Anatomy of the Bear
- Russell Napier
This insightful book based on painstaking research by Russell Napier uses financial history of over a hundred years to understand the anatomy of bear markets.
The author defines using the lessons of financial history: If there is a legitimate role for the study of human judgment and decision making under uncertainty, then financial history is redeemed. What is financial history if not such a study? The behaviouralist school of psychology, around for nearly a century, is based on observing reactions to selected stimuli. Financial history looks at market prices, which are a reflection of the behavior of thousand of participants to certain stimuli. In behavioural economics, history is a useful tool for observing how financial markets work, rather than theorizing about how they should work.
Such historical studies have not yet lent themselves to the comforts of empiricism. This, in itself, may be enough of a reason for many to reject the approach. However, the inability to translate all understanding into binary code does not necessarily denude it of value and insight. If psychology is a soft science, then using financial history to assess human decision-making in times of uncertainty is softer still. For those who accept that human judgement and decision-making cannot be divided by equations, financial market history is a guide to understanding the future.
Some of the conclusions that the author makes on studying the common characteristics of the great bear markets and the buying opportunities that they present are as follows:
It is axiomatic to say equities are cheapest at the bottom of the market. One indicator of value available to investors at the time was the q ratio. It fell below 0.3x at all four bear market bottoms. The cyclically adjusted PE provides the next best contemporary indicator of value, but its range has been rather wide at the bottom - from 4.7x in 1932 to 11.7x in 1949. Even calculating cyclically adjusted PE using inflation adjusted earnings, the range is still a wide 5.2x to 9.1x.
Equities become cheap slowly. On average, it took nine years for equities to move from peak q ratios to their lows. If one excludes the 1929-32 bear market, the average period for the adjustment in valuations was 14 years. The US equity market reached its highest-ever valuations in March 2000, and all extremes of valuation have been followed by this slow move to undervaluation.
With the exception of 1929-32, our bear markets occurred against a background of economic expansion. On average, real GDP expanded 52% over the course of our three long bear markets. Nominal GDP expanded by an average of 285%.
Reported corporate earnings growth, at least in real terms, is muted during our bears, but it too has a wide range. Inflation-adjusted earnings growth ranged from -67% to +28%. For nominal earnings in the four bear markets, the range is -67% to+ 119%.
A material disturbance to the general price level will be the catalyst to reduce equities to cheap levels. On three occasions - 1921, 1949 and 1982 - the disturbance was a period of high inflation followed by deflation, although in 1982 deflation was confined to commodity prices. There was no initial inflation in 1932, but there was still a material disturbance to the general price level in the form of severe deflation. In such periods of price disturbance, there is great uncertainty as to both the level of future corporate earnings and the price of the key alternate low-risk asset government bonds. This in turn leads to a decline in equity valuations.
We have seen that all four of our bear-market bottoms occurred during economic recession. We have also seen that a return of price stability, following a period of deflation, signals the bottom of the bear market in equities. In particular, stabilising commodity prices augur more general price stability ahead and signal the rebound in equity prices. Of all the commodities, the change in the trend of the price of copper has been a particularly accurate signal of better equity prices. In assessing whether price stability is sustainable, investors should look for low inventory levels, rising demand for products at lower prices, and whether producers have been selling below cost.
We have seen that a sell-off in government bonds accompanies at least part of the bear market in equities. Things were slightly different in 1929-32, when bonds rallied from September 1929 to June 1931. Only then did a sell-off begin, lasting until January 1932. But even in the two bear markets associated with high levels of deflation - 1921 and 1932 - there was some sell-off in government bonds.
Tactical
Investors should look out for the key strategic factors when attempting to assess whether the move from overvalued to undervalued equities is nearing completion. When the strategic factors suggest this process may be coming to an end, there are a host of tactical considerations to be considered in attempting to find the bottom of the market. As we have seen, a recovery in government bond prices precedes a recovery of equities. In 1932, equity prices bottomed seven months after the government bond market. In 1921, 1949 and 1982, the lags were 14, nine and 11 months respectively. The price decline in the DJIA following the bottom of the bond market was 23% in 1921,46% in 1932, 14% in 1949 and 6% in 1982.
The birth of a new bull market for corporate bonds will precede the end of the bear market in equities. The recovery in corporate bond prices led equities by two months in 1921, one month in 1932 and five months in1982. In 1949 the lead was much larger - 15 or 17 months - depending on how one defines it, but this was probably due to the distortions to the bond markets in the post-war era.
In our three long bear markets, reductions in interest rates by the Federal Reserve preceded the bottom for equity prices. The lag before equity prices bottomed was three months for 1921 and 1949, and 11 months for 1982. On all three occasions, the decline in the DJIA over the period of the lag was less than 20%. It was a different story in 1929-32. The Fed cut rates in November 1929, while the bear market was still in its infancy.
A number of further tactical conclusions can be summed up briefly:
Economic and stock market recoveries roughly coincide. Recovery in the auto sector precedes recovery in the equity market.
Bear market bottoms are characterised by an increasing supply of good economic news being ignored by the market. While numerous bulls bang the drum for equities even at the bottom of the market, they will be ignored.
Many commentators will suggest the worsening fiscal position will prevent economic recovery or a bull market in equities. They will be wrong.
Decline in reported corporate earnings will continue well past the bottom of the market.
The bottom is preceded by a period in which the market declines on low volumes and rises on high volumes. The end of a bear market is characterised by a final slump of prices on low trading volumes. Confirmation that the bear trend is over will be rising volumes at the new higher levels after the first rebound in equity prices.
There will be a large number of individual investors shorting stocks at the bottom of the market. Short positions will reach high levels at the bottom of the equity market and will increase in the first few weeks of the new bull market.
Dow Theory works to signal a buy for equities.
These are the identifying features of the bear and its bottom. Just as the possession of fur does not, of itself, permit the identification of an animal as a bear, the possession of anyone of the features above should not be considered as constituting positive identification of its financial equivalent. Our list is the financial equivalent of Einstein's questions. In trying to identify the bear-market bottom you will have to find the answers to most, if not all, of the questions.
A classic.
