Anatomy of the Bear

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Anatomy of the Bear

• Lessons From Wall Street's Four Great Bottoms

Russell Napier
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Isnt history bunk?

• Progress is cumulative in science and
  engineering but cyclical in finance - James
  Grant (Money of the Mind)
• . . . for having integrated insights from
  psychological research into economic science,
  especially concerning human judgment and
  decision-making under uncertaintyDaniel
  Kahneman, Nobel Prize in Economic Sciences 2002
• What is financial history if it is not a study of
  human judgement and decision-making under
  uncertainty?

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Defining the bottom of a bear market

• When were the best subsequent returns achieved?
• Calculate hindsight value
• August 1921, July 1932, June 1949 and August 1982
  
• Not December 1974

Source CLSA Asia-Pacific Markets
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Hindsight value
Source Smithers Co., CLSA Asia-Pacific Markets
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Definition of Q

• Market value of equities Equity q
• Tangible assets minus net corporate debt
• Rationale behind Q - because stocks represent a
  title to the ownership of real assets, they
  should, if fairly valued in a competitive
  economy, have a market value equal to the cost of
  their production

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Methodology

• Value considerations are not enough to find the
  bottom - Q ratio relative to geometric mean -
  equities get cheap and keep getting cheaper
• Analyse the turning points in these bear markets
  with the benefit of hindsight
• Analyse the turning points based on contemporary
  opinion right and wrong
• 70,000 WSJ articles - good sample of contemporary
  opinion

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Q ratio
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Equities become cheap slowly- Cyclically
adjusted PE
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Conclusions - Strategic

• Bear markets are long - at least a decade
• Equities move from over- to undervaluation slowly
• Equities become cheap following a major
  disturbance in the general price level
• Fiscal deteriorations are irrelevant
• Return of price-stability signals the death of
  the bear
• The bottom for equities follows the bottom for
  government bonds and corporate bonds

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Conclusions II

• Equities will trade at a 70 discount to the
  replacement value of assets
• They will reach this discount 2009-14 - probably
  nearer 2014
• Between 2005 and 2014 the following will happen
• a disturbance to the general price level
• a selloff in government bonds
• a selloff in corporate bonds
• a recession
• The bear market ends when price stability returns

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Long bear markets (DJIA) 1899-1921
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SP Composite Index Earnings (1871100)as a
ratio of US nominal GDP
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Long bear markets II 1937-1949
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Long bear markets III 1964-1982
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General price disturbanceslead to cheap equities
Source Economagic, CLSA Asia-Pacific Markets
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General price disturbanceslead to cheap equities
III
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What signals the death of the bear?1. Evidence
of price stability

• Inventory in the system is low
• Some commodity prices start to stabilise
• Demand evident at lower price particularly for
  luxury goods or goods in structural demand
• Greater certainty on general price level and
  valuations more certain
• Corporate bond rally?

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Commodity prices bottom with equities

• Commodity prices bottom Aug 1921 with equities
• Commodity prices bottom July 1932 with equities
• Commodity prices bottom July 1949 with equities
• Commodity prices bottom Oct 1982 just after
  equities
• Copper price bottoms August 1921, June 1932, June
  1949 and June 1982

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Bonds first, then equities

• August 1921- May 1920 government bonds, June 1921
  Baa corporates, August 1921 commodities
• July 1932- January 1932 government bonds, May
  1932 Baa corporates, July 1932 commodities
• June 1949- October 1948 government bonds, January
  1948 corporate bonds, July 1949 commodities
• July 1982- October 1981 government bonds,
  February 1982 Baa corporates, October 1982
  commodities

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Conclusions - Tactics

• There is good news at the bottom of the market
• There are lots of bulls at the bottom of the
  market
• The final market collapse is not on high volume
• Watch Fed interest-rate policy, not changes in
  the Fed balance sheet

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Myths debunked 3 Capitulation 1921
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Capitulation 1932
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Capitulation 1949
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Capitulation 1982
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Myths debunked 4Fed watching of limited use at
bottom

• August 1921 Fed's balance sheet still
  contracting in 1924
• July 1932 Fed attempted balance sheet expansion
  in mid-1931 prior to 50 collapse in market
• June 1949 Fed supporting bond prices and balance
  sheet signals confused
• August 1982 Fed balance-sheet expansion evident
  by October 1982 but trigger was evident distress

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Other tactical considerations

• Not absence of good news but apathy towards it
• Market falls on small volume and rises on larger
  volume
• Short position rising but market not falling
• The dance of the little bears
• Market rising and bears not covering

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Other tactical considerations

• Over a real bear market , volume decline is much
  larger than market decline with a major caveat
• The success of Dow Theory Market is in a basic
  upward trend if one of two averages (DJ
  Industrials and DJ Transport) advances above a
  previous important high, accompanied or followed
  by a similar advance in the other. Both averages
  dipping below previous important lows confirms a
  downward trend
• The autos sector led the economic recovery on all
  four occasions
• News which threatens the financial system, July
  1982, signalled a buy when the Fed is unfettered
• Interest in equities declines

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Interest in equities declines

• Turnover-rate declines
• 1919 153 1921 - 59
• 1929 119 1932 - 32
• 1946 22 1949 - 13
• 1968 24 1982 - 42

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NYSE membership prices 1932-49
Source NYSE
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Turnover of NYSE shares traded as a percentage
of total listed
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Why October 2002 was not1921, 1932, 1949 or 1982

• Stocks are never cheap - Cyclically adjusted PE
  29x versus long term average of 14.9x. Q ratio
  1.32x geometric mean not the 70 discount
  expected.
• A 1929-32 short bear market is exceptional
• There was no disturbance to the general price
  level
• Turnover rate rose from 88 (2000) to 105 (2002)

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Conclusions - Strategic

• Bear markets are long - at least a decade
• Equities move from over- to undervaluation slowly
• Equities become cheap following a major
  disturbance in the general price level
• Fiscal deteriorations are irrelevant
• Return of price stability signals the death of
  the bear
• The bottom for equities follows the bottom for
  government bonds and corporate bonds

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Conclusions II

• Equities will trade at a 70 discount to the
  replacement value of assets
• They will reach this discount 2009-2014- probably
  nearer 2014
• Between 2005 and 2014 the following will happen-
• a disturbance to the general price level
• a sell off in government bonds
• a sell off in corporate bonds
• a recession
• The bear market ends when price stability returns

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