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Bearish Sentiment Not Justified

(Guest Commentary by Bill Rempel - February 4, 2007)

Dear Subscribers and Readers,

As I discussed in our mid-week commentary, I have been “out and about” this weekend (we actually down in San Diego and Coronado Island) for some R&R since it is my birthday today.  I really haven't taken a day off since the first couple of days of January – so it was definitely a welcome change of pace.  In my absence, I have asked our regular guest commentator, Bill Rempel, to write an extended weekend commentary for us instead of his usual monthly mid-week commentary.  Thanks for doing this on such a short notice Bill!  Bill is a prolific writing on the stock market and individual stocks and is the author of a very active market blog at: http://www.billakanodoodahs.com/

Before we follow with an introduction of Bill's commentary and his usual biography, I just want to point out to our readers the recent discussions in our discussion forum.  As many of our readers may know, both the Dow Industrials and the Dow Transports hit all-time highs in the same week last week – something that hasn't occurred since the middle of 1999!  You can find a quick discussion of the most recent Dow Theory signals in the following thread.

There is also an interesting post on the reduction in float that we have experienced in the U.S. stock market over the last few years, which was initiated by a prolific poster on our discussion forum, Dash.  And finally, I have also just posted a summary of the 2007 CFA LA Society Annual Forecast Dinner.  The dinner was very well-attended.  No surprises here, given that the three panelists included Abby Joseph Cohen, Paul McCulley of PIMCO, and John Taylor, Stanford professor and the creator of the “Taylor Rule” – a rule that the Fed has used in the past to make monetary policy.

In this commentary, Bill is going to discuss the pervasive bearishness among the financial community on the internet – why it is popular to be bearish and why it is currently not justified.  Bill gives examples of past corrections and crashes, and lays out a very good argument as to why we are not due for a similar correction in the stock market, just yet.  The conclusion is clear: The market is definitely nowhere close to a top just yet, and folks who are currently long and are in the “right sectors/stocks” should continue to hold for now.  Without further ado, following is biography of Bill:

Bill Rempel (aka nodoodahs) is an active poster on the MarketThoughts forum as well as a few others around the web. Bill is a regular, monthly guest commentator on our website (see “Kraft – A Compelling Buy” for his last guest commentary). Bill graduated from Caddo Magnet High School (a high school for nerds) back in 1985 and proceeded to learn the hard way when he drank his way out of a scholarship to Tulane later that year. After a few years of sweating for a living, he decided to go back to school, and graduated from LSU-Shreveport in 1995 with a Bachelors in Mathematics - all the while working the overnight shift stocking shelves in a grocery store.

Post-college, Bill has been in the P&C insurance industry as an actuary, product manager, and pricing manager. Bill and his wife Millie are amateur investors with a variety of holdings, but they prefer to buy and hold value investments. In typical "value" style, they live cheap, driving old cars and preferring to save or invest instead of buying fancy "stuff."

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.


When Henry asked me to write an extended commentary this weekend so he could take some extra time off on his birthday (slacker!), I was initially at a loss for a subject.  Then I took a good look around, was reminded of the very bearish sentiment being thrown about, and decided it needed a good debunking.  In the interest of brevity, I'm going to explain why bearishness is prevalent, explain why bearishness is foolish, focus on the three most recent major "bear" events, summarize some important similarities between them, and point out the very real differences in today's market.

Bearishness Just Feels Good

You may have noticed a fairly pervasive bearishness in commentary on the 'net.  Sure, there are more than a few permanently bearish individuals, but even those not necessarily known for being bearish seem to be pounding the drum about an imminent correction, or a "long in the tooth secular bull," whatever that is.  It seems to me that a lot of this negativity is human nature, and the remainder of it comes from a misunderstanding of historic market returns.

There's no doubt about it, bearishness is "sexy."  It "sells" because it's exciting, it's different, it's "scary."  Think about it in terms of the network news; have you heard the phrase, "if it bleeds, it leads!"?  Why do you suppose that so much time is taken up by the negativity in the available stream of data, when there is so much that is good and right happening in the world?  It happens for the same reason that the network news puts all of the auto accidents and abused animals ahead of the weather and sports, and for the same reason people rubberneck when driving past the scene of an accident.  It's a simple fact of human nature that we are emotionally drawn to tragedy.

