Previous bear markets:

The 1904-1908 bear. A 48.5% decline from peak to bottom, that lasted 96 weeks. A W-shaped bottom gave rise to a new bull market.
The 1919-1922 bear. A 46.6% decline from peak to bottom, that lasted 96 weeks. A W-shaped bottom gave rise to a new bull market.
The 1937-1938 bear. A 49% decline from peak to trough that lasted 56 weeks. A W-shaped bottom gave rise to a new bull market.
The bear market of 1973-1974, a decline of 46.3% that lasted 101 weeks. A W-shaped bottom gave rise to a new bull market.
The 2000-2003 bear. A 47% decline from peak to low, then a W bottom gave rise to a new bull market.
The Great Depression bear. The Dow declined 89% in 136 weeks in total. The initial panic falls took 48% off before a W bottom and a multi-month rally that retraced 50% of those declines.
The Japanese asset bubble crash. An intial decline of 48% then a W bottom gave rise to a multi-month rally retracing almost 40% of the falls. The bottom (to date, as this 2 decade bear is still ongoing) was 80% from the original peak.

Every one made a decline of between 46 and 49% from peak to low before a bull run emerged from a W bottom (either a new true bull market or - for Japan or Great Depression - a multi-month cyclical bull before a new secular bear leg down). Our current bear of 2007 onwards saw a 47% decline in the Dow from peak to the November low - right in that correlated zone - and we have a W bottom shape on the charts with the Nov and Jan lows. The Japan and Great Depression experiences suggest we could see a multi-month rally to over 10k Dow, 1100 S&P, before a new major down leg later in the year.

Note though that we could decline from our current point (as per the 3rd chart above showing a double top on the S&P) to a lower low than the January low (but above the Nov low) and still make for a W bottom shape on the Daily/Weekly, with the ultimate low of Nov still making this a 47% decline from peak to low. That would still be consistent with all the previous major bears - but as would a continued rally from the current point (not straight up, but a series of higher lows, higher than the January low). 

We see only one of those two scenarios, positionally. 1 - we have started a multi-month cyclical bull (a B-wave up) heading for 1100-ish S&P, or 2 - we will dip down again to somewhere between the Nov and Jan lows before putting in the multi-month rally. Anything else - and that would mean a decline to lows beneath the Nov lows - into the 500s or 600s on the S&P - before any kind of rally emerged - would be anomolous to all the previous major bears including the absolute worst.

In the very near term we see the key test to be can the S&P hold 842-850. A retracement back to there followed by a further move up would cement the 'cyclical bull underway' option. A breakdown through 815 would suggest the market wants to take longer to bottom out before a cyclical bull is to emerge. We are net long and will be adding long in either scenario - break out up or down.

 

 

 

 

 

 

 

Where will the opportunities be in 2009 and where should you put your money? We will consider the different asset classes below, but let's start by emphasising that we don't see this as a time to buy and hold in any asset class. If you can trade, and trade short term, then you can be flexible and adjust quickly. We are in a rapidly unfolding severe economic crisis and the pace of developments this last year has been breathtaking. We have a house of cards scenario where it is difficult to predict the next card to fall. We expect tipping points, inflexion points and sudden stops this year in different assets (e.g. momentum into precious metals, runs on currencies, companies unable to refinance bringing a loss of confidence on their industry) and it is important to be quick and flexible in response. A painful global deflation is threatening to take hold, which is being met with a largely unprecedented series of counter measures by global governments, particularly the US, which if successful would unleash strong inflation (whilst growth would remain weak). So far, the bailouts, interest rate cuts and stimulus packages have had little impact in getting lending moving again, and we continue to see a global deleveraging and liquidation of assets. The Fed has made it clear that they will do all it takes to prevent deflation taking hold and we can expect increasingly radical action from them as 2009 unfolds should the current measures make no headway. The key point is that it is a different set of assets fare best depending on the outcome of this battle. Under deflation, cash, government bonds and eventually gold and silver are kings (cash gains in value and once faith is lost in the system gold and silver become important), whereas under strong inflation but weak growth - stagflation - hard assets are kings (cash loses value and commodities are the winners - gold, silver, oil, metals and agricultural commodities). The only common ground is precious metals - but under deflation they typically emerge later in the day. However, if you are looking for a 5 year buy-and-hold investment, that covers all scenarios going forward then it would be gold and silver (not mining shares, but the actual metals). OK, let's look at the different asset classes in detail:

