Secular Or Cyclical Bear Market Underway - That Is The Question!

Secular or Cyclical Bear Market Underway - that is the question!

Great traders of the past have often suggested that once a bear market in stocks begin, nobody can really now how far it will progress before ending, and it is wise therefore to assume the worst wait for definitive evidence that things are reversing before moving from a defensive investment stance once a bear market is underway.  The trend is down, and until that changes, be careful.

While we agree with this stance and trading philosophy, we also try to look at macro gauges to help us get a grip on what the likely downside potential is thus far.  In 1999-2000 we suggested that a secular peak in equity valuations was at hand and that a period of 12-18 years of down-trending PE's that would survive both up and down cycles was likely underway.  So far that thesis has held up despite a vigorous bull market since 2003 that has even sent some major indexes to test all-time highs.  But PE's have not come close to their peaks of 2000, and we suspect the secular decline in PE's is embarking upon a new leg down with the current bear market in progress. 

However we also did not expect the bull market from 2003 to be as strong as it has been in terms of appreciation.  The bull market and success of reflation efforts following the popping of the 2000 Tech Bubble has been impressive.  Yet it has not been quite as impressive as would appear at first blush.  Chart 1 shows the S&P since 1995, both in US dollar terms, and in Euro-terms.  While in dollar terms the S&P retested its 2000 peak at the height of the 2002-2007 bull market, in Euro terms the 2002-2007 bull market merely retraced little more than 38% of the decline from the 2000 peak.  In global purchasing power terms, the bull market is achieving a lower high than the 2000 peak, and if we soon make new lows below the 2002 lows in Euro terms, as appears quite possible, the S&P will be confirming a secular bear market underway in global purchasing power terms.  It should be noted that most, though not all, secular bear markets in PE ratios, tend to also accompany secular bear markets in stocks. 

 
Chart 1:In Euro terms 2002-2007 bull market only retraced about 40% of Decline from 2000 peak.  Crtsy StockCharts.com

A key question that investors must watch very closely therefore, is whether this bear market takes us to the point of making new secular lows in Euro terms below the 2002 lows.  If it does, then the bear market will have a lot of force behind making it more substantial than your run-of-the-mill cyclical bear market.  If the 2002 Euro-based lows in the S&P can hold and reflation efforts take hold to launch a new bull market, then a less dire outcome will become more probable. 

The stakes for the retest of the January lows will be high, but they will be even higher we suspect for a possible test of the 2002 lows in Euro terms.  Expect the Fed's efforts to grow more and more substantial if the January dollar-based lows in the S&P are broken, and to become even stronger on a test of the Euro-based lows of 2000, about 10% below current levels. 

Are we really in a secular bear market that started with the generational high PE's of 2000 in Techs and Internets that has merely been papered over by Fed monetary reflation since then - or are we simply in a cyclical bear market created by a financial crisis similar to 1990?  The action of the Fed, Feds, and market will tell the tale - and we would prefer to be heavily sidelined while watching for the verdict of the market as to whether this is a cyclical bear market underway or leg 2 down of a secular bear market. 

Until breadth and volume clearly develop on rallies, and tail off on declines, investors should stay cautious and watch with baited breath.  Our bias is that the Fed can hold off a true secular down-leg here.  However biases are best left to theories and not to investment actions.  Rate cutting is not solving the credit crisis and high yield rates continue rising as do rate spreads as the credit crisis spreads.  If an RTC-type bailout or Fed acting as lender of last resort to buy sub-prime debt or other such mechanism to allow this market to clear is not forthcoming soon, markets may careen lower to the point of testing the secular trend of the market ahead.  Stay cautious until some resolution is clear.

For many weeks now our long/short strategy was 100% on the sidelines and in T-bills, and it is still very heavily in T-bills right now.  However for the first time since the Fall, we have had some valid trades meeting our criteria with PHX on the long-side and TIN and PNK on the short-side.  We suggest lighter than normal allocation to these and close calls like HSVLY on the long-side and on the short-side MER, BLC, and NVLS.  It will take strong breadth and volume rallies in stocks and weaker volume and breadth declines before we would consider venturing into any net long exposure in global equity markets now - and so far these remain absent.

Yield steepening virtual banks got hit this week as the credit crisis extends to even reasonable credits.  Take profits here.  The commodity bull market got hit as contagion spills over from stock weakness and huge vertical moves are corrected.  Take some profits here and raise trailing stops on gold to lock in profits and exit if contagion spreads further, as is clearly possible.  Defense!

For those not familiar with our long/short strategies, we suggest you
review my book "The Hedge Fund Edge," my course "The Science of Trading," my video seminar, where I discuss many new techniques, and my latest educational product, the interactive training module. Basically, we have rigorous criteria for potential long stocks that we call "upfuel," as well as rigorous criteria for potential short
 stocks that we call "down-fuel." Each day we review the list of new highs on our "Top RS and EPS New High List" published
on www.midasresourcegroup.com for breakouts of four-week or longer flags, or of valid cup-andhandles of more than four weeks. Buy trades are taken only on valid breakouts of stocks that also meet our up-fuel criteria. Shorts are similarly taken only in stocks meeting our
down-fuel criteria that have valid breakdowns of four-plus-week flags
 or cup and handles on the downside. In the U.S. market, continue to only buy or short stocks in leading or lagging industries according to our group and sub-group new high and low lists. We continue to buy new long signals and sell short new short signals until our portfolio is
100% long and 100% short (less aggressive investors stop at 50% long
 and 50% short).

This past week in our US selection methods, our Top RS/EPS New
Highs list published on www.midasresourcegroup.com had three valid trades in long PHX, and short TIN and PNK.  We also had close calls on the long side in HSVLY (Long) & on the short-side in MER, BLC, and NVLS(short). This strategy is now only slightly positioned and net short, with the rest of capital in cash T-bills awaiting a better environment and some valid signals in individual stocks, with a bias to the short side (especially after a further rally). 

The chart below continues to show that now both Top RS new highs (available on www.midasresourcegroup.com) and Bottom RS New Lows are at relatively low levels, and neither has an edge of over 40 versus the other - meaning that the environment is not very good for longs or for shorts.  Let's wait until breadth is clearer and signals proliferate before risking precious capital in this treacherous environment therefore.  If the market can rally on strong volume further, and top RS new highs can rise consistently to 40 or higher over bottom RS new lows ahead, we may get a brief environment that allows for some long trades to work as trades.