Even among the negative items, only the strangest and most outrageous items ever make it into the wider public consciousness. Every day, more humans are injured by dog bites than dogs are injured by human bites – but the one reserved for the headlines is "man bites dog" not "dog bites man."  Take "bird flu" for an example; go out and find the total number of people who have died from this disease since its discovery – it won't be hard, just a Google search or two.  Your next item of homework should be to track down the following statistics: 

(1) number of U.S. residents who died last year of staph infections developed while in U.S. hospitals,

(2) total deaths from all infections developed in U.S. hospitals,

(3) in nations where humans have died of "bird flu," find the total deaths in the same period and the same nations from parasites in the water, and

(4) projected "government" spending to solve problems (1) through (3).

Unfortunately, our emotions do not hard-wire us for investing or trading success!  This is especially true with our penchant for seeking tragedy and finding worry.

Being a Bear: A Losing Proposition

Over any significant period of time, bearishness is, statistically speaking, a losing proposition.  There is a reason that stocks are generally favored over bonds, cash, and other assets for investment purposes, and that reason is that they are excellent tools for compounding equity!  While one can point to times where the return on stocks, loosely defined by the return on an index like the Dow or S&P, has been negative or negligible for a long period, those times are the exceptions to a rule that stocks are the place to be.

I checked 10-year returns on the S&P 500 index from investment points starting at Jan 1950 and ending in 1996.  I would like to have seen the ten-year returns from 1997 and up, but they haven't been printed yet.  In terms of annualizing the ten-year returns, excluding dividends, we can generate a lot of data points to study.  For example, the ten-year annualized return from Jan 3, 1950, the return from Jan 4, 1950, etc.  That's darn near 12,000 data points!  In all of those examples, the minimum 10-year non-dividend return was –2.5% annualized and the maximum was +17.2%.  However, the median return was +8.6% annualized, meaning that the long-term return on stocks will thoroughly trounce that of bonds or cash more than half the time.  Another interesting point is that over 95% of the time, the ten-year annualized non-dividend return on the S&P 500 is positive. Over the same set of sample data, I calculated the minimum 5-year annualized return for the index as –7.7%, the maximum as +26.2%, the median as +8.2%, and the percentage of positive returns as 84.8%.  Obviously, long-term bearishness on stocks is not only not advisable, it's almost retarded.

I calculated a minimum 1-year return of –43.2%, a maximum of +58.3%, a median of +9.5%, and positive returns a full 72.5% of the time.  Note the higher median return on the 1-year timeframe is because negative returns seriously impact the long-term compounding rate.

For impact, here is a histogram of the annualized 10-, 5-, and 1-year returns.

S&P 500 Returns Since 1950 - Note that while a good portion of individual years have negative returns, the vast majority return postive. Over longer terms, returns cluster around 11% annualized and the median is 8.6%. Bears should pick their spots. 


If we were to look at monthly returns, defined in this data set as a return over 21 trading days, we would get a different pattern, although with a full 60% of months returning positively.  Interestingly, on the very short time frame, the minimum return of –28.9% is much farther from the median return (+1%) than the maximum return of +19.4% is.  The returns of a bearish overall posture come quickly and very rarely.

In general, it does not pay to be a bear.  There are, however, exceptions.

When the Bear Awakens, Part I

If you were alert enough to be outright bearish, or hedged, or in cash, for the crash of October 1987, you were in good shape indeed.  Now, let's take a closer look at this crash. 

Here's a daily chart of 1984-1988, courtesy of Stockcharts.com.  At the top of the chart is the 252-period Rate of Change (ROC), which is just the annual return as of a point in time, since there are on average 252 trading days in a calendar year.  At the bottom of the chart is a Percentage MACD, or PPO indicator.  If you look at the period selection, this is equivalent to a standard MACD on a monthly percentage scale, converted to a daily chart.

$SPX (S&P 500 Large Cap Index) INDX starting December 30, 1988

Exhibit A: At the top left of the chart, under the ROC indicator, in green.  This line is at an annual Rate Of Change of 9.5%, the median return over our 1950-1996 period.  The index spent two and a half years with an annual ROC that never even touched the median, and most of the time was two or three times the median number!