 

UK housing

 

We foresee another year of house price declines. UK house prices tend to follow 18 year cycles, compared to 16 years globally. Typically there are 12-13 years of gains, followed by 4-5 years of declines. House prices tend to wave above and then beneath a long term trend line. Studying the UK long term house price chart and referencing house price cycles, we can expect a bottoming around 2011-2012, at a price level that is around 50% of the peak reached in 2007. Given the very poor economic outlook going into 2009, we would not be suprised if declines this year were steep and unforgiving. The only positive we can see is that UK interest rates may be cut to 1% or lower early in 2009, and that bear markets in any asset class rarely go down in a straight line. We could feasibly see the sharp cut in borrowing costs bringing about a temporary easing off in house price declines before the steeper downtrend is resumed - in other words, a possible consolidation in prices on the way down. In terms of your money, however, steer clear of putting it into UK property this year.

 

US housing

 

The bottom dropping out of the US housing market was the initial card that toppled the global economic house of card. The peak in house prices is sometimes quotes as 2005, which based on global house price cycles suggests a bottoming could occur in 2009-2010, however there was in effect a triple top ranging from 2005-2007 so we should not expect a bottoming until further out - 2010-2011 - and of course we should not expect it in isolation, if the economic crisis continues to deteriorate. Nevertheless, US interest rates have been reduced to zero and the US government has been buying up mortgage debt and the two should provide some relief to the housing market. Whatsmore, we can expect further measures from the Government in this area to shore up the housing market in order to return consumer confidence. Also note that housing market bottoms tend to be rounded. That means before the bottom itself is hit, we can expect an easing off in the bad housing figures. However, if deflation beats all counter measures in the US then house prices would remain suppressed for an extended period, as per Japan's lost decade. In short, for 2009, we see no recovery for US house prices, but as per the UK housing market, it is possible that some of the favourable factors quotes could see a period of less bad figures before the downtrend resumes.

  

Stock markets

 

We are fairly confident we will see a rally in early 2009. All previous major bear markets, as measured on the US Dow index, put in correlated declines of 46-49%, typically with panic selling in the later part (as we have seen in Oct and Nov) before staging a significant bull rally. We hit that 46-49% range when we made the lows in November, and since then we have rallied from the lows but not with the conviction of volume nor positive newsflow. The previous major bear markets typically made a W shaped bottom following the panic selling, as sentiment recovered gradually over a period of around 3 months, before rallying with volume. We may therefore see the right V of the W form over the next few weeks before we get the rally. In all but the Great Depression bear market, the rallies were new genuine bull markets. In that 1930s bear market, the rally retraced 50% of the falls before resuming the bear and falling significantly beyond the lows already hit. Given the parallels with the Great Depression in terms of the lending excesses, bank failures and government actions, and the serverity of the current crisis, we will at this point expect the rally to be a bull interlude before the bear resumes, rather than the birth of a new long term bull market. We can therefore expect a rally of several weeks or months. Aside from the historical reference, we have other reasons to expect a rally. Much of the selling of 2008 was by hedge funds needing to meet customer redemptions before 1 Jan 2009. The passing of that date may release some pressure, although we are alert to the possibility that it could give way to new selling on new deadlines. Also, selling has been indiscriminate and once the fear subsides as the market consolidates, unjustly bombed out shares will be snapped up, probably in consumer staples and defensives, maybe in banks too if the crisis moves out of finance and more into the general economy, leading the markets up. The inauguration of Obama in the US will give the markets hope, particularly if he takes early decisive action. Cheap oil, food and other resources, thanks to heavy falls in commodities and energy could also help sentiment, as these are beneficial developments to both the consumer and to companies. And cheap mortgages should help consumers too. So that may be the newsflow to support, and we will position for a rally in stocks in early 2009. We would add that various cycles (long valuation waves, 60 and 120 year cycles and Tobin's Q) all suggest a true secular bull market for stocks should not emerge until 2014-2018. So we do not see this as an asset class to pile in with buy-and-hold yet. We are expecting a further wave of trouble this year as regular companies simply cannot refinance because of the credit crisis and go under. Therfore, position for the rally and then take profits.

