HUGE INSIGHTS: The Big Picture - Issue #7
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Amid inflation concerns and military conflict in Eastern Europe, the S&P 500 experienced a 14.6% peak-to-trough correction over 51 days from January 4th through February 24th. Is it over, or should investors prepare for a bear market?
Bull Market, Bear Market...A History Lesson
In 1680, a coffee house was opened by Jonathan Miles on Exchange Alley in the city of London, England. Jonathan's Coffee House, as it became known, was made famous in 1696 when several of its patrons were implicated in a plot to assassinate William III.
In 1698, it was used by John Castaing to post the prices of stocks and commodities. This was the first evidence of the systematic exchange of securities in London. That year, all stockbrokers were expelled from the Royal Exchange (the place where commercial goods were bought and sold) for rowdiness, and thus migrated to Jonathan's to do business.
As the ranks of brokers grew, the shouting throughout the day became so raucous, that Jonathan had to insist that the open outcry of bids and offers be conducted only during specific hours of the day. He then installed a bulletin board along the back wall of the coffee house, so that buyers and sellers could silently post bulletins indicating their bids and offers to the board during the off hours of the day.
When trading activity was heavy, and the board was full of "bulls," as these bulletins became known, then it was said by brokers that there was a "bull" market for shares. Conversely, when trading activity was light, and the bulletin board was bare, brokers were known to say that there was a "bare" market for shares.
Jonathan's became the scene of a number of critical events in the history of share trading, including the South Sea Bubble and the panic of 1745. It was destroyed by fire in 1748, and rebuilt. In 1761, a club of 150 brokers was formed to trade stocks. The club built its own building in 1773, which was dubbed the Stock Exchange of London. It is now known as the London Stock Exchange.
Across the pond in New York, on May 17, 1792, twenty-four stockbrokers stood outside 68 Wall Street, under a buttonwood tree where the earliest transactions had occurred, and signed a document that has become known as the Buttonwood Agreement, founding the New York Stock Exchange. Trading originally took place inside the Tontine Coffee House on the corner of Wall and Water streets until 1817. NYSE trading then moved about to various New York office buildings until 1865, when the present location was adopted.
How Did "Bare" Market Become "Bear" Market?
The terms "bull market" and "bare market" migrated across the Atlantic ocean, but their exact definitions were somehow lost in translation. "Bull" was thought to mean strong, and therefore named after the animal, which best illustrated that condition. "Bare" became "bear," and was thought to have meant that when conditions were weak, it was as though investors were getting mauled by a bear.
Before his death in 1902, Charles H. Dow, the founder of the Wall Street Journal, wrote a series of editorials, which outlined his principles for investing. His successor, William P. Hamilton, took up Dow's principles and over the course of 27 years of writing on the stock market, organized them and formulated them into what is now known as the "Dow Theory." Among those principles were detailed discussions of the conditions which define both a "bull phase" and a "bear phase" in the market.
By 1923, the term "bull market" was even more plainly defined in Edwin Lefevre's fictionalized biography of Jesse Livermore, Reminiscences of a Stock Operator, as a period in which there exists a broad and persistent advance of share prices. Specifically, in chapter 5, whenever old Mr. Partridge was asked for advice by a fellow brokerage customer in Fullerton's lobby, he would always repeat the same phrase, "You know, it's a bull market." That meant, don't give up your position when the primary trend of the stock market is advancing.
Robert D. Edwards and John Magee, in their classic 1948 text, Technical Analysis of Stock Trends, further broke down Dow Theory into its most basic tenets. Within their discussion, they highlight three trends of the market: The primary trend, the secondary trend, and the minor trend. They compared them to a tide, a wave, and a ripple. They further defined the specific characteristics of both the bull and bear phases in the market.
The bear market phase is of particular interest. The authors explain that it can be divided into three parts: 1) The distribution phase, 2) The panic phase, and 3) The exhaustion phase. Importantly, according to Edwards and Magee, a bear market phase can occur at any of the three aforementioned degrees of trend. In other words, there are no arbitrary percentages that define a bear market.
Then, What Characterizes a Bear Market?
The estimable Martin Pring, a 53-year veteran trader, technician, market historian, and author of Technical Analysis Explained, defined a bull market as "an extended period, usually lasting somewhere between 9 months and 2 years, in which most stocks move up most of the time, " and a bear market as "an extended period, usually lasting somewhere between 9 months and 2 years, in which most stocks decline most of the time." His textbook, now in its fifth edition was first published in 1979, and is required reading for the CMT exam.
