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Do Bull Market Rules Apply? at Trader’s Narrative




Do Bull Market Rules Apply?


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Yesterday we looked at what happens when the S&P 500 is this far above its long term moving average. If you haven’t yet read that, click on the previous link and read it first because then what follows will make much more sense.

As you’d expect, when the stock market is stretched 20% or more above its 200 day moving average, it has a hard time continuing such a heady move. Instead, we find that the market pauses or retreats in the short term (1 to 3 months). But as Barry pointed out in the comments, there is a difference to how the market behaves in a bear market rally and a real secular bull market. With that in mind let’s analyze the data further.

If you looked at the historical data table that I showed outlining the previous extremes you probably noticed that 4 out of the 13 instances occur very close together in late 1982 and early 1983. This was, of course, the launch pad of the super bull market. The S&P 500 closed at 102.84 on August 10th 1982 and never looked back.

So naturally, there is a cluster of data points (chart below) as the market went on a rampage. This also explains why the 6 month period returns are so inordinately high:

1982 launch of bull market SPX relative to 200 d MA

That’s a lot of red marks! Between January 1st, 1980 and June 30th, 1983 there were 28 days when the S&P 500 was above its 200 day moving average by at least 19.5%.

If you look at the chart carefully, you’ll notice something remarkable. Even in such a super-strong bull market, this simple indicator is still able to identify short term tops in the market. But in the intermediate term, the market simply ignored any and all overbought signals. And eventually, by May 1983, they were’nt even able to mark a teeny bit of a correction. After all, in a strong bull market, ‘overbought’ is meaningless.

The question then is, are we about to see something similar? That is, do bull market rules apply? will this most recent extreme be simply the first of many? will the stock market simply ignore each and every one as it goes on yet another rampage the way it did in 1982?

No one knows of course. But personally, I think such a scenario to be highly improbable. It just wouldn’t make sense to expect a repeat of the 1982 experience. For one, we do not have the volume to fuel such a move. Second, and most importantly, we do not have the valuation.

robert shiller irrational exuberance book coverI know, I know, fundamental analysis is for chumps. But I’m not talking about trying to game next quarters earnings estimate. I’m referring to the aggregate valuation of the market. Something for which we have much evidence to indicate excellent predictive value in the long term. For details, I refer you to Shiller’s excellent book: “Irrational Exuberance“.

Let’s pretend to ignore that the market has never rallied 60% in 6 months before. Let’s also ignore that never before has it performed even remotely close to that when the unemployment rate was this high. And ignore that corporate insiders are selling like lemmings. That sentiment is way too optimistic. That 95% of issues closed above their 200 day moving average (and 93% above their 50 day moving average). Even if we brush all of that and more under the rug, we can’t ignore how expensive the market is here:

  • the trailing P/E (for operating earnings) is 26
  • at the onset of the bear market in October 2007, it was 19
  • the trailing Price Earnings ratio is 184 (reported earnings)
  • on October 2007 it was merely 23 (in October 1987 it was just 20)
  • the price to dividend ratio (click for chart) is at 53
  • on October 2007 it was 55 and way back at the start of the super bull (1982) it was 16
  • based on one year forward (operating) earnings the P/E ratio is 16 - highest in 5 years
  • on October 2007 the forward est P/E was 14 (same as on Oct 1987)
  • Price to Book ratio is 2.3 - August 1982 it was below 1 (discount to book)
  • based on recent Tobin’s Q analysis, the market is 40% overvalued

While the market is a forward discounting mechanism, there is a limit to how much and how far ahead it can do so. Arguably, at these prices, the stock market is discounting the next 3 years operating earnings (2012). Historically, the market faces strong headwinds when P/E reaches 25. The average 1 year return at that valuation (or higher) is -0.3%. (All valuation data sourced from David Rosenberg’s invaluable research at Gluskin Sheff).

All of the above leads me to conclude that the most apt script is the one we’ve seen before many times in the aftermath of secular bear markets. While the performance of the stock market since March has been more than impressive, the stage is not otherwise set for the launch of a secular bull market.

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9 Responses to “Do Bull Market Rules Apply?”  

  1. 1 Nick

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    Perhaps the current stock market is similar to the dot com mania in the late 1990s. Many investors at that time didn’t care about the P/E ratios or the fact that many companies they were buying never made any profits. They only cared about the fact that stock prices were going up. And they were happy with their paper profits.

    In a real bull market, stock prices keep going up because company earnings keep going up. While in a speculative bull market, stock prices keep going up because stock prices have gone up. Both are bull markets. And both go up a lot. But the long-term outcome is very different for these two types of bull markets.

    Real bull market gains are real. Because companies are earning lots of real money. It makes sense for investors to stay invested for the long-term and collect their dividends from good company earnings.

    Whereas speculative bull market gains sooner or later disappear, when the money runs out and speculators can’t drive stock prices any higher. With high P/E ratios, it doesn’t make sense for investors to stay invested for the long term. They can get a better return with a lot less risk by investing in US government bonds. And that’s why they sell like crazy, when stock prices stop going up.

  2. 2 tradeking13

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    @Nick

    Yes, but the late 90’s was a time of prosperity: low unemployment, wage growth, exciting new technologies, etc. Plus these companies were seeing revenue growth. So, there at least was a semblance of a fundamental argument.

