Stock Bull Topping
Adam Hamilton October 19, 2012 2653 Words
With the US stock markets near major multi-year highs, traders are naturally very optimistic. Predictions abound for a continuing advance to new all-time highs. But behind this happy facade, the secular picture is actually quite bearish. The powerful stock bull of recent years appears to be topping in recent months. This means the odds are ballooning that a new bear market is being born or soon will be.
Few, if any, things are more important for stock investors to understand than the bull-bear cycles. They can only be ignored at great peril. Investors who refuse to study them inevitably end up buying stocks at the wrong times in these cycles. And that derails their wealth-building progress for many years. For example, today the US stock markets remain lower than they were in March 2000 over 12 years ago!
As stock markets march ever forward through time, they perpetually alternate between bulls and bears. The worst time to buy stocks is when these bulls are topping, as bears inevitably follow. And it is just such a major bull-market topping that is almost certainly underway today. So investors need to be very wary of all the recent complacency and greedy hype, as the bull-bear cycles argue this bull is ending.
Yes, cycles plural. There are two separate bull-bear cycles that are equally important, secular and cyclical. As the word itself means long periods of time, secular bull-bear cycles are the overarching strategic ones. Incredibly one full cycle (bull and bear) lasts a third of a century. I call these Long Valuation Waves. The first 17 years or so are a secular bull, the second 17 years or so a secular bear.
And it is in this secular-bear second half where the stock markets now languish. Todayís secular bear began when the last secular bull topped in March 2000. So we are now roughly 12 years into a 17-year secular bear. Secular bears exist because stock valuations get too extreme near the ends of secular bulls. So during these bears stocks grind sideways long enough for earnings to catch up with stock prices.
But alternating within secular-bear consolidations are the smaller cyclical bull-bear cycles. They are much shorter, lasting a few years or so each. It is these shorter cycles that make secular bears so profitable to trade. Cyclical bears cut stock prices in half, and then cyclical bulls double them. So prudent investors can sell high when cyclical bulls top, and later buy low when cyclical bears bottom.
All this secular-cyclical stuff may seem confusing at first, but a good chart makes it crystal-clear. This first chart looks at todayís secular bear as rendered through the lens of the flagship US stock index, the mighty S&P 500 (SPX). The last 13 years or so are rendered in blue, superimposed over the preceding SPX secular bear between 1966 and 1982 shown in red. The bull-bear cycles are readily apparent.
Way back in March 2000, seemingly an eternity ago, the last 17-year secular bull topped when the SPX hit 1527. Though investors were greedy and euphoric then, expecting that bull market to power higher indefinitely, stock valuations were at bubble extremes. But all throughout market history, secular bears have immediately followed secular bulls. And indeed right when least expected, todayís bear was born.
Though secular bears are gigantic sideways grinds, they always kick off with a shorter cyclical bear. And indeed over the 2.6 years between March 2000 and October 2002, the SPX lost 49.1%! The stock markets had been literally cut in half, the SPX falling to 777 at worst. Investors who foolishly bought stocks in early 2000, right when it felt like the best possible time, were ripped to shreds by that cyclical bear.
But the bull-bear cycles dictate that cyclical bulls always follow cyclical bears. So out of those cyclical-bear lows in late 2002 a new cyclical bull was indeed stealthily born. It would ultimately power 101.5% higher over 5.0 years, doubling the SPX to 1565 by October 2007. Yet again at that last major topping, investors were greedy and euphoric. They expected stocks to rise forever, complacency ran rampant.
But with the SPX back near the levels where its secular bear began nearly 8 years earlier, a cyclical bear was due. And that one was a doozy, greatly accelerated by a once-in-a-century stock panic. By the time the dust settled only 1.4 years later, the SPX had plummeted 56.8%! It was essentially still cut in half, though that epic fear super-storm pummeled the SPX lower than a normal bear would have to 677.
Cyclical bulls follow cyclical bears, so from those panic ashes a new cyclical bull was indeed born. And coming from excessive lows, it would more than double the stock markets again. Over the 3.5-year span running to just last month, the SPX blasted 116.7% higher! And that brings us to where we are today, what is almost certainly the third major bull-market topping witnessed in this secular bear.
