R.I.P. Great Bear?
Adam Hamilton April 25, 2003 3391 Words
After watching the stock-market trading action this week, I have to admit my admiration for the bulls’ success. Not only did they extend the impressive war rally, but they managed to bid up the flagship S&P 500 to a fresh new multi-month interim high!
The rampaging longs have been humiliating the shorts lately, and I am one of these shorts being played for a fool at the moment. The high-probability sentiment-anticipated S&P 500 waterfall decline has gone Missing In Action and the falling VXN wedge defied convention and collapsed to the downside rather than breaking out to the upside. Amazing!
The stock bears, of which I am an outspoken grizzly, were flat-out wrong about the magnitude and duration of the war rally and the bulls have won the latest round in this speculation game hands down. Our sentiment research at Zeal painstakingly designed to catch major swings in stock-market action failed to anticipate the excellent war rally. I was also proven dead wrong in my recent belief that the March 21st highs marked the end of the war rally.
I am personally responsible and accountable for underestimating the war rally. I offer my heartfelt apologies to all of you who have honored me by reading these humble weekly rants on the markets. Our carefully cultivated sentiment indicators should have anticipated a rally lasting six entire weeks, but they strangely didn’t this time around. Nevertheless, this failure has given me and my team at Zeal much food for thought which we will use to improve our speculation system going forward.
Part of the great game of speculation is learning and adapting, of constantly absorbing new data and using experience to build market wisdom and savvy. One of my favorite things about the art of speculation is the constant learning and growing. As a lifelong student of the markets, even though my own open short positions have been mercilessly hammered since mid-March, I am still fascinated by the events that transpired and want to understand them.
There seems to be a growing belief that something really special is happening in the stock markets today. An increasing number of bulls are going on the public record boldly proclaiming that the October V-bounce marked the ultimate lows in this Great Bear market in US stocks. More and more folks, both professional analysts and talking heads, are proudly saying that the Great Bear which menaced the markets for three long years has finally been slain!
Is the Great Bear dead? Or is it Missing In Action, just resting for a little while and watching with malevolent glee as the overconfidence of the bulls continues to multiply?
The six-week war rally has been very impressive and the bulls deserve big kudos for pulling it off, but there remain serious issues plaguing the continued viability of this rally. While I nurse my unrealized capital wounds administered by this bullish thrashing, I believe it is far too premature and presumptuous to claim that the Great Bear is dead yet. For powerful fundamental and sentimental reasons, odds are the Great Bear will soon be back to play.
Since it was the impressive six-week war rally that led to the widespread rumors of the Great Bear’s demise, we must begin our journey there this week. The following short-term tactical chart of the war rally is indeed impressive, and the bulls deserve a big round of applause for playing this one on the right side.
Regardless of what your bias towards the long-term stock markets is these days, this is a bullish chart by any definition. The war rally which launched a few days before Washington’s apparently successful annexation of Iraq has soared towards the heavens in two primary uplegs.
The war rally’s first upleg managed to run up 12%, extremely impressive in such a short period of time. For you fellow market junkies who don’t mind cluttering up your brains with market trivia, this first war-rally upleg was quite memorable. The 8 green candlesticks in a row above heralded the greatest weekly gain in the US stock markets in over 20 years, since October 1982! In addition, it was the first 8-day-in-a-row winning streak since December 1998, when the stock markets were in an immensely powerful primary bull market.
This sharp initial upleg soon slammed into old Great Bear resistance at the S&P 500’s 200-day moving average and fell hard. This led me to wrongly assume that the war rally was over, a big mistake. The rally then pulled back to the S&P 500’s 50dma and then started relentlessly marching higher. This first interim low in the war rally created a short-term support line, shown in blue above, which has held rock solid since that day.
The second upleg in the war rally after this initial bounce wasn’t quite as compressed as the first, but it was still very impressive in its consistency. As of Wednesday of this week, the data cutoff for this essay, the S&P 500 war rally was up almost 15% from its mid-March lows. This bullish assault on fresh new short-term territory was enough to render me a nervous short this week, and I am not alone judging by the e-mails I am getting from my fellow bears these days.
