Trader’s Narrative

There are a few frameworks we can use to build a model of the stock market. We’ve looked at the Weinstein stage analysis of the market and compared the previous bear market to this one. A recent Morgan Stanley report authored by Teun Draaisma, Ronan Carr, Graham Secker, Edmund Ng, Matthew Garman provides a more nuanced model.

They looked at 19 historical secular bear markets. Most of them were in equity markets around the world but they also considered one bear market in gold. Then they looked at what happens in the aftermath of each secular bear market. The report identifies 4 separate stages:

1. a decline which on average slices market valuation by half in a little more than 2 years
2. a rebound or counter-trend rally - taking prices 70% higher in 17 months
3. a shallow correction which lasts almost as long as the rebound rally
4. finally a trading range which lasts almost 6 years

Click to see full size:

Applying this script, the current bear market showed a 56% decline from its peak in October 2007. That’s perfectly within the historical parameters.

In the next stage, the S&P 500 climbed +53% from the March 2009 lows. According to the historical pattern of secular bear markets, we would have expect the S&P 500 to climb 70% from its low to 1150. But if it had followed this pattern, then it would arrive there by July 2010. However, the S&P 500 has managed to climb two thirds of its allotted 70% counter rally in only 5 months. So this rally is anomalous because its slope is much, much steeper than the average historical one.

The third stage is understandable as such a large move usually gives back a portion due to profit taking. But the next and last stage is the most interesting.

This is where the market has to finally digest the consequences of what initiated the bear market in the first place. A trading range or base building - according to Weinstein’s model - is necessary because it sets the stage for the next bull market.

Broad multi-year trading ranges followed the initial rebound in 10 of 19 bear markets. In most cases, structural problems in the real economy acted as a headwind to a new bull market…

During this moribund time in the market, structural pains such as inflation, deflation, inordinate debt levels, unemployment, etc. work themselves through the economy.

But for now, the consequence of this research is that the counter trend rally which we seem to be in right now can go on for much longer than most anticipate. Even if we do manage to climb the remaining 20% to 1150 on the S&P 500, the market can take its time until the summer of next year. The report concludes:

If the aftermath of these 19 secular bear markets is anything to go by, the current rally could go on a bit longer; is likely to stall a few months before the first Fed rate hike, which we expect in Q3 of 2010 … and is likely to be followed by some sort of trading range for years to come because of the structural problems of financial sector and household deleveraging as well as the poor state of government finances.

But as the study itself proves, while the past may rhyme - it hardly ever repeats.

Examples of the Four Stages of Secular Bear Markets
The following charts are 4 examples of individual markets which demonstrate the stages mentioned above. Notice that while the trading range may sound boring, on average they have a +50% width, making them extremely tradeable and lucrative. For example, the first instance, the 1930’s experience had a trading range of +/- 147%:
Continue reading ‘The Aftermath Of Secular Bear Markets’

Often it seems our analysis of the markets are like children looking at ants through a magnifying glass. So once in a while it is always useful to take a step back and get a long term perspective. The chart below shows the inflation adjusted Dow Jones Industrial Average since 1925.

There are a lot of lessons to glean:

• While the corrections in 1929 and 1964 were of equal magnitude, the latter took much longer to play out.
• The 1960’s top (previous resistance) acted as support and repelled prices to initiate the spring rally in March 2009.
• The Dow trades at less than twice where it closed at the 1929 top.
• After more than 40 years the Dow is only trading a trifle 30% above its 1964 peak (inflation adjusted).
• Finally, the Dow managed to rise 31% since the spring rally in March 2009 - that is amazingly a pinch more than the gain from the top in the 1960’s.
• The Dow has traded in a very wide and rising trading range - so if you are really really pessimistic, you could say we are headed to 4000 (eventually)

Source: Chart of the Day

To get a full picture, compare this to the (very long term) inflation adjusted chart of the S&P 500 index.

This is just a quick follow up. For further details see my first message from last summer on the I/B/E/S Valuation Model for the stock exchange.

What’s amazing is that according to this model, we are even more undervalued now. Pretty much as “cheap” as the bear market bottom in 2002. So, when a fairly good historical indicator goes totally berserk like this, it can be two things:

1. circumstances have changed (GIGO principle)
2. something real is going on

If you like the first option, you can trot out the 10 Year Note’s crazy low yield and blame it for the outlier result.

If you like the second, you can retort with, “Pshaw! We had the same rates in 2002 and look how far equities ran.”

In either case, it’s your call.

(FYI:I’m leaning towards #2)

I didn’t lose any money in the implosion of E*Trade, but I still wanted to take a look at what happened from a technical analysis perspective to see if I could pick out any warning signs.

Here is the chart of E*Trade Financial (ETFC) prior to any nasty stuff:

Meandering with a mazy motion and rangebound - as the moving averages show by flat lining.

Moving Averages Legend
The green line is the simple 50 daily moving average, the blue the 150 daily moving average, the red line the 250 moving average.

The next important event was on July 24th, 2007 when price approached, yet again, the floor of the trading range:

Ranges occur because people come to believe that above a certain price, a stock is too “expensive” and below one, too “cheap”. The longer a trading range remains, the more investors and traders become active participants. And the more participants, the more stop-losses which accumulate near the same obvious price points.

Lesson #1
When a range is pierced to either direction, the stop losses of one side are triggered and as the “wrong” side investors and traders scramble to limit the hemorrhage to their accounts, they in effect fuel the move… creating a strong trend.

Which is exactly what happened:

Lesson #2
The rest of the market wasn’t doing that well either at this time, so E*Trade wasn’t the only stock suffering - especially in the financial sector. But the important point is that E*Trade had no relative strength compared to the market:

Lesson #3
The warning signs were there: the “death cross” on the moving averages, the lower lows and the lower highs being carved on the chart as market swatted the shares around.

So it wasn’t surprising when the insult was added to injury and a massive gap down took the shares to the low single digits and talk of bankruptcy started to float about E*Trade like vultures:

According to technical analysis, the price itself was telling you to stay away from this (at least, from the long side!). The best thing you can do if you did lose money on E*Trade (ETFC) is to learn from the experience and apply it to the next trade.

No that isn’t a typo, I really do mean undervalued. And extremely is the correct adjective also.

Sometimes a graph just speaks for itself:

So what is this graph ?

It comes from the Institutional Brokers’ Estimate System (sometimes written as I/B/E/S) which started in 1976 for US equities and 1987 for international equities. IBES is a huge database that gathers the different estimates of earnings by stock analysts for the majority of U.S. publicly traded companies.

The IBES valuation model compares the 12-month forward estimate earnings yield (earnings/price x 100) of the S&P 500 to the current yield of the 10-year Treasury note.

Lets see how one would have done following its guidance:

• it got you in at the start of the bull market in the 1980’s
• it cautioned you just before the crash of 1987
• it flashed a warning again in late 1991
• but it was premature as the market dipped only a little bit and went much higher
• it got you back in in late 1993 which was during the plateau - just before another dramatic liftoff
• it told you to buy again when the market dipped in late 1995 (fantastic!)
• it signalled caution in 1997 which resulted in a sideways trading range 2-3 years
• it repeatedly signalled caution during the bubble years
• it told you to buy again in mid 2002 - almost the exact bottom of the bear market!
• it has remained stubbornly flashing a buy signal ever since