Bear Market Physiology

Lynn Carpenter gives us a history of bear market behavior…and reveals how the current one will end…

Something just happened in the United States that has never happened before, may never happen again and almost certainly won’t happen in the rest of our lifetimes: a 16-year bull market. It lasted so long that a generation of investors think that is normal. They are spoiled like grown-up children who still live at home and think someone else always buys the cookies.

Normal is a bear market, at least a 15% drop, once every three to four years. That is the way it has been in the United States since the Civil War. In the last 100 years, we have had 25, including this one. All totaled, they have lasted 32 years. Most lasted only six months to a year. A couple, including the big 1987 crash, were shorter. Up until now, the very longest ones came during the Great Depression. In four more months we will tie the big one from 1929-1932, and in five months, this bear will be the record holder.

In fact, until now, the pattern had been heating up. If you go all the way back to 1795, bear markets occur an average of once every seven years. There were few bear markets at the beginning, only 10 in our first century.

It’s no different elsewhere. The London market has gone bearish 42 times in 307 years, again an average of once every seven years. And again, the pace has quickened to once every four years in this recent century. The Germans have also enjoyed a bear every four and a half years, only their markets are much worse than ours and typically fall by much larger amounts. The average German bear eats 47% of market value, while American bears average a 32% bite.

According to Harry Shultz, who has been studying bears for 40-some years, all bear markets have at least two “legs.” Some have had as many as eight legs. But these “arachnid” bear markets are rare. Two to four legs is the norm. That’s what we must prepare for now – not so much the down legs, but the mini-breaks in the bear market, the rallies.

Even if we cannot predict with certitude when the next bull market will appear, we can predict one thing with a high degree of confidence: those rallies will come. The next rally could be the beginning of a new bull market (probably not; the S&P 500 is still wildly overpriced at a P/E of 34 and price to book ratio of nearly 4). It doesn’t really matter, because the same thing happens in a bear rally that happens in a new bull market: your stocks begin to rise as the indexes do – assuming you have good stocks, of course, not a basket of busted dot- coms.

That is when you sell out your dogs. With the S&P 500 down 25% for the year and the Nasdaq down another 37%, you are not going to get a good price today. You will get a better price on the next rally, if you can stick it out.

Let’s look at the worst market we ever had here in the United States, the secular bear from 1929-1942. Once the bottom was hit in 1933, most people left the market for good. Their losses were permanent. But those who stayed enjoyed a 100% market gain from 1933-1934 and a nearly 200% gain from 1935 to early 1937. Through the whole period, 1933-1937, the market rose nearly 400%.

As I was researching this market I came across some information that I had never seen before. I already knew that there had been strong rallies during the period; what I didn’t know was that those who stayed in the market and averaged down – continually buying stock through the whole ugly period – would have made 12.7% during the Depression, according to Vanguard research.

The 1929-1932 collapse was an exceptional bear market – longer and deeper than any other so far. But, historic as it was, that bear market was not at all exceptional in how it worked. Steep selloffs were punctuated by sharp intermittent rallies. The same pattern can be seen in the most violent bear market, the 1973-1974 Nixon bear that actually began with Mideast saber-rattling and ended with the Watergate cataclysm in 1973-1974, leading up to the president’s resignation. The market fell 44% over four years.

It was more decidedly downhill than the long bear of the ’30s, but it had its rallies too…a 15% gain from August of 1973 to November of that year, then another 25% gain from the bottom in November 1974 to January 1975.

Those two markets illustrate the extremes of the pattern, with the 1930’s bear being the bumpiest and most rewarding on the rallies and the 1973-74 bear being the most inexorably downhill with the smallest rallies.

The point is, once you’ve lived through a market that is down 75% like the Nasdaq is now, you’ve seen the brunt of it. This is not 1929 and it is not Germany. A lot of that decline was caused not by every stock but by a few particularly bad ones washing out. In the rest of the bear, it is now likely that most of the permanent or persistent damage will come to the remaining very bad companies and very overpriced ones. That doesn’t mean we will see rising prices from this point forward. It means we will be enduring scratches, not maulings. Right now, we only have surface wounds.