The bulls have been quick to point out, and rightly so, that the most bullish development of this whole war rally surrounds the S&P 500’s 200dma, the black line above. This week’s trading action carried the S&P 500 to its highest levels above its all-important 200dma in this entire Great Bear to date! Not since early September 2000, when the S&P 500 was within spitting distance of its all-time highs, has the index exceeded its 200dma by 4.5% as it did this week! Three cheers for the bulls!
With all due respect to the recent success of the bulls, there is also another side to this war rally that you won’t hear about on CNBC. Technically, fundamentally, and sentimentally behind the scenes there are important issues of which all investors and speculators ought to be aware that seriously question the continued viability of this war rally.
While a 15% run in six weeks certainly sounds impressive on the surface, it really isn’t anything special within the context of our powerful primary bear market. As the graph below shows, there have already been no less than three separate S&P 500 bear-market rallies that have run up 21% in an average of 8 weeks or so each! A fourth major bear-market rally ran up 19% in only 6 weeks.
As of this Wednesday’s war-rally highs, impressive though they may feel today, this war rally is only the fifth most powerful rally in the entire Great Bear to date! As the first four major S&P 500 bear-market rallies that were more powerful than this one all failed, perhaps it is a bit premature to celebrate this 15% run as the end of the Great Bear! Provocatively, major historical bear-market rallies have tended to run for 6-8 weeks or so before they fail, so this war rally is definitely already growing long in the tooth by historical standards. Food for thought.
As a battered bear these days watching my short positions bleed, my next big focus is on the latest major S&P 500 interim highs of 939 reached by the last serious 21% bear-market rally off a V-bounce low in late November. If the bulls can stampede through these too, I want their autographs!
If the S&P 500 manages to close more than 2% or so above 939 in the coming weeks if this war-rally momentum continues, it will mark the first time in this entire Great Bear that a major interim high off a V-bounce failed as overhead resistance. The war rally would have to extend to +17% to pull it off. In light of this week’s exciting action it could certainly happen, as the bulls have been stampeding hard, but odds are it won’t. I am going to be biting my fingernails and watching S&P 500 939 like a hawk in the coming weeks!
The short-term tactical scene is always interesting, but the real game plays out over the long-term. Our next graph shows the S&P 500’s entire Great Bear market to date, with the tactical graph above highlighted in red at the bottom left. In multi-year strategic terms, the war rally is nowhere near as impressive as in multi-month tactical terms. Perspective matters.
In my twisted mind, the whole Great Bear market since 2000 swirls around one single all-important question. Does valuation matter or not? In 2000 we all heard about the “New Era”, where profits and dividends relative to stock prices were irrelevant because the old rules didn’t apply anymore in the Information Age. What a joke! Today the bulls are making the exact same argument, claiming that the Great Bear is dead because today’s extreme valuations don’t matter anymore. Déjà vu all over again!
The stock markets perpetually meander in both long-term and short-term cycles. Over the long-term Long Valuation Waves tend to dominate these cycles, with the markets oscillating from overvalued to undervalued levels and back over decades. Short-term emotional greed-and-fear cycles, the major bear-rally and subsequent downleg movements shown on the graph above, oscillate over weeks or months within these dominant Long Valuation Waves.
Forecasting the stock markets is a lot like forecasting the weather. Imagine a weatherman trying to make a forecast for tomorrow’s temperature but having no idea of which season he happened to be in at the moment. If he was in Alaska in the winter, but this fact somehow eluded him, he would look pretty silly forecasting a 90-degree day. The short-term day-to-day temperature cycles are utterly dominated by the long-term annual seasonal temperature cycle. Summer is warmer and winter is colder, and all-short-term day-to-day temperature trends occur within this overarching strategic seasonal context.
Similarly in the markets, the long-term valuation cycles, or seasons, dominate the short-term emotional movements. All short-term trading action, including the war rally, only unfolds within the context of the dominating Long Valuation Waves. From the early 1980s until 2000 equity valuations were rising to extremes, and in 2000 the expected mean reversion kicked in and now valuations will almost certainly fall until they reach historically undervalued levels once again.
