More Bear Market Rallies!

Adam Hamilton     March 8, 2002     3876 Words


What a week in the perpetually fascinating US equity markets!


Very exciting rallies erupted almost simultaneously in the ruling triumvirate of US equity indices, the Dow Jones Industrial Average, the NASDAQ Composite Index, and the Standard & Poor’s 500 Index.  Needless to say, the new strong multi-day rallies have already generated great excitement among equity investors.


The bulls, bless their hopelessly gullible hearts, were quick to announce that the bullish stock market action proved the US economy had finally eked out the fabled “V” recovery.  They breathlessly explained that the current stock rally is just the very tip of the iceberg of a coming great rally in equities now that they believe all the bear market nastiness of the past two years is finally behind us. 


As being a perma-bull allows one to blissfully ignore crucial stock-investing concepts like earnings, valuation, market history, bubble consequences, debt loads, and virtually every other fire-tested fundamental attribute that really drives markets over the long run, the bulls joyously frolicked in their verdant green meadows under a warm sun beckoning from glorious azure skies.  All was well in the world for the bulls this week!


While the bulls danced in ecstasy, the bears were fuming in their dens.  With day after day of large rallies in US equities, many bears covered their shorts to get out of the way of the speeding US equity train.  No sense being a martyr, they reasoned, just because mutual fund managers were gleefully throwing fresh Other People’s Money they received around month-end into the US equity markets by the bucketful. 


As usual when the markets rally aggressively, the action ripped a great schism through the heart of the bear camp.  Some of the grizzled old bears who were trading before 1982 and have actually seen a bear market or two with their own eyes just laughed at the equity rallies and patiently bided their time.  Some of the new bear cubs who grew up during the tech bubble, however, were quite disturbed and confused by the bullish equity action.  Could the bulls really be marshalling to stampede again?


As you no doubt already discerned from the very subtle and low-key title to this essay, I continue to find myself in this malcontent bearish camp.  Late last November I wrote an essay called “Bear Market Rallies” where we examined the NASDAQ scene since its bubble burst in March 2000 and compared this with the most notorious bear market of all time, the mega-bear following the infamous 1929 stock market crash in the States.  Surprisingly, the similarities between the two eras, even though vastly disconnected by the long threads of time, are overwhelming.


Bear market rallies are confusing for everyone, bull and bear alike.  Any large countertrend move in a major market almost inevitably throws investors off guard and raises legions of worries for market participants.  This is to be expected, however, as the “job” of the stock market is to keep everyone on their toes.  The great obstacle to successfully playing the markets is not divining the chicken entrails of the US economy or beating one’s competitor investors, it is the warring emotions lying deep in the heart of every speculator.


If you are bullish and the markets plunge, they can sow seeds of great doubt in your heart.  The warring emotions of greed and fear can lead you to make premature trading decisions not based on logic that you will regret later.  Same story if you are bearish and the markets roar ahead.  The greatest challenge in conquering the markets lies not without, but within, the brutal emotional battlefield that rages hidden inside every speculator.


Another signature attribute of bear market rallies that I discussed in my last essay on the subject is their abrupt and violent nature.  The biggest, baddest, most aggressive, and most spectacular daily rallies in market history are almost all bear market rallies!  It seems counterintuitive at first that the most exciting rallies actually erupt from deep within the bowels of bearish downtrends, but it does actually make a lot of sense.


As bear markets relentlessly crush equity prices ever lower, they have an interesting psychological effect on both the bulls and bears.  The bulls, with each passing day grinding down both the markets and their greedy resolve, eventually reach a point in time where their greed is crossing the knife-edge evolving into fear so they sell.  This pushes the markets even lower.  The bears, witnessing this same phenomenon, awake from their slumber with hunger in their bellies and bloodlust in their eyes.  They short the heck out of the markets with glee and stocks continue to fall.


But, inevitably, short-term sentiment waxes too negative and a bounce becomes overdue.  The bulls, at the first tentative signs of a bounce in a bear market, stop licking their wounds on the sideline and pour money into equities with a vengeance, driving up prices.  The bears, observing this action, immediately begin to cover their short sales for a profit by buying the same stocks as the bulls.  When combined, this bull and bear dynamic that coalesces at key short-term oversold points becomes a magnificently powerful force that can run up the markets to spectacular daily gains, record-breaking in both percentage and point terms.


The dynamics of the immensely powerful bear market rallies are unbelievably fascinating to study and observe in action real-time!


With the benefit of a strategic perspective longer than a day or two (the typical condensed news sound-bite attention span on BubbleVision), I believe the odds are overwhelming that the recent exciting equity market action is nothing more than garden-variety bear market rallies.  We built three new graphs this week, one for each of the major US equity indices in proper longer-term strategic perspective, to build on this bear market rally thesis.