 

 

Commodities

 

Oil hit as high as $140 a barrel in the face of a rapid economic slowdown earlier in the year, which made about as much sense as oil now down under $40 in the face of peak oil (fossil fuel exhaustion), under-investment in supply over the past 20 years, a global population growing by 70 million a year and demand from rapidly industrialising countries such as China and India. Speculation, fear and greed, have brought about extreme price action in oil and most other commodities. Oil and base metals are unlikely to bounce back to highs in 2009 in the face of negative global growth. However, we do expect the declines to end and some recovery to be made. We will be looking to get into oil for that recovery, and that could be a buy-and-hold opportunity, as a victory of inflation over deflation together with the supportive factors listed above would make for another 1970s super-bull. It's all about opportunity cost though, and money locked up in oil whilst deflation is in focus, could mean sitting patiently not being able to take opportunities elsewhere. The returns could be phenomenal however, so we believe it may be worth getting into an oil position whilst prices are low even before deflation is either defeated or suffered. Right now oil is still in a steep downtrend so a blind entry currently cannot be recommended. However, we believe the opportunity will arise as the stock market begins its rally. We should see a general pro-risk move across the board, out of the US dollar and US treasuries and into stocks and commodities. Unlike the position in stocks though, a position in oil may then be one to hold on to. Turning to agricultural commodities, they also shared the swings from record highs earlier in the year to major lows at the time of writing. Agricultural commodities tend to perform relatively well in times of deflation, because people still need the essentials. In the Great Depression, prices of agricultural commodities dropped, but less than other assets. In inflationary times, they rise in value, as they are assets not cash, and if global governments are successful in seeing off deflation they will soar again. The story for agricultural commodity demand is also one of global population growth, developing emerging economies and limited supply. They could again be a 5 year investment, but like oil, they are unlikely to resume true uptrends until we are out of the deflation woods. We would again expect some recovery in 2009, but see larger gains further out. Global governments are massively increasing the monetary base but the money is as yet failing to get into circulation as lending has stopped. If that money does get into the system then it will be chasing limited or declining resources in terms of commodities that will drive prices up, potentially to massive extremes. Whilst massively high commodity prices would wreak havoc for most people, they would make alternative (green and renewable) solutions economically viable and most likely be the catalyst for a once-and-for-all move away from fossil fuels and plundering the planet of natural resources. Obama's plans to change the US to green and renewable solutions comes at a time when oil is sub $40, making alternative energy solutions particularly expensive. Expect him to have to scale back those ambitions and put more money into near term fire-fighting, as it will be very difficult to justify. That retreat will keep the US's dependency on oil, whilst sub $40 oil is also killing off supply (projects cancelled unviable, job cuts), making for a tighter demand/supply squeeze on oil in the future - again subject to deflation being seen off. It is that inflation-deflation battle again, that is so key to future performance in all these asset classes, and that therefore makes predictions tentative and short term trading advisable, where possible.

  

 

Gold, Silver and US treasuries

 

Precious metals performed relatively well to most asset classes this year, but were not immune from the sell off. US treasuries were seen as the ultimate safe haven, resulting in a strengthening dollar and treasury returns going negative in real terms. We see that as a defensive play and not a vote of confidence in the dollar, and those foreign holders of US treasuries will be accutely aware that if the dollar resumes its downtrend then they will be faced with negative rates of return AND a decline in the dollar value. It may be that those long term holders of US debt see the dollar's recent move up as an opportunity to exit their dollar positions. That would then accelerate the move out of US treasuries and the dollar. Either way, treasuries are offering a poor return, and should a different asset class start to perform, there will be a significant migration of money out of the former and into the latter. We see the most likely class to perform as being precious metals. Gold is the anti-dollar (so will rise if the dollar resumes its downtrend), gold is a hedge against inflation (so will rise if the governments' counter measures start to see off deflation), gold also performs well in an evironment of negative real interest rates and should deflation truly set in then gold also becomes sought after as faith is lost in the system. You could argue that all the possible scenarios for 2009 are favourable to gold. However, we would add that it is possible gold may underperform if another round of asset sell-off rolls over into gold and also fear keeps interest in US treasuries and therefore the US dollar. However, we believe a tipping point is close where precious metals will regain momentum that will see money pour into this asset class, even if a new round of fear and sell-off takes hold. Silver acts as a leveraged version of gold, so if gold is in a strong bull market then silver is in an even stronger one (and the reverse if in a strong bear market).