There are a few more things you should know about bear markets. According to conventional wisdom, bear markets tend to last half as long as the preceding bull market. Mathematically, this is true. The average bear market lasts 18 months and the average bull market lasts 3.1 years.

But there is no consistent pattern, no reliable relationship between how overpriced the market gets before the bear arrives and how long the cleanup bear stays around to eat the garbage. It takes as long as it takes depending on the mood of the times. The 1987 bear was over in three months. The 1929 bear lasted 33 months. But let’s compare similar cleanup jobs…

In 1946, 1961 and 1987 the market reached an average P/E ratio of 22 each time. The bear markets in those cases lasted 11 months, six months, and two months. In 1991, the P/E ratio reached a new all-time high of 27. That bear lasted less than three months. It takes as long as it takes. The end depends on psychology, not time passing.

Investors should always be prepared for bears. On average, the Dow suffers a 10% decline about once a year and a 15% decline during some period about once every two years. Any of those declines could be the beginning of an actual bear market.

About a third of the time, the recovery period is faster than the bear market. In other words, prices come back up to the old highs faster than they went down. When that happens, you surely don’t want to miss out. But most of the time, the recovery period takes about twice as long as the bear lasted.

When does the bear market end? Conventional wisdom has a pocketful of old bromides for this one, too…when the last bull capitulates. When no one wants to buy stocks anymore…I never did understand that one. If no one is buying anymore, then by definition there couldn’t be a rally. Come to think of it, the same is true of the first old saw. I don’t know when this bear market ends. But I can tell you some definite things to expect first:

1) Leaders get hit. The bear market doesn’t end when Amazon falls, it ends when the likes of Johnson & Johnson or 3M fall. The solid blue chips are the last ones to go.

2) Nobody in the official world will believe the rally. Someone is buying, but the financial media are still gloomy, predicting it won’t last. So far, each rally in this bear market has been met with a barrage of coverage predicting it was all over now.

3) There are 90% days – that is, days when the downside volume on the market accounts for 90% or more of the total activity (upside volume and downside volume together) and the points lost also exceed 90% of the total upside and downside points. This occurs at the bottom, but doesn’t predict the rally all by itself. For that, demand has to return. The rally kicks off with a 90% upside day as buyers finally get interested in the bargains again (thanks for this sign goes to Paul Desmond, winner of the Charles H. Dow Award from the Market Technicians Association and the Dow Jones Co. in 2002. He studied 69 years of data to find this pattern. It is probably the most reliable of the signs listed.)

When you see these things happen, you can welcome the bull back, or at least take a break from the bear. But unless you want to start buying only when prices start toward highs again, you need to be in the market to have something to sell. Bear markets are no fun. Unless you know how to use them.


Lynn Carpenter,
for the Daily Reckoning
September 5, 2002

Editor’s Note : Fleet Street Letter editor Lynn Carpenter will tell you: ‘I’m not easily convinced by anybody about anything.’ And maybe that’s the secret behind her sought-after series of investment reports and her trading service – The Contrarian Speculator – where she’s helped investors earn profits in everything from oil and steel to emerging technologies, defense stocks, Swiss annuities and commodities.

The world is deflating. The heat of summer is gone. There’s a coolness in the air…less zeit in the zeitgeist…an approaching gloominess.

And why not? People in the developed world are getting older. Winter is coming. And September is the worst month for stocks.

We can’t prove it; but we feel it. All around the globe, stock markets are selling off. And prices are either rising less rapidly than before, or actually falling. In America, consumer prices – depending on how you figure them – are barely rising. In Germany, they are falling. And in Japan, prices have been falling, off and on, for years.

‘But America is not like Japan.’