A few technical notes before we begin… 


All the graphs in this essay are composed of daily market closes, ending Wednesday March 6th.  When we outline the number of days that specific rallies took to run their courses, we are talking trading days when the markets were open, not calendar days.


All P/E ratios discussed below are market-capitalization weighted-average P/E ratios that we calculate internally at the end of each month at Zeal and publish exclusively for our private newsletter subscribers.  Unfortunately, since even respected financial publications these days are partaking in the unacceptable fraud of using pro forma fantasies like the now fashionable “operating earnings” instead of rock-solid SEC-reported GAAP earnings in computing P/E ratios, we calculate them ourselves with GAAP numbers each month so we absolutely know for sure they are honest.  All the P/E ratios shown below are from the month-end closest to the extreme data point on the graph that each yellow P/E label is positioned next to. 


We also placed a yellow bar in each graph that outlines the period of time in 2001 when the most aggressive interest-rate slashing in the entire disastrous and mega-inflationary 89-year history of the private US Federal Reserve was perpetrated.  All fundamental and technical analysis aside, in order to provide even a shred of credibility for their mega-bullish thesis the bulls today have to adequately explain why interest-rate cuts proved absolutely futile contrary to their stellar expectations in 2001. 


We contrarians already know the answer, that history shows that nothing on earth can stop a post-bubble bust from fully wiping out the speculative excesses that created the bubble in the first place (see “Bubbling Interest Rates”), but the perma-bulls haven’t yet felt enough pain to be ready to admit it. 


As the elite Dow 30 seemed to be the center of attention for much of the rallying action this week, we will start our journey there. 



When one arrives home from work and hears that the Dow 30 was up 200+ points, it is easy to get excited.  The problem, however, is that a daily move or two taken out of context can be extremely misleading.  Viewing a single day’s or week’s market action as an isolated island in time instead of as a mere tiny component of a much larger market campaign is quite dangerous.  The trend is what is ultimately important, the sum of months and years worth of market activity, not a few exciting days.


In the broader context of the couple years or so of DJIA action shown above, the first thing that jumps out of the graph is the Dow’s very evident downtrend.  Since its early 2000 top, the elite US blue-chip index has only jumped out of its trend channel once, after the tragic events of September 11th.  Interestingly, even after that understandable negative divergence, the DJIA consolidated on its bottom support trendline, marked with the white-dashed circle above, before moving higher.  This bearish trend pipe has held remarkably well for two years.


One enormous rally in particular, which bounced off of the late March 2001 lows in the Dow 30 to advance up the whole trend pipe, is a perfect example of the breathtaking power and fury of a bear market rally.  We marked this rally as number “1” in the graph above.  Note that in 41 trading days, the DJIA rocketed up by 21%, an exciting achievement because technically a 20% gain is popularly believed to constitute a new bull market in equities. 


If at the time you had just looked at this large 41-day rally in isolation, it would have been very easy to be suckered in and eventually lose more than 20% of your risk capital when the bear market rally collapsed.  But, with the benefit of a proper longer-term strategic perspective, there were bright red flashing warning signs that this great rally was nothing more than a bear market rally and was not worth deploying scarce capital to the dangerous market frontlines to pursue.


First, the great bear market rally of spring 2001 in the Dow stalled at the very point that the top trendline of its downtrend would suggest.  Even back then you could have used the two previous Dow 30 lows to define the slope of a trendline and then apply that same slope of line to not only the bottom support side of the channel but the top resistance realm as well.  A failed assault on a top trendline in a bear market is incredibly bearish just as it proved to be in this recent example.


Second, much more telling than even the technicals, the Dow 30 fundamentals at the time were abysmal.  The rally began at a P/E of 25.6, vastly overvalued, and ended at a P/E of 27.6, even more vastly overvalued.  Fair value over the last hundred years or so for the DJIA is a P/E of 13.5 times earnings.  New bull markets almost always begin their stampede at an undervalued P/E, well under 10x earnings.  We have searched and searched the historical archives and to the best of my knowledge there has never in history been a new secular bull market that launched from a P/E over 25x earnings.


Fundamentally and technically the great DJIA rally last spring was nothing to wax ecstatic about, yet untold legions of investors, led by the shameless carnival barkers at BubbleVision, were severely burned by taking this bear market rally out of strategic context.  We think a similar mistake is being made today.


Rally “2” above marks the current fantastic DJIA rally, already up 10% in 23 trading days.  But, looking at the long-term chart above, today’s Dow spike is right in the middle of its bearish trend channel.  There has been no breakout thus far and we are not even really close to the breakout level yet.  Technically the current bullish action is not impressive and looks exactly like another spectacular bear market rally that, like the mythical Sirens of Homer’s Iliad, simply exists to entice more gullible perma-bulls to their doom on the jagged rocks of the primary bear market trend.