See the obvious secular-bear pattern here? A cyclical bear cuts stocks in half, then a cyclical bull doubles them again. At best the stock markets trade near their preceding secular-bull top that birthed the secular bear, and at worst they trade near half those levels. This recurring cyclical bull-bear-cycle pattern has carved major secular-bear resistance near SPX 1500, and major secular-bear support near 750.
And we are awfully close to that bearish 1500 upper resistance today! Last month after the Federal Reserve launched its highly-anticipated third round of quantitative easing, the SPX climbed to 1466. This was the best levels the SPX had seen since December 2007, just a few months after the last major cyclical-bull topping. In September 2012, the US stock markets were trading at a staggering 57-month high!
Itís no wonder investors are excited today with stocks near 5-year highs. Somewhat paradoxically since the core mission of investing is to buy low then sell high, investors love buying stocks high after major bull runs. And a 117% cyclical-bull market since early 2009 is a massive run by any standard. But it has catapulted the SPX to the top of its secular trading range, to the limits of this secular bearís tolerance.
After the mighty 17-year secular bull failed near SPX 1500 in early 2000, and the first cyclical bull of this secular bear failed near 1500 in late 2007, why should we expect a different outcome for this latest cyclical bull? We are still mired deep within a 17-year secular bear, only about 3/4ths of the way through so far. And this 117% cyclical bull has already been considerably larger than the expected doubling.
Market history is crystal-clear, as this chart drives home. The 17-year sideways grind of secular bears consists of an internal oscillating series of cyclical bulls and bears. After a cyclical bear a cyclical bull is due, and after a cyclical bull a cyclical bear is inevitable. This pattern couldnít be simpler, bull, bear, bull, bear. And since the last few years have enjoyed a massive cyclical bull, a cyclical bear is next in line.
And the stock marketsí position within these bull-bear cycles and the SPXís giant secular trading range between 750 and 1500 certainly isnít the only argument for a major bull-market topping being underway. Other critical indicators corroborate this, including the duration of todayís cyclical bull and the stock marketsí current valuations. This bull is way older than average and valuations remain far too high.
The previous chart had zeroed axes so the cutting in half by the cyclical bears and subsequent doubling by the cyclical bulls wasnít distorted visually. This next chart zooms in for a higher-resolution view of the past decadeís secular bear and the cyclical bears and bulls within it. Neither bulls nor bears last forever, and todayís cyclical bull has already defied the odds to grow much longer in the tooth than its peers.
Every secular bear is a sideways grind consisting of internal cyclical bears and bulls. And the best way to gain insights into how long these cyclical moves last is through past precedent. So this chart looks at the durations of every cyclical bull within the last two secular bears, todayís and the one that straddled the 1970s. Excluding todayís, which we are trying to game, there have been 5 other ones in modern times.
Their average duration was 34.8 months. A typical mid-secular-bear cyclical bull tends to run for just under 3 years. Provocatively as of its latest mid-September high, our current cyclical bull was already 42.3 months old! It is already much older than average, increasing the odds that it is imminently due to give way for the next cyclical bear. The markets abhor extremes, so they often spark big mean reversions.
The older any move gets, especially beyond typical durations, the higher the probability for a major reversal. And todayís cyclical bull is long in the tooth, already thriving well past the average life expectancy of its peers before it. When this old age is coupled with this cyclical bullís bigger-than-average gains and proximity to the SPXís 1500 secular-bear resistance, the topping case is compelling.
And valuations push it into overwhelming territory. Remember that the whole reason secular bears exist in the first place is to bleed off the excessive valuations of the preceding secular-bull topping. So secular bears typically drag general-stock-market price-to-earnings ratios from above 28x when the bear starts to under 7x before it gives up its ghost. Long-term fair value is halfway in between, at 14x earnings.
Incredibly the SPX was trading at 43.8x when this secular bear started in early 2000, deep into record bubble territory! And though great progress has been made in letting stocks grind sideways long enough for corporate earnings to catch up with prices, the SPXís collective P/E has never come close to a bear-ending 7x yet. Not even during the worst levels of this secular bear, driven by 2008ís stock panic.
Heading into the primary stock-panic low, the SPX was trading at 13.0x earnings at the end of October 2008. And approaching the subsequent March 2009 secondary low, it was still way up at 11.6x. This is much closer to 14x fair value than the 7x cheap levels that mark the ends of secular bears. And just after this latest new bull high last month, the SPXís P/E had once again soared back up to 19.8x earnings.
