Stock Bear Looming?

With the US stock markets challenging a major multi-year high, investors are feeling pretty complacent these days. But unseen below the placid surface, a serious risk is arising from the depths. With each passing day, the odds grow that a new stock bear is imminent. As these merciless beasts typically maul the markets until stock prices are cut in half, they are dangerous threats that cannot be taken lightly.

The stock markets perpetually march forwards in great bull-bear cycles. All bull markets eventually mature and top when greed and complacency grow excessive and everyone willing to buy has already bought. Then bear markets are born, which don’t run their course until fear reigns and everyone susceptible to being scared into selling has already sold. And then this endless cycle begins anew, bull bear bull bear.

The problem today is our current bull market is long in the tooth, running longer and higher than average. And the older any trend in the markets gets, the greater the odds of an impending major reversal. After a bull market, a bear is absolutely inevitable. The only question is when it will awaken from hibernation. And thanks to our position in the bull-bear cycles today, probabilities favor that tipping point being soon.

Understanding these bull-bear cycles is crucial for investors and speculators. If you wrongly buy near the top of a bull, or sell near the bottom of a bear, it will derail your wealth-building progress for years. There are two distinct species of bulls and bears, secular and cyclical. The secular ones persist for the better part of two decades, while the shorter cyclical ones alternate every few years within the secular ones.

A full secular bull-bear cycle lasts a third of a century, or about 17 years each for the bull phase and bear phase. To get up to speed on this essential strategic context, read one of my essays on Long Valuation Waves that encompass full secular bulls and bears are remarkably consistent in their third-of-a-century duration, as are secular bears which run for the second halves of these waves. The previous two secular bears ran 16.5 years (1960s) and 19.8 years (1930s). Today’s is only 12.4 years old.

So the averages suggest we have the better part of five years left, and even in a best-case scenario there should be a few more. I suspect that one more cyclical bear will take us back down near secular support (750 SPX) over the next couple years or so. And then the subsequent cyclical bull will once again eventually regain resistance (1500) over the following three years. And then this secular bear will end.

Also realize that the primary reason secular bears exist is valuations. Valuations, or how high stock prices trade relative to the underlying earnings their companies can generate, are propelled to unsustainable bubble extremes late in secular bulls. The mighty companies of the SPX were trading at an astounding 43.8x earnings back in early 2000 when today’s secular bear was stealthily born!

Get The News You Want

Read market moving news with a personalized feed of stocks you care about.

Get The App

Secular bears typically don’t end until the general-market price-to-earnings ratio falls back down near 7x earnings, half the historical average of 14x. The 1970s secular bear didn’t end until the SPX was trading at 6.6x, way after it started at roughly the same SPX level 16 years earlier but then priced at 24.1x. If the SPX’s P/E ratio was down under 10x today, then we could consider the possibility of this secular bear ending early.

But it’s been nowhere close. Near the SPX’s latest cyclical-bull high in early April, the elite component stocks of this flagship index were collectively trading at 19.4x earnings. There is no way a secular bear, which exists to force stocks sideways from extreme overvaluation to extreme undervaluation, would end on such a high metric. This bear’s valuation work is only about half done so far, with lots of drifting left to go.

And not even that crazy stock panic or the Obama scares afterwards pushed the SPX to secular-bear-ending territory. Its P/E ratio was still 11.6x heading into the March 2009 secondary low, and was 13.0x at the end of October 2008. Secular bears are a valuation thing, and valuations have never been anywhere close to levels that could send this decade-plus bear back into hibernation early.

In light of all this, the risk that a new cyclical stock bear will soon be upon us is high and growing. This has enormous implications for investors on multiple fronts. If you want to plow new surplus capital into stocks, late in a cyclical bull is the wrong time to do it. After the subsequent cyclical bear cuts the markets in half again, the same cash will buy twice as many shares at very cheap prices. Don’t buy high late in a bull.

If you are going to need to sell significant stock positions to raise cash anytime in the next five years or so, it is prudent to do it soon while the SPX is still high in its secular trading range. I say five years because a cyclical bear can run for two and then a cyclical bull for another three before we get back up near resistance again. As an added bonus, capital-gains tax rates remain low for the rest of 2012.

Provocatively not every sector gets sucked into cyclical bears, there are isolated areas that thrive when the rest of the markets are selling off. Chief among them is gold, and therefore its leveraged subsidiary plays of silver and the precious-metals miners. In the last cyclical bear when the SPX lost 56.8%, gold rallied 24.8% over that exact span! In the one before that when the SPX lost 49.1%, gold climbed 12.6% even though its secular bull didn’t start until the middle.

The bottom line is the stock markets’ cyclical bull of recent years is getting long in the tooth. It has both lasted longer than the average mid-secular-bear cyclical bull and powered considerably higher. Greed and especially complacency run high, with the flagship S&P 500 stock index nearing the top of its giant secular-bear trading range. All of this is increasing the odds a new cyclical bear will be born anytime now.

These dangerous beasts are not to be trifled with, as they tend to cut the stock markets in half. The losses in popular high-beta sectors are even greater. The surest defense is boring old cash, as falling stock prices greatly increase its purchasing power. But a far-more-profitable and exciting alternative is gold, which has continued rallying through each previous cyclical bear of this long secular bear.

Written By: Adam Hamilton