But Pring also distinguished between secular trends and cyclical trends. Secular, or structural, market trends are very long-term in duration, and can last from 10-years to several decades, as illustrated by the market's 1966-1982 range consolidation (16 years). Cyclical market trends can last from several months to several years, such as the 2018-2020 market advance (14 months). So, secular bear market phases can be extended affairs that include numerous cyclical bull and bear market phases that meet the aforementioned definition.
Following the stock market crash of 1987, a number of analysts began quantifying the characteristics of past bear markets. Most notable was a study published by Ned Davis Research (NDR). In their original paper, NDR evaluated the prior ten bear markets in the DJIA going back to 1960 and compared them to the 1987 bear market. They measured the depth and duration of the decline from peak-to-trough, as well as the average frequency of past bear markets.
The firm continues to publish an updated version of the study to include each passing bear market, most recently that of March 2020. As of today, the study shows that the current number of bear markets since 1960 numbers 19, with and average duration of 10 months, and an average decline of 26.8%. Furthermore, according to NDR, bear markets occur approximately once every 3.2 years on average, with the most severe being the 17-month period from October 2007 to March 2009, registering a 53.8% peak-to-trough decline, and the least severe being the 9-month period from May 2015 to February 2016, logging a mere 14.5% peak-to-trough decline.
But Doesn't the DJIA Need to Decline By At Least 20% In Order to Qualify as an "Official" Bear Market?
The short answer is that there is no "official" definition of a bear market. But, since at least the fourth quarter of 1998, a new definition of a bear market began to gain acceptance. It arbitrarily described any peak-to-trough decline in a major market index of 20% or greater as a bear market, adding that any peak-to-trough decline of at least 10%, but not greater than 20%, was a correction. The importance of the distinction could be no better affirmed than by the opening line of an Associated Press article from January 1999, which asked this question following the Long Term Capital Management debacle, "Was it a bear market?"
Several top Wall Street strategists at that time opined on the subject. Ned Riley, CIO of BankBoston, described 1998 this way, "This year wasn't without its casualties and it wasn't without a lot of unpleasant memories of cascading portfolios." Hugh Johnson, CIO of First Albany, said of the 1998 affair, "We've never faced a financial crisis of this magnitude." Then there was Ralph Bloch, Chief Market Strategist at Raymond James who exclaimed, "Every criteria for a bear market was fulfilled. These people who say it wasn't a bear market because the Dow fell 19.3% instead of 20%? That's nuts."
More than 22-years later, that arbitrary down 20% definition has gained a lot of traction. Perhaps too much. Nary a day goes by when some taking head on a financial news network attempts to eruditely point out that a stock has entered "official bear market territory." Not most stocks, mind you. Just, a stock. To quote veteran market timer Tom McClellan, proprietor of the famed McClellan Oscillator, "A single stock can no more experience its own bear market than a city block can experience its own hurricane." McClellan has been been on a personal crusade to have this useless definition removed from the lexicon of financial analysis. He's even gone as far as suggesting publicly that news anchors on CNBC pay a fine of $5 to a swear jar every time they use it. See video clip below:
THIS is a great tell for a big bounce — www.cnbc.com Tom McClellan, The McClellan Market Report, shares his market forecast.
Enough About History, What About the Future?
As COVID-19 slips into the rearview mirror, at least for now, geopolitical events, supply chain disruptions, and labor shortages continue to drive inflation measures to near 40-year highs. Military conflict in Eastern Europe, slowing GDP growth, tough y/y EPS comps, and a newly initiated Fed tightening cycle have put investors on the defensive in 2022.
The S&P 500 index topped on January 4th at SPX 4818 and subsequently declined 14.6% into its February 24th low of SPX 4114. Concomitantly, volatility, as measured by the VIX -- aka the Fear Index, has spiked to recent highs approaching 40%. This spike appears to be most closely linked to the rising price of WTI crude oil. NATO sanctions imposed upon Russia, in defense of the Ukraine, are being described as a form of economic warfare. The US and the UK have banned the import of Russian oil and gas. This removes an estimated 3 million bbl/day from the available supply.
Large increases in the price of WTI crude, now north of $100/bbl., have been associated with past recessions. Will oil prices remain elevated, or will the West find away to fill the supply gap? Negotiations are currently underway with Iran, and Saudi Arabia to provide additional production. But regardless of the success or failure of authorities attempts to ease the pain, high oil prices are their own solution in a free market economy. Eventually, the invisible hand, as Adam Smith called it, will elicit its own supply response from US producers, whose fracking operations become hugely profitable when WTI is above $100/bbl. In the meantime, high prices themselves will elicit a demand response from consumers who will curtail spending on transportation, where possible, and engage in substitution effects in order to maximize their own utility preferences.
What's Next for the Stock Market?