The job of a secular bear is to maul stocks from extremely overvalued levels to extremely undervalued ones. And despite more than 12 years of stock prices grinding sideways at best, and being cut in half at worst, weíve never seen anything close to 7x earnings secular-bear-killing valuations. So this secular bear is far from over, having lots more work to do before it finally achieves its original and only mission.
Thus the bull-bear cycles make the case for a major stock-bull topping being underway very clear. Todayís cyclical bull is already much larger than normal, with gains far exceeding any of its peers in modern times. And it is already much older than average, increasing the odds it is due to roll over. And it is near the graveyard in the sky, secular-bear resistance around SPX 1500. And stock valuations remain way too high as well.
Against this ominous backdrop, the past monthís weak stock-market behavior is very telling. Remember that this cyclical bull originally topped way back in early April. But despite many easy attempts, the SPX couldnít break out to new highs for over 5 months. It wasnít until the major central banks started to try to goose the markets in early September that the US stock markets finally managed to make headway.
First the European Central Bankís bond-buying pledge arrived. For years the markets had eagerly anticipated the ECB buying up troubled European sovereign debt to keep high yields from exacerbating Europeís debt crisis. Yet even when the ECB pledged unlimited buying, the best the SPX could muster was a 2.5% rally over two trading days. This did finally push it to new bull highs, but that rally was weak considering the news.
And then a week or so later after the ECBís inflationary quantitative easing, the Fed satisfied the desperate and long-awaited desire for QE3. This campaign was open-ended just like the ECBís, exactly what the markets wanted to see. Yet the best the SPX could do after waiting well over a year for this very announcement was a 2.0% rally over two trading days. This was an extraordinarily weak response.
If you actively trade the stock markets, you know how big of deal the European debt crisis and desire for QE3 have been to traders. There was nothing they wanted more, hanging on every word any Fed official uttered since QE2 ended. There was no more potent buying catalyst possible! Yet after both the ECB and the Fed gave traders exactly what they wanted, the SPX could barely manage to rally. At best it was up just 3.3% over 5 months.
And since then the SPX has drifted sideways to lower, the third-quarter earnings season now underway failing to really impress anyone. When stock markets fail to react strongly to fantastic news (QE3), and canít manage to edge to new highs even on good earnings, they are topping. With pretty much everyone interested in buying anytime soon already deployed, the stock markets have simply run out of momentum.
And when buyers are tapped out, it doesnít take much of a spark to ignite serious selling. And there are lots of potential catalysts on the immediate horizon. Europeís problems are far from solved, the crises there could flare up again anytime. Meanwhile the global economy, including China, continues to slow. And the upcoming US elections are creating intense uncertainty, with the scary US fiscal cliff looming.
In light of all this, the powerful cyclical stock bull of recent years looks to be topping. Of course that means a cyclical bear is due next. So it is a very dangerous time to get caught up in the complacency, greed, and localized euphoria that marks any major topping. Buying most stocks now is buying high, not the recipe for success. The bull-bear cycles demand extreme caution during any major topping.
Provocatively, the one major proven performer during this secular bearís past cyclical bears was gold. This metal thrived through both episodes where the SPX was last cut in half, especially during the cyclical bearsí first halves before stock selling grew intense. Just coming out of deeply-oversold territory, gold is looking super-bullish today. So at Zeal weíve been loading up on cheap gold and silver stocks.
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The bottom line is the strong stock bull of recent years appears to be topping. It is long in the tooth, much older than average. It has also powered far higher than average, driving it up near bull-killing secular-bear resistance. And since stock-market valuations remain way too high to herald the end of this secular bear, it needs to reassert itself. And the recent topping behavior sure looks like this process is starting.
Cyclical bears within secular bears are not to be trifled with, as they mercilessly slash stock prices in half over a couple years or so. But not everything gets sucked into this selling. Gold actually becomes much more attractive during stock bears, an island of strength in a sea of weakness. And gold stocks generally follow gold higher, particularly earlier in stock bears before the selling grows more intense later on.
Adam Hamilton, CPA October 19, 2012 Subscribe at www.zealllc.com/subscribe.htm