    Today we have high unemployment, a deleveraging consumer, stagnant revenue and earnings growth, a retiring baby boomer population, etc. Plus retail investors have seen two 50% drops in the stock market in the span on 10 years (Twice bitten, thrice shy?).

    With that said, this trader’s market can continue to go up as trader’s buy simply because the market is going up.

  3. 3 wayne

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    Good Morning Guys

    One of the interesting aspects of the market is the fact that everyday when the bell rings, we close at a price in which half the participants are willing to purchase the market and half the participants are willing to sell it. Each side of the equation has 100’s of statistics to support their case. The internet provides us with great forum to espouse our support of whichever of those statistics support our case. If we choose, we don’t even have to post our name, since all of us will eventually be wrong at some point and in case we are right, we can come back and quote our post a year later. But regardless, I’ll participate again today.

    Mr. Rosenberg (im assuming, he is the author) writes a very professional piece with well supported statistics. There is a very good chance that his bearish position is justified. To play devil’s advocate, I provide the following comments for thought. Most daily readers know my position on the tape, seasonals, and such, let me take 15 minutes to give you my comment on earnings.

    As Mr. Rosenberg alluded, there are probably some traders/investors out there who have made a living trading index valuations, but I’m not sure I know any of them. Most of such creatures were correct between 1997 and 2000 when they argued that the market was overvalued but were put out of the game long before they were proven correct in 2001-2002. In early 1974, the market looked incredibly cheap (PE’s 10), PE’s gravitate toward the 10ish area. You could do the regression analysis to show what a fair PE is when interest rates are zero, but since there isn’t a lot of past data to draw such conclusions the answer is somewhat questionable. But sensibly, we can argue that a fair PE for stocks when interest rates are zero would be somewhere in the highest range (25-30) of historic PE’s. My expectation is that the worse for earnings is over, but that’s not my area, but if we assume a very expectation that earnings will average 10 a quarter over the next 4 quarters, the current PE would be 1072/40 = 26.8, (using very conservative estimates for Earnings.

    Gotta pay some bills, have a good one.

  4. 4 wayne

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    Babak, a couple of lines edited out , needed for clarity.

    In early 1974, the market looked incredibly cheap (PE’s 10), PE’s gravitate toward the 10ish area.

  5. 5 Steffen

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    As you do, I also compare the current situation rather to the aftermath of the oil-crisis shock low of 1974. Stocks also rose very fast in that period, the S&P500 also made 50% in half a year, and it also happened that the SP500 was 20% above its 200 MA. A secular bull market should start not earlier than 2012, more likely around 2015.

    Also from a fundamental view, I favor the 1937/1974 scenario over the 1982 scenario. The economy is in the middle of a transformation phase; the major innovation cycles (especially in information technology) come to an end; and there is not yet any clear indication what the next major innovation might be. Perhaps alternative energy systems; but this technology was quite hyped in the last years.

    5-7 more years of turmoil to be expected, but turmoil where one needs to keep his eyes wide open. Microsoft was founded in 1975 and had its IPO in 1985. Remember, this stock proved to be a “thousand-bagger”. Mid/Long-Term investors jump with joy when they have a “ten-bagger” in their portfolio.

    1974 and 1982 also seemed to differ psychologically. When I read reports from that time, 1974 was a staggering shock (like the late year of 2008); 1981/82 was no shock, but the stock market was seen simply with sheer disgust. The late 70s were also the period where left-wings became more radical; something we might see in the next years.

    So when somebody now is not too old, keeps his head cool, and brings a lot of patience, he might be able to retire as a rich man. It’s very interesting that everybody is now shunning “Buy and Hold”. Might be an indication that in the not to far future we will get again a period where you just need to “buy stocks, buy more at market corrections, and otherwise go to sleep”, like it was from 1982-1999. Wait until everybody just shakes his head on the crazy idea of buying stocks, and when Marxism is seriously discussed as an alternative economical system. Then the next secular bull market should be raring to go.

  6. 6 bob j

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    Hi,

    Both 1974 and 1982 were periods of very high inflation and much lower stock valuations unlike 2009. Maybe 2009 is fair value.

    Both 1974 and 1982 were post recession just like 2009.

    I believe ( I could be wrong here) that neither 1974 or 1982 had a credit crunch or a credit crunch as severe as 2008/2009.

    Debt is much higher in 2009 then in either 1974 or 1982.

    All three periods (1974, 1982, and 2009) are seeing explosive technical rebounds.

    A major difference is that 2009 is in a era of hedger funds,derivates and other forces which can distort historical comparisons to either 1974 or 1982.

    Unlike either 1974 or 1982, both fiscal and monetary stimuls in 2009 is unpreceedent which provides a bandaid over both the debt and credit crunch differences.

    My opinion is that this is a bull market. Dont fight the tape or the Fed/US Treasury. How long it lasts is another story however.

  7. 7 fouad sayegh

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    How can the market be overvalued according to the Q Ratio when the ratio is at .781 ? My understanding is that it has to be above 1 for it to be ovevalued.

  8. 8 Babak

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    fouad, yes, but where are you getting that number?

  9. 9 fouad sayegh

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    Line 35 divided by line 32 , as you explained it.

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