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This is Still a Secular Bear Market, You Know

(October 17, 2004)

Please note we initiated a 25% short position in our DJIA Timing System on the afternoon of October 11th.  We currently remain short and have no plans yet to reverse our position.  Readers please stayed tuned.

Dear Subscribers and Readers:

Readers who have followed my commentaries for the last twelve months or who have gone back and read my past commentaries should understand my position and the longer-term trends I had anticipated (and still do) for the domestic stock market.  Readers who have read my Special Reports section should know that I had turned bearish and called a secular bear market in Spring 2000 (my friends and associates at that time could attest to that) – and therefore the longer-term trend over the coming decade or so should be down.  More recently, I have claimed that we are still in a cyclical bull market – a cyclical bull market that began in early 2003 but that is still within the context of a secular bear market (similar to the secular bear market of 1966 to 1974).  I still continue to hold this belief.  This is still a secular bear market, you know.

John Mauldin, in his NY Times best-seller “Bull’s Eye Investing,” stated that the only two time-proven methods for individual investors to outperform the stock market during the long run were to either buy when valuations were low or to adopt a trend-following system.  Let me be more clear.  The average individual investor can only expect to outperform the stock market by buying a diversified group of common stocks during the beginning of a secular bull market (similar to the 1974 to 2000 bull market) and continuing to hold them until the end of the secular bull market and selling them during the beginning of a secular bear market.  In some instances, buying and holding just one individual stock (similar to holding just company stock in one’s 401(k)) during a secular bull market can make you a fortune, but this strategy could also easily lead to huge losses.  In most cases, the strategy of buying and holding just one individual stock during a secular bull market should lead to average returns with above-average variance.

Again, I believe that we are still in a secular bear market – a secular bear market which began in early 2000 and which may not ultimately end until 2008 to 2013 (since secular bear markets have historically lasted one-third to one-half times as long as the previous secular bull market).  A sure way to lose money would be to buy and hold common stocks (this includes mutual funds and index funds) during a secular bear market.  A sure way to impending financial disaster or total financial annihilation would be to buy and hold just one single stock in his portfolio or retirement plan during a secular bear market.  Quote from the great Dow Theorist Richard Russell: “In a bear market, everyone loses.  The winner is the one who loses the least.”

I am writing this commentary (with mixed emotions) in response to the complaint filed by the New York State Attorney General, Eliot Spitzer, against Marsh & McLennan Companies (MMC) last Thursday morning.  I used to work for MMC (on the consulting side) and I have friends who are still working there today.  The allegations outlined in the official complaint are very serious, and furthermore – this from the NY Times:

“… What's ahead for the investigation? Mr. Spitzer would not say. But an industry executive, who spoke on condition of anonymity, said that the next phase of the assault would probably involve another questionable insurance industry practice known as tying. That is when a broker threatens to stop sending primary insurance business to an insurer unless it agrees to let the broker provide all of that company's reinsurance needs in return.

”The executive said that Mr. Spitzer's office was receiving "crates of evidence of tying" as a result of subpoenas submitted recently. Profits on reinsurance, by the way, are far richer than those on primary insurance.

”Marsh did $775 million in reinsurance brokerage revenues last year, roughly 11 percent of total revenues generated in its insurance segment. If Marsh is found to have been tying through its reinsurance subsidiary, Guy Carpenter, some or all of these revenues may be vulnerable.

"This is the industry that for years has been blaming everyone else for premium increases," Mr. Spitzer said. Greedy trial lawyers were the usual excuse for premium increases. Now we know that greedy corporations also have a starring role.”

(An update on MMC as of Sunday evening: According to the WSJ, the conference call scheduled for 11am ET on Monday has been postponed to later this week or even next week.  This will probably not go down well with investors who had anticipated a quick response or clear up to this official complaint by the NY State Attorney General.)

The impending civil suit (and possibly a criminal suit – if a criminal suit is indeed filed, then the chances of MMC surviving as a company are very slim) by Eliot Spitzer is no coincidence.  In a secular bull market (and especially during the near-unprecedented boom times we had as a country in the late 1990s) nothing really matters except for rising equity and real estate prices.  Executives push the edge of the envelope in order to meet or beat earnings (think of GE and Cisco beating earnings by one penny in most of their quarterly earnings reports during the last few years), various industries are deregulated (think of the banking industry in the late 1990s) and everything is okay as long as everyone is making a lot of money.  In an email correspondence that I sent to all my friends and associates on April 2, 2000, titled “The Perfect Crash Scenario,” I stated:

“However, the main factor that will be driving down stock prices [over the next few years in the NASDAQ] is that a boom always sows the seeds for a bust.  In a boom, nothing really matters when we have rising equity and real estate prices.  Banks make bad loans, aggressive accounting is ignored, and people are generally very trustworthy.  Conversely, in a bust, people are more suspicious.  Every financial transaction is carefully scrutinized, and people tend to save more.  It is this discipline which sets the stage for the next boom or bull market.  What we currently have are numerous companies committing financial atrocities which range from aggressive accounting to something just short of outright fraud.  In the following, I will outline some of this--discussing companies like Microsoft, Cisco, and Dell in the process.”