Exhibit B:  Top middle of the chart, in red.  Note that each time the market touched a 40% annual return, a spike down followed.  The index touched 40% one-year returns three times in the thirteen months before the crash!

Exhibit C:  Bottom right of the chart, in blue.  This line represents the equivalent of the monthly PPO reading of "12."  In simple terms, this means the difference between the 12-month exponential moving average of price and the 26-month exponential moving average of price is 12%.  For more on the PPO, see the Stockcharts.com "chart school." The good thing about the PPO is that it is value-neutral; a "12" means the same thing for a 300-dollar index as it does for a 1,000-dollar index, and this will come in handy.  Note the index spent about a month in some very rare air before the crash! 

Exhibit D:  Bottom right mid-chart, in purple.  The "W" of Death!  Just a reminder, BUYING PANIC IS USUALLY A GOOD IDEA.  I love "W" bottom patterns in a panic situation, remember that this crash was a buying opportunity!  Even the worst possible post-crash 1987 entry was worth +10% by year-end 1988.

So we have a very long period, several years in fact, of above-median annual returns, several instances of tech-bubble-like annual returns intra-year, and truly incredible long-term momentum indicators leading into a crash, panic, and a superb buying opportunity.  If you are the type to have a bond or cash allocation in addition to your stock allocation, it would have paid you to sell your bonds post-crash and then buy stocks with them.

When the Bear Awakens, Part II

Who can forget the big she-bang in 1998?  Let's take a look at the chart, again.

$SPX (S&P 500 Large Cap Index) INDX starting December 31, 1998

Exhibit A: At the top left of the chart, under the ROC indicator, in green.  This line is at an annual Rate Of Change of 9.5%, the median return over our 1950-1996 period.  The index spent three years and three months with an annual ROC that never even touched the median, and sometimes was two, three, four, or even five times the median number!

Exhibit B:  Top middle of the chart, in red.  Note that the index exceeded 40% one-year returns three times in the thirteen months before the crash!

Exhibit C:  Bottom right of the chart, in blue.  This line represents the equivalent of the monthly PPO reading of "12."  Once again, the index spent more than a month in some very rare air before the crash!  And did you see the "mini-crash" in the fourth quarter of 1997, following a monthly PPO "12" reading?  Wow.  Marked with blue arrows.

Exhibit D:  Bottom right mid-chart, in purple.  The "W" of Death!  Just a reminder, BUYING PANIC IS USUALLY A GOOD IDEA.  In this case, buying the confirmation of the "W" was worth 14% in a quarter.

When the Bear Awakens, Part III

Nobody has forgotten the bear market that started in 2000.  In fact, memories of it are so prevalent that many people are still fighting the "bear war."  Quite frankly, it reminds me of the stories of Japanese soldiers on Pacific isles, still thinking the war was raging, years later.  Oh, bother.  Let's look at the chart!  In this case, we'll look at a 27-year chart.   In this case, the base of the chart is monthly and so are the indicators.

$SPX (S&P 500 Large Cap Index) INDX starting February 2, 2007

Exhibit A: Take a look at the green line showing the ROC of 20%.  Great Jumpin' Jehosaphat!  This was a five-year period where the average annual return exceeded 20%!  This was completely unheard of!

Exhibit B:  From Jan 1980 to Oct 2000 is 20.75 years.  If you compounded at the median ten-year rate of return, which is 8.6% annualized, from the 105.76 reading on the first day of January 1980 to the end of September 2000, you'd have 585.86.  You can see how stretched we were by that point in time, from looking at the red triangle which signifies the target compounding rate and the deviation from it.

Exhibit C:  This is a truly massive long-term momentum divergence.  Shown with blue.

Exhibit D:  Here it is, another "W."  This formation is a tried and true indicator of major bottoms, and this signifies the true end of the bear market – just like it usually does.  Anybody that didn't get long following this point was playing with their emotions and not with their eyes, or brains.

Summarizing the Bear Recipe

The bear recipe has just a few parts, but they seem to be pretty important.  First, we need to see a long period of performance, and by long, I mean years, without the year-over-year return ever being below the median year-over-year return.  Second, there are profound spikes of incredibly high annual returns that precede these crashes.  Third, the momentum as measured by a slow-moving variant of the MACD reaches a historically extreme reading.  Finally, our sign that the bottom is reached is marked by a "W," for "W"here it pays to buy panic.