 

We have covered the US dollar's anti-trend rally above. The Japanese Yen also rose as the carry trade was unwound and investors went defensive. The British Pound took a major beating, because the UK economy copied the overly-indebted US economic model, making the UK economy at risk of a stronger downturn than most. And unlike the US who hold the world's reserve currency, which gives some support to their otherwise bankrupt position, the UK has the Pound, and the risk is that there could be a tipping point in 2009 where the world exits the Pound on its fundamentals - i.e. a run on the Sterling. Other countries with high debt economic models are also at risk of runs on their currencies. It's a question of confidence. If it appears that a country's Government is becoming impotent in the face of massive debts and a deep economic downturn then investors could choose to migrate to currencies of nations who have large reservers and a savings based economy. Those counties (such as China, Japan and Germany) have much more flexibility to deal with a downturn. The US is not immune from such a tipping point. Thus far, the Government's actions have had little effect, and as its actions become more extreme if it appears impotent then countries with large dollar holdings may diverify out of the US dollar, which could quickly turn into a tsunami against the dollar as there is a rush for the exit. There could also be some as yet unknown event - the next card to fall in the house of cards - that causes a loss of confidence in the US and a sudden stop in capital inflows into the country and out of the dollar. Should neither of those occur, then the dollar could gain some support versus other currencies as interest rates are already at zero and the UK, Euroland and other countries will be busy in the first half of 2009 slashing interest rates. As the differential closes with the US, Sterling and the Euro and other currencies could feasibly weaken against the dollar. These actions are essentially weakening all currencies, which should further support precious metals as the real alternative to fiat. It is this devaluing of all fiat that makes us therefore a position in gold and silver to currencies.

 

 

Short term trading, rather than buy-and-hold; active response to key tipping and inflexion points

A position in gold and silver for the duration of 2009, adding on weakness

Positioning for a stock market rally in early 2009, taking profits in anticipation of a new bear leg down later in the year

A longer-term position in oil once the steep down channel is broken

Avoid housing and US treasuries

 

 

 

 

 

 

12 November 2008

 

The current global scene is one of deleveraging, recession and deflation. House prices, stocks, commodities and corporate bonds are all falling. The US dollar is rising, as money pours into the safe haven of US Treasuries and as the hot money that was put to work in emerging markets and commodity-related investments comes home to the US, creating demand for the dollar. The Japanese Yen is rising, as there was a large amount of money borrowed in Japan (due to interest rates there close to zero) then switched into the currencies of emerging markets to chase their amazing gains over the last 7 or 8 years - paying back the borrowed money as these investments are sold means switching back into the Yen, causing it to rise. Most other currencies, and gold, are declining against these two.

 

There has been blanket selling across all asset classes as institutions and hedge funds have indiscriminately sold out of positions to meet customer redemptions, and fear has gripped the market with the depth of the recession (or even depression) ahead as yet unknown. Money has poured into US Treasuries to such an extent that the yields are negative in real terms - but still 'relatively' better than the money that was left in other assets - as the global selling became panic selling in October with spectacular falls across the world's markets, including the biggest ever 1 day points fall on the US DOW.

 

In the current conditions, there is significant market correlation between asset classes and there are only two real types of trade out there: risk-averse (short (sell) stocks, commodities, corporate bonds, long (buy) Treasuries, USD and Yen) and pro-risk (the opposite of all those positions). In other words, we see the markets moving in tandem - good or bad news or sentiment making investors switch between the two positions. So, following the climax selling in October, and with global stock markets around 50% down from their 2007 peaks, can we expect a recovery rally in the stock indices (which would also mean a recovery in commodities and a decline in Treasuries, USD and Yen) - in other words, will proper risk appetite return any time soon?