Like I said, the impending civil and possibly criminal lawsuit against MMC is no coincidence and the fact that these dubious “contingent commission agreements” began in the late 1990s is also no coincidence.  Five years ago, a figure like Eliot Spitzer would neither have the political backing nor the resources to bring about such a suit.  Moreover, the pressure to meet or beat earnings during the late 1990s period was too great – and as long as everybody else was doing the same thing and in an era of easy money, it was probably viewed as an “okay” thing to do.  A boom always sows the seeds for a bust.  This has happened all throughout history – including the 1920s “new era” driven by new technologies such as the automobile and the radio, the 1960s conglomerate boom, the activities during the 1980s in the S&L industry, and in the deregulated utility industry in 2000/2001.  Today it may be MMC, but tomorrow it may be Fannie Mae (Jim Rogers has a target price of $5 a share for Fannie Mae), Freddie Mac, GE, or any of the other companies that have a significant amount of their earnings tied to the financial sector.  Make no mistake: Given the near-unprecedented bubble we experienced in the late 1990s, there are definitely more skeletons in the closet, and you can be sure that Eliot Spitzer realizes this and the fact that all of these provides a great opportunity to further realize his political ambitions (future President of the United States, anyone?).  If there is one axiom I learn from trading the stock markets and in the corporate world it is this: Do not ever get cocky.  One can be a hero today and a dunce tomorrow.

And here’s another one: The further one rises, the further one falls when/if he does.  Corollary: Everyone has at least one character flaw.  But if your character flaw involves making money at all costs or if you have no problem with misleading your clients or your coworkers, then maybe you shouldn’t be in management or upper management in the first place.  At some point, I guarantee that you will fall – big time.

But enough – let’s switch to a discussion of the current state of the stock market.  While I still believe that the intermediate technical conditions (and with the backing of financial history that I have discussed all throughout my commentaries for the last few months) supports the continuation of a cyclical bull market, I still believe the short-term trend is down and that a further correction in the major indices is in store.  Let’s cut to the chase and discuss the current state of investors’ sentiment.

On our Wednesday’s commentary, I mentioned that the Bulls-Bears% Differential in the Investors Intelligence Survey increased for the seventh consecutive week as of the close on Wednesday – from 28.4% to 30.6%.  From a contrarian standpoint, we are definitely not near a bottom in terms of market sentiment.  While the Bulls-Bears% Differential in the American Association of Individual Investors (AAII) survey does not exactly confirm this bullish sentiment in the Investors Intelligence Survey, their current readings also do not suggest a bottom – not even close:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - While the latest reading in the Bulls-Bears% Differential in the AAII survey has come down slightly (from a high of 37% last week to 17% this week), the current reading is still not close to being low enogh to signal capitulation by the bulls.  Therefore, a further correction should be in store.

Please note that the current reading of 17% is not even close to the readings that we got during the March, May, or August bottoms.  The lowest reading that we got this year was the late March reading of (11.0%).  Like I have mentioned before – because of the lack of strength we have seen during the last seven months (even though all the conventional signs of a sustainable bottom were in place) I now believe that we would need to see readings in this survey that are similar to the early 2003 readings (about negative 15%) before we can achieve a sustainable bottom.  Maybe this kind of reading will come this week, but I highly doubt it.

Another sentiment survey which I have not discussed in my prior commentaries is the Market Vane’s Bullish Consensus Survey of the stock market.  You can learn more about this indicator by reading the FAQ on the Market Vane website but here is the relevant paragraph: “How is the Bullish Consensus calculated? The Bullish Consensus is compiled daily by tracking the buy and sell recommendations of leading market advisers and commodity trading advisers relative to a particular market. The advice is collected by: 1. Reading a current copy of the market advisers' market letter. 2. Calling hotlines provided by advisers. 3. Contacting major brokerage houses to learn what the house analyst is recommending for the different markets. 4. Reading fax and E-mail sent from advisers. The buy and sell recommendations from each adviser are  tracked during the day to verify the entry and exit of each trading position. The Bullish Consensus is compiled at the end of the day to reflect the open positions of the advisers as of that day's market close.”  Note that the readings we are using for this website are the weekly readings, since this weekly reading should smooth out any fluctuations of the day-to-day swings in advisory sentiment.  Following is a weekly chart of the Dow Jones Industrials vs. The Market Vane’s Bullish Consensus from January 2002 to the end of last week:

DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - Dear readers, please note this downward trending support line for the Market Vane's Bullish Consensus readings that dates back to mid-January of this year.  Therefore, not only is the current reading of 63% too high and not indicative of even a ST bottom, a logical support level (and possibly indicative of a sustainable bottom) should be the 50% level, which has acted as support in the past and a level which should intersect with the downward trending support level should the market continue to decline in the weeks ahead.