As the graph above shows, the S&P 500’s lowest monthly valuation numbers to date in this Great Bear have been about 21x earnings with a dividend yield of 2% for the index. If the bulls are right that the Great Bear died at the October lows, this means that the S&P 500 will have bottomed at the highest post-bubble valuation levels in all of financial-market history. Possible? Perhaps. Probable? Heck no!
Real meaningful long-term valuation bottoms in history occur around general stock-market P/E ratios under 8x earnings and dividend yields over 8% or so! We aren’t even remotely close to these levels today and we certainly weren’t when the October V-bounce occurred either.
Any short-term war-rally prognostications made without considering the Long Valuation Wave mean reversion in progress are, in my opinion, like trying to forecast tomorrow’s temperature without knowing whether it is summer or winter. The bulls have managed an impressive short-term bear-market rally on pure sentiment, but can they continue to buck the all-powerful valuation-wave mean reversion for long? Odds are the massive strategic valuation waves will crush the short-term sentiment greed waves into powder as they have in the past few years.
Contrarian investors and speculators inherently understand this crucial concept of valuation, that the price you pay for any investment matters. Sadly, even after three years of horrific valuation-induced misery, the majority of investors still don’t understand the importance of valuation though. Every time I mention valuation the bulls bring up the worn-out ludicrously-low-interest-rates objection, which I really need to write an entire essay on in the future to thoroughly refute. For now though, here are some brief thoughts.
The bulls argue, “Sure, valuations are high, but this is ‘normal’ now since interest rates are so low.”
This particular bullish argument designed to ignore Long Valuation Waves is based on the so-called Fed Model of Valuation, which claims that “fair-value” valuations in equities are based exclusively off of the interest rates on long-term Treasury bonds. If you think that God created the world in 1980, this silly idea might make sense to you since during the early 1980s low valuations corresponded with high interest rates. But the moment you dig back deeper in history than only two decades or so the Fed Model rapidly implodes.
In the early 1950s, for example, the US stock markets traded at low valuations under 10x earnings and yielded dividends over 7%. Just as in the early 1980s these low valuations, a classic Long Valuation Wave trough, heralded a coming multi-decade major bull market. But, believe it or not, general interest-rate levels at the same time in the early 1950s were actually slightly lower than even today’s incredibly low rates!
That’s right, horror of horrors, very low equity valuations existed in a very low interest-rate environment! Since today we find ourselves suffering through the worst bear market since the 1930s, perhaps the bulls should consider valuations precedent farther back than merely 20 years ago. Myopia kills.
In addition, the Fed Model falsely assumes that the returns, and hence the risks, involved in stock and bond investing are equal. Stocks and bonds have dramatically different risk profiles in general and equity investing is far more risky on balance than bond investing. The Fed Model is utter nonsense, a weak rationalization for chronically overvalued markets in the 1990s.
The short-term war rally notwithstanding, as impressive as it was, the bulls still have the same type of serious valuation problem today that they had in 2000. Proclaiming the Great Bear dead today based on a six-week rally while not considering the fundamental overvaluation remaining in US equities is a dangerous strategy. History says that until the US equity markets are truly undervalued in historical valuation terms, the US Great Bear is far from over.
While long-term market behavior cannot defy the Long Valuation Waves, short-term market behavior can since day-to-day action is driven almost exclusively by popular sentiment, the powerful dueling emotions of greed and fear. Like the ugly overvaluation situation, the short-term hyper-greediness in the war rally today based on sentiment indicators like the venerable VIX also suggests that the war rally’s days are numbered.
As I explained in last week’s “Trading the Relative VIX” essay, the Relative VIX is designed to show current VIX extremes relative to a recent volatility baseline that we arbitrarily defined as the VIX’s 200-day moving average. The formula for computing the Relative VIX is simple, all you have to do is divide the normal VIX close by its 200dma and you arrive at the Relative VIX. A high Relative VIX signals extreme unsustainable fear and an imminent major rally, and a low Relative VIX signals extreme unsustainable greed and an imminent plunge.
As the war rally rocketed higher this week, the Relative VIX closed at 0.66, or 66% of the VIX’s 200dma, two days in a row! (And even 0.65 on Thursday, the third day!) As this graph shows, these extraordinarily low Relative VIX levels are bust-to-date record lows, highlighting a colossal greed extreme that we hadn’t yet witnessed in this entire Great Bear until this week. The VIX fear gauge is so unbelievably low today that it is practically heralding zero fear, a surreal state of complacency to be in, especially three years into the worst bear market since the Great Depression!