So, Where Do We Stand Right Now?

We can answer that question by taking a look at a five-year daily chart, keeping the same indicators we used when looking at the crashes of 1987 and 1998.

$SPX (S&P 500 Large Cap Index) INDX starting February 2, 2007

Exhibit A:  This is the line at 9.5% annual return.  Please note that while we've been above it for a while, we've been below it several times over the past three years, and never ever been egregiously above it.

Exhibit B:  This line is at 20% year over year.  Note that the index return has never touched even this low 20% number, as opposed to the 1987 and 1998 crashes, where it exceeded 40% three times before each crash.

Exhibit C:  Here is the momentum PPO indicator.  The peak momentum level over this bull run has not even hit "5" – much less the "12" that was hit before the prior crashes.

Exhibit D:  Here are several "W" bottoms.  If you weren't staring at your navel lint during these periods, you had some excellent buying opportunities.  In retrospect, it's easy to note the sector rotation and changes of the guard taking place, but I leave that homework to you.

The Current Bearishness

I think you can plainly see that the current "scare tactics" being thrown about are just that: scare tactics.  It seems I can barely go a week without reading a blogger or pundit compare the current market to 1987 or 1998, or complain about levels of bullishness and excessive gain that hasn't been seen before!  The reality is that while we currently are in the middle of a nicely trending bull market, we are nowhere near the excesses of the prior crashes.  For us to get to the point where something besides a minor correction was imminent, we would need to see some spectacular gains from this point – the kind of gains that haven't been seen in many years.  So relax!  There may be corrections in the near future, and there may be bear markets and crashes ahead of us, but the big downside moves aren't imminent.

Did I Say "Correction?"

I'm amazed at the flippancy with which certain pundits will throw out arbitrary percentages, as if they had some significance.  I covered the cognitive errors inherent in the typical "2% down day" streak commentary in a post titled streaks, distributions, black swans, and golden swans, but a short recap is in order.  Basically, we get streaks of low volatility and streaks of high volatility, some of them very long, and they are not at all unusual.  Another item that isn't unusual, is that the bears will twist the truth – through either ignorance of, or avoidance of, the fact that UPside volatility is compressed in these streaks as well.   For example, we've had only TWO 2% up days in over three years, both of them at the June lows of 2006. 

A similar arbitrary measure often used is the "10% correction," as if movements of less than 10% from high to low just don't count.  Hmm.  I guess "Dr. Destructo" shouldn't get on Bubblevision and say he expects a 7% to 13% correction in equities, then.  After all, if it's 7%, it's not a "10% correction."  Or is a 7% move "allowed" to be called a correction?  A good example of this may be the "summer swoon" in the S&P 500 that occurred last May 2006.  From the high of 1326.70 to the low of 1219.29 is a loss of 8.1%, which by the standards of an intellectually honest man calling for a "7% to 13% correction" should qualify.  Especially so, in light of the lower volatility that has been experienced over the past few years, a low volatility that finds many bears complaining about it.

About Those "W"s of Death

Most of the current blogs weren't around during the bear years, but it's relatively easy to find commentary in many folks' archives going back into 2005, occasionally 2004 or 2003. This is very helpful in terms of analyzing whether the writer that you're reading is actually capable of making a market call, or if they are merely a toothless old perma-bear, trying hard to scare you.

On the five-year chart for "Where Do We Stand Right Now" I marked three "W" bottoms, going back to April-May 2005, October 2005, and June-July 2006.  You can easily identify the other "buy" points in 2003 and 2004 using the same criteria, and knowing what you do now about panics, you can see how easy they are to identify in general.

This isn't investing advice: this is intelligent advice.  The next time you find yourself reading a popular columnist that is advocating a flight from equities, espousing a coming "melt-down" or "melt-up" in the markets, or generally expressing the probability of imminent financial disaster on a Biblical scale … go to their archives.  Read every column written in the weeks before and after the critical "buy" points marked on the chart.  If they were advocating selling, consistently and every time when you really should have been buying, do yourself, your serenity, and your account a favor, and remove them from your bookmarks.

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