Fundamentally, with today’s fast Dow rally trading at around 40x earnings, far more overvalued than even the spring 2001 Dow rally, there is virtually no chance that this present rally will evolve into a new bull market.  The legions of ebullient Dow 20,000 folks out there are either smoking crack or they have no concept of market history and how the ultimate long-term driver of stock-market valuations is always earnings.  In addition, the psychological gravity of big round numbers is overwhelming.  It took the DJIA 26 years to forever banish the Dow 100 level and 17 years to leave Dow 1000 in the dust.  Will Dow 10,000 prove to be an exception to this historical phenomenon?  Only time will tell.


The wonderful Dow 30 rally we witnessed this week, while certainly exciting, looks like nothing more than a typical bear market rally.  Unless this thing miraculously bursts out of its heavy primary downtrend and consistently trades over 11,000 for a month or so, there is yet no reason to suspect it is anything other than just another dangerous bear market rally. 


Caveat emptor, long-term Dow 30 investors!  You are fighting the trend, history, fundamentals, and reason by being long the Dow for anything other than a very short-term trade at this moment in time!


I can understand why people can grow excited about a Dow rally, as the DJIA has seemed relatively strong in the last two years of brutal bear market action.  But, as we approach the second anniversary of the great NASDAQ bubble burst, it blows my simple mind that anyone can bother growing excited about the NASDAQ before the bust fully runs its course.  NASDAQ truly has become the graveyard of fools, just as classic post-mania busts before it.



Unlike the Dow, no sane person on earth can argue that the NASDAQ is not in a brutal bear trend and in a world of hurt.  I recently wrote an essay called “Trading the NASDAQ Bust” that dug into the current sorry NASDAQ situation in more depth and compared it to the 1929 stock market disaster in the US.  In that essay, we elaborated on the readily evident NASDAQ downtrend outlined in the graph above by the red-dashed lines and discussed a few possibilities to profit from trading the NASDAQ bust.


Not surprisingly, the greatest rallies in the entire 31-year history of the NASDAQ have erupted in the midst of the primary bear trend since March 2000.  Watching the NASDAQ today, a crippled market in a very rare post-bubble bust, is an incredibly educational experience about the raw power and fury of bear market rallies.  The experience of witnessing these monsters temporarily burst forth from the NASDAQ ashes like a doomed Phoenix is far more revealing and enlightening than reading a dozen books on the great bear market rallies of the past!


Note rally 1 in the graph above, a very sharp 9% gain in six short days.  That rally soon collapsed like all bear market rallies, but rally 2 quickly stepped up to the plate with another 9% gain in only nine days.  While no doubt exciting at the time, was this action bullish?  Obviously not with the benefit of 20/20 hindsight!


At around a level of 1638 in early April 2001, the NASDAQ put in a temporary bottom at a breathtaking P/E of 47.9, far, far overvalued.  As it reached the summit after its oversold bounce back up to ultimately define its new trend channel, the NASDAQ was trading at 74.8x earnings, an absurd level by all conceivable measures.  Just like in the physical world, the financial world also has a form of gravity, valuation, that cannot be circumvented for long without vast inputs of new force (money) to keep the levitation act going.


The two subsequent sharp bear market rallies after this interim NASDAQ top were doomed for two reasons.  First, they occurred in the midst of a primary bear market trend after a once-in-three-generation speculative mania.  Both rallies failed to pierce the trend channel and they each reached lower highs and subsequently collapsed to lower lows.  Early last summer, as I wrote at the time, there was no technical reason to get excited about the bear market rallies.  Second, when the hellishly distorted fundamental picture was added to the technical woes, the probability reached near certainty that the primary bear trend was strong as ever and the bear market rallies would collapse.


Our current high-profile NASDAQ rally, “3”, has rocketed up by 10% in 9 days, very impressive when viewed out of the strategic context of a longer-term chart.  But, once again, fundamentally and technically, there is no reason yet to be excited about this particular bear market rally.


Fundamentally, the NASDAQ swoon post-9/11 took it down to a P/E of 32.2, very overvalued but at least approaching the rational realm under 20x earnings once again.  But, as Alan Greenspan, for the umpteenth time in his mega-inflationist career, cried “Moral hazard be damned!” and started pumping fiat currency into the US economy at spectacular rates to bailout stock investors, the NASDAQ P/E was soon carried up through the stratosphere once again to reach 65.6x earnings near the most recent top. 


New bull markets, even in the hyper-speculative NASDAQ casino, are never launched with stocks trading at a level where, all things being equal, it would take them 65+ years to earn back the price that investors were being asked to pay for them!


