnings. The machinery is spinning furiously simply to stay in place. Without share buybacks and dividend increases, market performance would be much worse.This is the psychological issue referenced above. Why worry about corporate malfeasance, earnings misses and bad management? Instead, fix up your home and watch it appreciate! And, it won’t get marked to market every day (less stress), and, unless you live near a toxic waste dump, it won’t go to zero.This explains how sentiment affects multiple compression. But does this process have a mathematical explanation?Yes: Mean reversion is the process by which earnings ratios oscillate above and below its long-term average. And markets do not seem to stop on their means. Instead, they swing wildly above and below.The accompanying chart shows we have been way above the historical averages for P/E ratios. From 1955 to 2005, the median P/E was 17. Stocks may not be terribly expensive at present, but they are hardly cheap by historical measures. An even more discouraging analysis comes from Clifford Asness of AQR Capital Management. He calculated the P/E ratios for the entire market from 1871 to 2003 at about 11. That suggests stocks are even less cheap (or more expensive) than is implied by our measure of “only” the past 50.

Source: Mike Panzner, Rabo Securities

Whether you take the 50- or the 132-year perspective, the theory of reversion to the mean implies that stocks likely will become even cheaper as P/Es revert to the mean — and then overshoot.P.S.: I know “P/E mean reversion” has been the mantra of the permabears since the bubble burst (if not prior), causing most to miss the rally from the October 2002 lows. But that doesn’t mean they’re entirely wrong or that the theory should be dismissed.Over the long term, I do believe P/Es will ultimately revert back to average levels, after falling below for a period. But there certainly are going to be short-term opportunities within the longer-term reversion cycle and, unlike the permabears, I’ve made various bull/bear calls such as here and here.Despite accusations from critics and inflammatory headline writers, I am not part of the “Cult of the Bear.”

Forthcoming Conclusion

In part 3, I’ll tie together the top-down approach from part 1 and the technical factors discussed above to show how I got to my 2006 forecast of Dow 6800 and S&P 880.



Originally published at the on Jan 9, 2006.


Cult of the Bear, Part 2, 1/9/2006 7:12 AM EST

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