Provocatively, so far each time in this Great Bear when the Relative VIX has fallen down under 0.75, the S&P 500 ended up falling dramatically after each of these Relative VIX extremes as the lack of fear was too anomalous to be sustainable. The red zones in the graph above mark these low Relative VIX levels in the Great Bear. The phenomenal greed and complete absence of fear in the war rally has bludgeoned the Relative VIX down to unprecedented levels this week, an important development.
If the war rally is to run significantly higher, the bulls will have to miraculously figure out a way to short-circuit the normal greed-to-fear-and-back short-term emotional stock-market cycle. Today’s blind greed, which some folks say already rivals the 2000 market tops in terms of sentiment, would have to somehow be whipped into an even greater frenzy to keep the war rally rolling. Could it happen? Sure, anything can happen. Is it likely to happen? No way!
Interestingly, a Relative VIX level of 0.66 isn’t only extremely low in the context of this Great Bear, but similar levels have only been witnessed three other times in the popular index’s entire history! The VIX was launched in 1993 and back-calculated to 1986. I would like to write an entire essay analyzing the complete history of the Relative VIX in the future too, but for now investors and speculators need to consider just how incredibly rare such phenomenally low Relative VIX levels truly are.
In the last 12 years, there has only been one other single trading day with a hyper-low Relative VIX reading of 0.66. Since 1991 there have only been nine times when the Relative VIX approached the usual 0.72-0.73 bottoming levels I discussed last week, but the only other 0.66 reading occurred in July 1999, during the last stage of the powerful multi-decade primary bull market in US stocks.
On July 16th, 1999 the Relative VIX fell to 0.66 on the very same day that the S&P 500 reached 1419, an all-time-record high at the time. Provocatively, this low Relative VIX signaled such a silly greed extreme that the S&P 500 plunged by 10% over the next several weeks. Remember that this 10% fall occurred near the late-stage ultimate bubble blow-off after a phenomenal two-decade Great Bull market!
If an extremely rare near record-low Relative VIX 0.66 was a short-term bearish sign in 1999 during a Great Bull, how much more bearish is it today deep in the bowels of a brutal Great Bear?
So, in addition to the war rally having to contend with an overwhelming long-term valuation headwind, it is also fighting against the endless short-term emotional market cycles. Extreme greed, as we are witnessing today, is always the fertile breeding ground of major downlegs, not continuing sustainable rallies. The war rally was impressive, but can it defy the odds and keep running significantly higher when popular greed is already redlined?
If you are interested in studying all of our major sentiment indicators like the Relative VIX for yourself, I am planning on discussing about 10 of them in the upcoming May issue of Zeal Intelligence for our subscribers, to be published on May 1st.
I will discuss each indicator, how it works, what we learned about it during the war rally, what it is signaling to speculators now, and where to find it on the Web if you want to track it yourself. In these surreal times drowning in greed approaching the extremes of the 2000 bubble top, it is very important for all investors and speculators to monitor the fickle tides of popular sentiment.
A century ago legendary speculator Jesse Livermore said that the difference between gambling and speculating was that gamblers merely “hoped to win” while speculators know they “ought to win on form”.
It seems to me that the bulls are bucking long-term valuation and short-term sentiment cycles conspiring against them right now and purely gambling. They desperately hope to win, but they are playing a dangerous game trading against history and probability. The markets will not be mocked.
The bears, on the other hand, ought to win on form because they are cognizant of the grand strategic picture and aren’t trapped in short-term stock-market myopia and mania. The bears are betting with history and probability these days and will almost certainly win in the end.
Which trend do you think is more important? A 6-week-old 15% S&P 500 rally or a 37-month-old -40% S&P 500 primary Great Bear downtrend? The burden of proof remains on the bulls!
I respectfully tip my hat to the bulls who have been winning for six weeks now, but I sure don’t believe their fanciful tale that this Great Bear is dead!
Adam Hamilton, CPA April 25, 2003 Subscribe at www.zealllc.com/subscribe.htm