 

History can assist us. Let's study all the previous major bear markets of this last century by looking at the DOW charts. Firstly, the current bear market chart. The low of 7882 hit in October was a 44.5% decline from the peak, achieved in 53 weeks. From the May highs (point a) to the October lows, the Dow was down just over 39%. This occurred in just 19 weeks. The Dow formed two normal continuation patterns since the 2007 highs—one from the March lows to the May highs and the second from July into early September.

 

 

Next, the 1904-1908 bear. The Dow closed above 100 for the first time in January of 1906 and then began what turned out to be a 48.5% decline that lasted 96 weeks.

 

 

The bear market that lasted from the high in October 1919 to the lows in August 1921 made its high at 119.6 and over the next 96 weeks declined 46.6%.

 

 

The worst of them all was the bear market from 1929 until 1932 - the Great Depression - as the Dow declined 89% in 136 weeks. The historic plunge that terminated in October of 1929 took the Dow about 48% from its all time highs in just ten weeks, even more severe than our recent decline. The rally into 1930 retraced just over 50% of the decline and the Dow peaked in April. From the April high at 294 to the low in July 1932, the Dow dropped 86% in 117 weeks.

 

 

Next, the bear of 1937-1938. The Dow peaked in March 1937 and eventually bottomed in April 1938 after a 49% decline that lasted 56 weeks.

 

 

Lastly, the bear market of 1973-1974. The Dow peaked during early July 1973 with the high of 1062 and made a low in December 1974 at 570. This was a decline of 46.3% that lasted 101 weeks.

 

 

So what can we summarise? All the bear markets hit the same kind of level of 46-49%, before putting in a sustained rally. The exception being the Great Depression bear that went on to hit 89%. However the first phase of decline for the Depression market saw a sell off of 48%, before it went on to rally and retrace 50% of the falls. It appears that falls of 46-49% (a virtual halving of values) represented an exhaustion point common to all the bear markets. That's a significant correlation.

 

Our low of the current bear market so far was 7882 last month, 44.5% off the peak. 49% off would be 7240. So what support levels are there in this kind of zone? The 2002 low was 7197, and this is a level we may retrace to. Above that we have a support level at 7550. And 7500 is the 'general' level much talked about it the financial press as it was around that mark that the market bounced from in both 2002-3 and earlier in 1988 - in other words it is a 20-year support zone. Since the October panic selling we have been moving sideways, in a large trading band, but as yet it is not clear whether we are making a continuation pattern (breathing time whilst oversold indicators ease off, before moving down again to a new low) or whether we are in the middle of creating a bottom and will move up away from this range. Either way the panic selling has stopped. Note in the historical charts that the bottoms typically formed over a period of around 3 months, and typically took on a W formation. We can add this to our 'framework of expectation'. There are also seasonal patterns - October is typically a bad month for the stock markets and following it we typically lay the foundations for a 'Christmas rally'.

 

So, in conclusion: strong historical bear market patterns suggest we can expect a sustained stock market rally from levels ranging around the current market price down to levels in the 7000s. We can follow the market from here and look for the chart putting in a W bottom from here or moving down into the 7000s before basing in a similar shape. We can observe what happens at the support levels of 7550, 7500 and 7197, if we move down that far, to see if a support level holds. We can buy into the market once we see evidence that suggests the rally is taking off. We can then expect a powerful rally lasting several months following the bottoming.

 

As to when the bottom occurs, we could be weeks or months away. Patience and observation is the key. For the markets to be happy bottoming, we need a string of news items that give some confidence that the worst is over - for now. That confidence may well be misplaced and we should not rule out the possibility that this recession may morph into a 'Greater Depression'. We would not be looking to invest for the long-term at this point - rather just 'riding the trends'. Be aware that stocks actually took 25 years to reach their 1929 peaks again, following the Great Depression and its subsequent recessions. However, even the Great Depression had strong bull market rallies within the overall long-lasting bear, and we believe we are on the verge of such a rally imminently.

 

We will update on this as the charts take shape.