How so? Well, for one thing, we Americans eat our fish cooked. And we drink wine made from grapes.

But do the gods that rule markets and economies care? Maybe not. They may think that one bubble is the same as the next. And if the Japanese can be forced to suffer a 20-year bust…why not the Americans?

As reported in this space yesterday, the poor Japanese have just proven that long-term investing can take a very long time to pay off. The Japanese investor who bought stocks in 1983 has not made even a single yen from his money. Thirteen years after the bear market began, stocks are sinking to new lows…with the Nikkei Dow now down more than 75% from its high.

“But the American economy is more dynamic and flexible,” said a companion at a dinner party Saturday night after I raised the issue. (Your editor always likes to lighten up the conversation with references to Japan’s economic troubles…which makes him a favorite at any get-together.)

Dynamic? Flexible? Do the gods care about such things? Or are they just empty words, held up like the sign of the cross in front of a werewolf?

But don’t worry. The American economy is nothing like Japan’s. We Americans are taller. Eric, what happened yesterday? (Don’t miss your chance to see our intrepid Wall Street reporter on television. Eric will be appearing this afternoon on “Your World with Neil Cavuto,” airing from 4-5 pm est on the Fox network).


Eric Fry in New York:

– Following Tuesday’s debacle on Wall Street, the stock market picked itself up, dusted itself off and put on a brave face. The Dow Jones Industrials recouped about a third of Tuesday’s losses to gain 117 points to 8,425. The Nasdaq also rebounded a bit by picking up 28 points to 1,292.

– It was nice to see a few plus signs for a change. But we expect plus-sign sightings to remain something of a rarity. Stocks are still too pricey and the economy is still too sluggish.

– Yesterday we quoted a dead English novelist, today we paraphrase a dead English playwright, “Now is the summer of our economy’s discontent.” US corporations face at least one or two more seasons of discontent before any hope of sustainable economic growth will arrive.

– “We have not seen any improvement in the current IT spending environment,” griped Sun Microsystems CFO Steve McGowan last week. “In fact, some would say it may actually be worsening.”

– Falling share prices and sluggish IT spending aren’t the economy’s only problems. Some very important economic underpinnings are rotting away. Namely, manufacturing jobs. “The BLS estimates that manufacturing jobs represent 20% of the workforce,” Dan Denning points out. “From January 1999 to December 2001, 1.3 million manufacturing jobs disappeared. According to the BLS, nearly all these jobs had been held for a minimum of 3 years, making them ‘long-tenured’ jobs. Long-tenured manufacturing job losses accounted for nearly 30% of the total number of long-tenured job losses. In other words, manufacturing job losses are taking place at a disproportionately high rate compared to job losses elsewhere in the economy.”

– While many of the rank and file are being forced to file out the door with pink slips in hands, the higher- ranking folks are simply quitting.

– “Challenger, Gray & Christmas, a placement firm that keeps an eye on such things, reports that each and every day an average of three CEOs abandon their posts,” writes Alan Abelson. “At that rate, the government may soon be forced to declare CEOs an endangered species and mandate them off-limits to class-action lawyers and other predators.”

– Maybe so. On the other hand, would the extinction of the CEO species really be such a bad thing? Would we miss these devilish folks any more than we miss the Tasmanian Devil?

– “Investors have not yet come completely to grips with the legacy of the bursting of the bubble,” Abelson continues. “There are the devastated portfolios, to be sure. The scale of such misfortune boggles the mind and, as to the notion that the shock will be cushioned by the fact that house prices are going up and his house is now a consumer’s most valuable asset – give us a break. Does anyone seriously believe that $6-7 trillion down the drain will be shrugged off because the blown-out investors’ houses have appreciated in value?

– “For many investors nurtured on the fevers of the ‘Nineties, the adjustment could be difficult and, oddly, discouraging,” Abelson concludes. “If you’ve grown up in a circus, suddenly finding yourself in more decorous circumstances can pose quite a challenge…The bear market’s alive and well.

