Studying financial history can be very beneficial, because observing the past gives us access to a host of information. Another good reason for examining financial history is that, unlike the evolution of science, which is cumulative, the financial past is cyclical, so it can teach us valuable lessons on how to deal with future developments. For example, those who experienced the last bear market first hand learned a lot, but those who used it as an opportunity to study previous bear markets now know even more. We can learn a great deal by comparing the peaks and troughs of different periods. Many of the same conditions are present at each peak and at each trough. In his study entitled “Identifying Market Inflection Points,” Russell Napier notes that all bear markets result from price instability, i.e. inflation that is either too strong or too weak.
Napier points out that all bear markets are of long duration. For example, the bear market after the 1901 peak lasted 20 years, and the one that followed the 1966 peak lasted 16 years. We reached the peak of the present cycle in 2000 and, according to Napier, we have not yet seen the trough. He maintains that all stock market tops are characterized by the same illusion, that we’re in a “new economy.” And this “new economy” is always marked by strong growth combined with low inflation. Such illusions must be broken and, in every case, a return of inflation is what does it. Underlying the notion of a “new economy” is the idea that a technological breakthrough will enable us to control inflation, while maintaining high growth and low interest rates. The cycle that peaked in 1901 troughed in 1920 when, you guessed it, inflation was at its highest. And the cycle that peaked in 1966 bottomed in 1982 when, once again, inflation hit record levels. Central banks then adopted draconian measures to curb inflation, resulting in a period of deflation. Deflation kills the illusion created by the “new economy” and has a major impact on business cash flows. When the price of a company’s products falls, it finds it increasingly difficult to turn a profit because of its fixed costs. Whether we go by the market value or the replacement value, asset values fall while debt service costs rise. The viability of companies is then jeopardized, a bit like when the value of our home decreases while mortgage rates increase.
Many characteristics mark the end of bear markets: stock prices are very low, commodity prices stabilize, demand for luxury goods increases, and the spread between corporate bond yields and government bond yields shrinks, reflecting a decrease in the risk premium. The market declines when trading volume is relatively weak and rises when it is strong. When the stock market finally hits bottom, the rebound is often very sharp and short positions increase, but the market doesn’t fall, so investors who want to profit from a bear market rally are eventually forced to cover their shorts. In fact, the greatest U.S. bull market began in 1932, just after the Great Depression. This phenomenon occurs when the multiple measures put in place by governments to counter the recession become highly inflationary when the economy recovers. In times of inflation, investors prefer the stock market to the bond market, because inflation greatly erodes bond yields.
Although all conditions now seem to point an end to the bear market and the beginning of the next cycle, Russell Napier cautions us not to draw too hasty a conclusion, as there is still one element missing for us to conclude that the bear cycle is over. When the market apparently bottomed, trading volume was still too high. According to Russell Napier’s analysis of bear markets, for a bear market to end, there must be no one interested in buying stocks. In other words, volume, expressed as a percentage, must fall more than the market. In his opinion, the turnover rate (the total number of outstanding shares divided by the total number of shares traded) remained too high. A turnover rate of 100% implies a holding period of twelve months. The turnover rate at the last bottom was above 100%, whereas at past market troughs, it was generally around 60% and the holding period was approximately three years, indicating strong investor reluctance to participate in the market.
According to Russell Napier, we have not yet hit bottom and investors were too quick to position themselves in the market; only time will tell if he is right or wrong.
Simplified summary of Identifying Market Infection Points, by Russell Napier, CFA Institute Conference Proceedings Quarterly, December 2009.