We're of the opinion that the market has reached a crossroads. Since the February 24th low, the S&P 500 has experienced several rally attempts, which have failed to recover the 30-week SMA, our preferred proxy for the intermediate-term trend. However, despite these fits and starts, the index has also managed to hold above January and February lows. In a recent study of the market's internal measures, including breadth, momentum, and volume, we found strong evidence to support the notion that the February 24th low marked a selling climax of at least some significance.
The chart above illustrates various measures of breadth and momentum in the broad Nasdaq Composite index of over 3,600 issues traded Over-The-Counter. The chart below illustrates the same measures in the broad NYSE Composite index of over 2,200 listed issues traded on the Big Board. Both suggest an easing in selling pressure as the major averages plumbed their lows last month.
From the perspective of trend analysis, there is some ambiguity, depending upon how one defines the trend. Our preference is to use a relevant moving average that provides the "best fit" for the data series. Many traditional market watchers favor the use of the 200-DMA. But why? 200 days is just an arbitrary period -- as is any period for that matter. The fact that the 200-DMA and 50-DMA are the industry's default standard, pre-programed into every data service, does not give them any great level of importance other than the fact that they are watched by a large, naïve audience, presumably with the belief that there must have been some exhaustive research conducted, which concludes that these are the statistically significant definition of what constitutes the short-term and long-term trend. Yet, nothing could be further from the truth.
Let's consider the fact that prior to the advent of the computer age, the calculation of a moving average was a tedious chore that had to be done completely by hand. One reason that the period of 200 days became popular was because it was a multiple of the 100, and 50 day periods, none of which actually fits the quarterly calendar particularly well. In fact, the most popular moving average in the pre-computer age was the 10-DMA. The key reason for this was because it was a very simple to aggregate the historical data of many 10-DMA periods in order to create longer-term moving averages, or to estimate long-term moving averages based upon multiples of shorter periodicities.
The 200-DMA gained in popularity during the 1970's following the success of famed market timer Joe Granville, who featured the moving average in his 1960 text, "New Strategy of Daily Stock Market Timing for Maximum Profit." With a title like that, there is no doubt that he sold a lot of books. It was later reported that Paul Jones of Tudor Investment fame used Granville's 200-DMA principle to side-step the 1987 stock market crash. Taken together, it's no wonder the concept apparently caught on.
But, much as each foot is unique to the leg to which it is attached, all stock price trends are unique to the security or index in question. None have identical price action, average true ranges, or momentum measures. Thus, just as it would be absurd to expect one shoe size to perfectly fit all feet, so is it absurd to expect a single measure of trend, such as the 200-DMA, to perfectly fit each security or index to which it is applied over every period in history.
Indeed, Stan Weinstein experienced tremendous trading success utilizing the 30-week/150-DMA. His strategy of Stage Analysis around that moving average, as outlined in his bestselling book, "Secrets for Profiting in Bull and Bear Markets," put him in the Trader's Hall of Fame. The key difference between Granville and Weinstein, is that Granville never bought or sold a single share of stock during his professional career as a market forecaster. He was on record stating that he viewed trading in his own account as a conflict of interest, and therefore did not partake in it. Of course he didn't need to. His bi-weekly market letter was generating $6 million in annual revenue at the height of his popularity. Unfortunately, in 2013, he died with little money, at the age 90. Weinstein, on the other hand, practiced what he preached. Now in his early-80's, he built a multi-million dollar fortune as a full-time stock trader and remains active in the markets to this day.
Moreover, in this age of computers and easy access to data, the likes of which has never been known, it is more important than ever to continuously test the trend of each security or index, using a variety of different moving averages in order to determine the best fit. We regularly adapt various moving averages to the market's trend in an effort to determine the best fit. Sometimes we use the industry's default standard. Other times we use a Fibonacci series. Still other times, we use various combinations or the moving average ribbon method.
Comparing the Granville & Weinstein Methods
Using the 10-week/50-DMA and 40-week/200-DMA, the Granville method as illustrated above, the S&P 500, in a more bullish display, has penetrated both the downward sloping 10-week/50-DMA and the upward sloping 40-week/200-DMA on a weekly closing basis, but as we go to press, remains below chart resistance at SPX 4600. Using the 20-week/100-DMA and the 30-week/150-DMA, the Weinstein method as illustrated below, the S&P 500, in a more bearish display, has so far failed to convincingly recover either key measure of trend, but instead has rallied directly into resistance, halting its forward progress exactly at the 20-week MA.
Your view as to which of these two trend methodologies is correct probably depends upon how your portfolio is positioned. But, the outcome depends upon the market's future price action. A sustained weekly close above SPX 4600 would strongly argue in favor of the bull case (Granville). A sustained weekly close below SPX 4300 would strongly support the bear case (Weinstein). We favor a wait and see approach. In our view, the market's set-up remains binary.
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