– I received some interesting comments recently from Agora’s own CFO extraordinaire, Bob Compton, about the essay I wrote for the Daily Reckoning on August 13th entitled “Thirst-Quenching Investments.” Here are a few of Bob’s “insider” observations:

“Eric, I read your recent essay in the Daily Reckoning with great interest. I am a CPA, and I was in public practice for over ten years. During that time I had the opportunity to work with many other CPAs and business leaders. As the years wore on and as I moved up the accounting profession ladder, I observed growing financial statement trickery…Unscrupulous CPAs can and do paint any picture the business owner desires. It just depends on the amount of paint the business owner is willing to supply.

“If I am a business owner and I don’t like what the CPA has to say, I will shop around until I find one who is willing to take my money and look the other way…The bottom line is, if you truly want to understand a business then you have to do your due diligence. Don’t just look at a snapshot in time. Instead, follow the business for a while and analyze its activities.

“I realize there is a perception that CPAs are there to protect the public, financial institutions, government, etc., but it is important to remember that the CPAs who prepare the financial statements are paid by the business owners…And that means, investor beware.”

– That’s good advice, even when the books aren’t cooked.


Back at Ouzilly…

*** Here’s something interesting from Richard Russell’s message board. Short term interest rates have fallen about 4% since Greenspan began cutting in January 2001. Lower rates are credited with having spared the economy a bad recession, making it easier for consumers to go further into debt. But there are two sides to every transaction, of course. And on the other side of the ledger from the consumers who pay less interest are the savers who receive less. One of Russell’s correspondents calculated that the lower rates have cost savers – mostly older, retired people – about $176.7 billion per year, or $484 million every day.

Low rates have helped consumers buy things they didn’t need with money they didn’t have; they have also prevented savers from buying things they might have wanted with money they should have had.

*** A reader sends this item: “Page 25 of the Economist, August 10, 2002. The article ‘A stigma that never fades’ points out that the U.S prison population has risen from 110 people per 100,000 in 1973 to 700 per 100,000 now! Compare this to other countries: Canada, 102 per 100,000, Britain 132, France 85 and Japan 48.”

Statistically, a person is 14 times more likely to have his freedom completely taken away in the ‘land of the free’ than he is in Japan.

*** Maria met someone she knew from Paris. She seems to be doing okay.

“They asked me if I would go to Finland for a photo- shoot,” she told me by phone. “But I don’t know. I think I’m going to be ready to come home…”

*** Sitting in the waiting room at the modeling agency in Milan, your editor could hardly keep his eyes on his copy of “Grant’s Interest Rate Observer.” There were more interesting things to look at.

A wan blonde’s pants kept threatening to fall off, for example. It must be the style, pants worn so low there is little to hold them up. So, she tugged at them every couple of minutes – just before they dropped.

Another woman – a thin, dark-haired beauty with, surprisingly, almost no upper lip – wore a tiny jean skirt which she pulled in the opposite direction, for it risked turning into a wide belt at any moment.

Your editor had never seen so many navels outside a supermarket. But he was still disappointed. They were just too young, too thin…there was no mystery or romance about them. Curiously, the models seemed inelegant, slovenly and sexless. After a few minutes, he didn’t care if their clothes fell off completely.

But out through the window was something of real beauty; he could hardly take his eyes away. What was most extraordinary about it was that it was so ordinary. There were hundreds, thousands of buildings similar to it all over Milan. Built of gray stone, the townhouse had huge windows with marble moldings and almost every other architectural adornment your editor has ever seen – roseates, dentelles, columns, pilasters, medallions, and features for which I have no words. It was ornate, but for all the embellishments – more than you might find in an entire city in the Midwest – the building still had a simple charm…with graceful wisteria vines growing up around the balconies.

Unlike the models, Milan’s old buildings have a hint of decay about them – like the season and the stock market.