Dear readers, please note the downward trending line that has acted as support dating back to mid-January of this year.  The author contends that the next logical support level should also be somewhere near this support line.  Like I mentioned on the above chart, the next logical support level should be a reading of approximately 50% in the Market Vane’s Bullish Consensus.  Therefore, the current reading of 63% is still too high to call for even a ST bottom here – let alone a sustainable bottom and the beginning of a new uptrend.

Finally (in terms of sentiment), I greatly urge my readers to keep track of Mark Hulbert’s articles and his periodic updates of his HSNSI readings.  His update as of last Thursday evening indicated that the ST market-timing newsletters he keeps track of is 25.5% net long, compared to negative 7.3% in mid-August and negative 19% in mid-May.  Compared to those readings at the last two bottoms, we are currently nowhere near close.  In fact,  based on the lack of strength in the market subsequent to the mid-May and mid-August readings, this author believes that we should get an even lower reading (lower than negative 19%) in the HSNSI before we can call a sustainable bottom.

Now, let’s turn to something which has historically proved to be pretty reliable in calling for a bottom but which I have not mentioned in a couple of weeks – the study of the 10-day and 21-day moving average of the ARMS index vs. the Dow Jones Industrial Average.  Following is a chart depicting the 10 DMA and 21 DMA of the ARMS Index vs. the Dow Jones Industrial Average from January 2003 to last Friday:

10-Day & 21-Day ARMS Index vs. Daily Closes of DJIA (January 2003 to Present) - In the author's opinion, while the recent spike in the 10-day ARMS Index may be a catalyst for a ST rally, we will definitely need a much higher reading before I can be comfortable with calling for a sustainble bottom.

Readers please note the spikes in the 10-day moving average of the ARMS Index during the March, mid-July (however temporary it was), and the mid-August bottoms.  The 10-day ARMS spiked above 1.65 in all three of those occasions.  Again, the reading of 1.38 we obtained as of last Friday (while it may be good enough for a few days of rally) does not suggest we have put in a sustainable bottom.  This author will not be convinced until I have witnessed a reading of, say, 1.70 preferably in the next few weeks.

Let’s now discuss the state of the Nasdaq Composite.  Breadth in the Nasdaq has been very good, but as can one see in the Nasdaq 100 and even in the Nasdaq Composite, the large caps have not been cooperating on the upside.  This significant divergence in the large caps and the mid and small caps in the Nasdaq has lasted well over a month, as can been seen in the following chart – an illustration of the Nasdaq Daily High-Low Differential Ratio of the Nasdaq vs. the level of the Nasdaq Composite:

Daily High-Low Differential Ratio of the Nasdaq vs. the Nasdaq (January 2003 to October 15, 2004) - Despite the Nasdaq High-Low Differential Ratio making a recent high of 4.98% on October 4th (surpassing the previous peak of 2.96% made on June 24th) - the Nasdaq Composite AGAIN fell way short of confirming on the upside by bettering its previous peak of 2,047.79 made on June 30th.  This continuing weakness in the large caps does not bode well for the broad market going forward - especially since the Nasdaq High-Low Differential Ratio is again in the process of rolling over (it is now near the zeroline).

The recent “blow-off” in the number of new highs vs. the number of new lows on the Nasdaq was not confirmed by a new high in the Nasdaq Composite – in fact, far from it!  This author does not believe that a rally will be sustainable in any market without the large caps eventually participating – the current situation in the Nasdaq is doubly bearish given that the daily Nasdaq High-Low Differential Ratio is in the process of rolling over – that is, the number of new lows is starting to outnumber the number of new highs on the Nasdaq on a daily basis. 

Bottom line: The market is currently still undergoing a correction, and this author will not attempt to call a bottom until all the previous indicators I have mentioned are at oversold levels.  Moreover, the Dow Industrials declined 1.2% for the week, while the Dow Transports actually rose 0.50% -- indicating further divergence in the two major Dow indices.  The Dow Transports is again set up to challenge its 52-week high of 3,388.72 made on October 6th but another high in the Transports without a corresponding 300-point rise in the Dow Industrials would lead to another non-confirmation in the Dow Jones Indices – a continuation of the most flagrant divergence in the history of the Dow Theory not seen since the 1933 to 1937 (four-year) non-confirmation of the Dow Jones Industrials by the Dow Jones Rails. 

Signing off,

Henry K. To, CFA

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