Technically, this latest exciting NASDAQ bear market rally is well within the primary bearish trend channel and has not yet come close to breaking out.  For a significant breakout from this downtrend, we would need to see the NASDAQ composite consistently trade over 2000 for a month or so.  Odds are it ain’t gonna happen!


Just like the Dow 30 we discussed above, there are simply zero fundamental or technical reasons to get excited about the current NASDAQ bear market rally.  NASDAQ investors who are deploying their capital for any trade longer than a few weeks are risking disaster once again.  It is truly tragic that the long-suffering NASDAQ investors still haven’t learned the hard lessons of the past two years, that earnings and valuation matter and bubbles do have very serious and painful consequences. 


I am starting to believe that NASDAQ investors actually want to lose money!  They have had two long years since the great crash to do their homework yet they still fail to take the time to protect and defend their scarce capital!  Over the cliff like lemmings they happily go.


Finally, we will step back from the grisly NASDAQ carnage and take a quick look at the broader S&P 500 index, the primary gauge of the health of the overall US stock markets as measured by the biggest and best companies in the United States of America.



Out of all three of our bearish charts this week, this one is perhaps the most frightening of all.  Many investors today seem to think that the bear carnage is limited to just the tech darlings of the NASDAQ.  As the bold red arrow above shows, however, the venerable S&P 500 topped in 2000 and has been languishing in a very distinctive bear trend for almost two years as well, vaporizing trillions of dollars of investors’ hard-earned and scarce capital.


I am convinced that this classic S&P top will be studied by market historians for centuries to come as a perfect textbook example of a massive speculative mania top and the ill-omened harbinger of a major bear-market cleansing of speculative excess to come.


Locked in a major bear trend, even the enormous S&P 500 witnesses extraordinary bear market rallies, as noted by rally 1 above which tacked on 19% in only 32 trading days last spring.  Note above that the general S&P 500 downtrend channel, which although not as well-defined as the DJIA or NASDAQ downtrend channels, is still quite evident.  The S&P 500 P/E ratio also remains staggeringly high, with the flagship US broad-market index trading at 35.2x earnings as recently as the end of February 2002.


Interestingly, out of all three major indices only the recent S&P 500 bear market rally can possibly be viewed as a tentative breakout.  As is evident above, the S&P 500 bear market rally of recent weeks thrust it above its top resistance line.  We suspect that it will not last though, for a couple reasons.


First, general market P/Es are far too high for anything really bullish to happen.  True bull markets are never born at such high gravity-defying valuations, although spectacular and short-lived bear market rallies can erupt at any valuation.


Second, the S&P 500 broad index encompasses most of the large and elite Dow 30 and NASDAQ 100 stocks.  As the Dow 30 and NASDAQ 100 (about 66% of the total market capitalization of the entire NASDAQ composite) respective bear market rallies slam into their trendlines and then plunge back down towards reality, the S&P 500 will be pulled down with them since such a large percentage of the entire S&P 500 market capitalization is commanded by these almost 130 huge stocks that are members of both or even all three indices. 


Together the Dow 30 and NASDAQ 100 account for an amazing 49% of the massive $9,973b market capitalization of the S&P 500!  When the Dow 30 and NASDAQ 100 bear market rallies fail, the S&P 500 will be dragged down kicking and screaming with them.


The only way this current S&P 500 bear market rally will continue to trade above 1125 or so is if the Dow 30 and NASDAQ keep rallying, which is highly unlikely as we pointed out above. 


While the S&P 500 is now above trend, there is not yet any profound reason to suspect a significant breakout has occurred.  The S&P 500 bear market is still alive and well and mauling unsuspecting perma-bulls at will.  A mere pound of flesh isn’t enough for this malevolent bear, who will keep slaughtering and ripping limbs from the bulls until the S&P 500 ultimately approaches historical bottoming territory way down at a broad market P/E ratio below 10x earnings. That is a loooooong way down from here folks!


While the recent US equity action has certainly been exciting and has ensured that every market player is now wide awake, we don’t believe there are any fundamental or technical reasons to believe these rallies are anything more than mere bear market rallies.  Only time will tell whether we are right on our thesis or not, but we still believe that going long the US equity markets today is extraordinarily risky at this peculiar moment in history.


Unless the earnings of most of the major US corporations suddenly leap into the stratosphere to bring P/E ratios down to less anomalously high levels, unless the Dow 30 and NASDAQ both shatter the heavy top resistance lines of their downtrend channels and trade above them for a month or so, we believe that the best speculative bet to make by far on these current wild US equity markets remains on the short side.


This week’s exciting rallies look like classic bear market rallies, smell like classic bear market rallies, taste like classic bear market rallies, so they probably are, you guessed it, nothing more than bear market rallies.  Caveat emptor!


Adam Hamilton, CPA     March 8, 2002     Subscribe