New Bull Market Or Bear Market Rally?

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Economic fundamentals are fairly useless as timing tools but  can be extremely valuable in characterizing the investment environment for risk. In this post I will discuss the economic fundamentals of bear markets in general terms along with the current fundamentals to assess current market risk. This will help you decide whether the current investment environment supports continued exposure to stock market risk.

Let’s begin by understanding the fundamental conditions that typify major stock market declines.

1. Overvaluation
2. Economic recession
3. Bursting of a credit bubble

If you look at the history of bear markets (see below) since the Great Depression you will notice the vast majority are manageable affairs contained within the 20-30% range, a handful approach 50%, and only the very rare beast exceeds a 50% decline by a wide margin. Knowing which type of bear market you are in is critical to managing your investment risk exposure. One useful set of clues, as discussed above, are the fundamental conditions existing at the time of the bear market.

For example, when you examine the manageable market declines in the 20-30% range (9 out of 14 bear markets listed) you will notice the fundamental factors typically include mild overvaluation and/or normal business recession. They are not usually characterized by extreme conditions nor do they occur in environments that fundamentally change the underlying economy or regulatory law. It is fair to say that the end of these market declines results in a return to business-as-usual. You can think of them as unfortunate and relatively inconsequential hiccups on a longer path to prosperity.

The 40-50% declines are a different animal. They are correlated with more extreme conditions of overvaluation and/or economic recession. For example, the two most recent bear markets beginning in 2000 and 2007 began from some of the highest stock market valuations in recorded history and both declines reached the 50% range. When these bear markets end there is often some significant (but not dramatic) change to the economic landscape.

The relevant question for investors today is whether or not the recent bear market is already complete and due to enter the history books in the 40-50% category (with a little stretch) or is it just taking a rest break on the way to something more consistent with the Great Depression bear market? In other words, is the current rise a new bull market or just a bear market rally? 

To answer that question you must understand what set the Great Depression apart from other bear markets. Yes, it had the first two factors that other bear markets contain – a correction of overvaluation and an economic recession – but it also had something much more: it included a banking and credit bubble collapse.

While tons of material has been written analyzing the Great Depression and its causes, the critical factor that led to such a dramatic deflationary collapse was the bursting of a credit bubble and the consequent banking collapse.

Hmmm, sounds disconcertingly familiar to today.

In other words, the history of stock market declines indicates the really serious wealth destroyers require extreme conditions to occur – extreme overvaluation and extreme economic decline which can result in bear markets ranging in the 50% ballpark. These are significant because they require many years to get back to even not to mention get a reasonable compound return on your money net of inflation.

However, the distinguishing characteristic that sets apart the rare-beast declines like the Great Depression is not only all the required conditions above (extreme overvaluation and recession) but the addition of a credit and banking collapse – something we are confronting today. Now, of course, everybody says this time is different because Ben Bernanke studied the Great Depression and pulled out all the stops in waging war to make sure we don’t repeat history. Maybe this time is different… or maybe not.

Unfortunately (or fortunately, depending on your perspective) the data sample for studying rare-beast bear markets is limited - the Great Depression and Japan’s recent experience being notable exceptions. What we find when analyzing recent comparable declines is some disconcerting similarities to the environment today. Specifically, they both had credit bubbles bursting with consequent banking panics preceded by extreme overvaluation and accompanied by economic recession.  

Another similarity is the rare-beast bear markets included dramatic rallies remarkably similar to the rally that has driven the S&P 500 from the 666 intra-day low to the 1070 high as I write this post today. In fact, the greatest bear market declines include some of the greatest counter trend rallies in history. Did you know 8 of the 10 best days for the S&P 500 occurred during the Great Depression? What you may not want to hear is the other two ”Top 10″ days occurred following the 1987 collapse (10/21/87) and recently on 10/13/08. Hmmmm… that is not very good company to be in.

Similarly, the great bear markets are characterized by brief and dramatic counter-trend rallies of 35-60% correcting 25-40% of the previous decline. The current rally fits that bill perfectly if it were to end somewhere in this range.

Another disconcerting fact is the great bear markets result in fundamental changes to the economic and regulatory landscape. One would be hard pressed to argue that this bear market will do any less.

One final anecdotal piece of evidence – great bear markets tend to correlate with instability and volatility in inflation. This could be outright deflation as occurred from from the 29-33 period in the U.S. and Japan recently, or inflation as occurred in the 1970′s in the U.S. The key factor is instability and increasing volatility in the  inflation numbers – the absolute direction of instability is not important. Again, current indications are pointing toward instability in inflation – another negative sign for the stock market.

In summary, many of the critical conditions exist today that correlate with rare-beast bear markets. It began from a period of extreme overvaluation, coincided with a severe economic recession, and resulted in a credit collapse and banking crisis. Additionally, the rally from the low has been extreme by any statistical measure and inflation is becoming increasingly volatile. These are not garden variety bear market conditions but are instead the conditions that have historically correlated with extreme, rare-beast, wealth destroying bear markets in stocks.

Amazingly, as I write this letter the S&P 500 has rallied to an intra-day high of nearly 1070 placing the net decline since the all-time high into the “garden-variety” bear market category.

So there you have it, extreme fundamentals coinciding with rare-beast bear markets; yet, the stock indexes are currently down just garden-variety decline levels. What should you do as an investor?

It would be one thing if all the problems that caused the bear market were fixed: you could then believe the decline to 666 was a ”washout” and this rally would be a little easier to believe in. Unfortunately, little has fundamentally changed to be optimistic. Severe unemployment, rising foreclosures, insufficient bank equity net of problem loans, and much more continue on. We have given the patient morphine by rescinding mark-to-market rules and provided band-aids with TARP and other debt funded government programs, but we haven’t healed the beast. It is still very sick and surviving on government funded life support.

Nobody has a crystal ball into the future. Maybe the patient will undergo a miracle healing. I could be wrong and we could be sitting on an incredible historical exception that breaks the rule books because of all the government funny-money games. Who knows, maybe pigs will fly. Clearly, my position is in the minority as most experts appear to read the tea leaves with an interpretation that the recovery is for real.

But I’m a rational investor who must go with the probabilities, and right now the weight of the historical evidence points to one thing – an unfavorable risk/reward ratio for the stock indexes at present. My position is to reduce risk in these circumstances.

Again, this is just a probabilistic outcome. Nothing says it has to occur. Nothing says I have to be right. But I consider my job to be a careful manager of investment risk, and as a blogger I just want my readers to know where the probabilities point, even it is unfavorable (IMHO).

How about you? Do you disagree? Tell me how you read the tea leaves in the comments below…