Faber's Latest: An Anatomy of Bear Markets
(Download PDF for charts)Market Comment: April 12, 2006 Dr. Marc Faber
Today, I wish to address the subject of bull and bear markets. This cyclical
movement in asset prices, investors will call, when prices are rising, “bull
markets” and when prices are declining “bear markets”. On the surface this
seems simple to understand. The Dow goes up, it’s a “bull market”, the Dow
goes down it’s a “bear market”. But, in reality, bull and bear markets are far
more complex. Let’s assume we have just five asset classes. Real estate,
stocks, bonds, cash, and gold (or a hard currency for which money supply
growth is kept at the rate of real GDP growth leading to stable prices). At
present, it is clear that the Fed is printing money. So, all asset prices except
bonds will rise in value. But, some asset prices will increase more than
others. Since October 2002, the Dow Jones has rallied in US dollar terms,
but against gold it has depreciated (see figure 1).
So, we can say that, yes, the Dow has been in a bull market since October
2002 in dollar terms, but it has been in a bear market in gold terms. This is
an important point to understand. In case we should experience continuous
monetary inflation, which could lift, over time, all asset prices such as
stocks, real estate, and commodities, some asset classes will increase more
in value than others. This means that some asset classes while rising in value
could deflate against other asset classes, such as happened with the Dow
against gold since year 2000. I have pointed out in earlier reports that since
2002, all asset prices rose in value. But recently, some diverging
performances emerged. Bonds started to decline and seem to be on the verge
of a significant long term break down (see figure 2).
I have also mentioned in earlier reports that, in times of monetary and credit
inflation, such as we have now in the US, bonds are the worst possible long
term investment.
Another asset class, which has recently begun to depreciate against gold
are home prices (see figure 3)
As can be seen from figure 3, since last summer, home prices while only
declining moderately in dollar terms, have declined significantly in terms of
gold. So, whereas it took over 500 ounces of gold to buy a typical house in
the US last summer, now, it only takes around 380 ounces of gold. In other
words, home prices have declined over the last 9 months by 25% against the
price of gold!
What I really want every reader to understand is that bull and bear markets
are extremely complex and an asset class, which seems to be in a bull market
may not necessary be in a bull market when compared to a hard currency
such as gold. In this respect the following is also important to consider.
Conventional wisdom has it that a true market bottom, which offers a
once-in-a-lifetime buying opportunities, only occurs after a devastating bear
market. In this context, the following severe market declines usually spring
to investors’ minds: the 1929–1932 bear market in US equities; the collapse
in the US bond market between 1970 and 1981, when yields on 30-year US
Treasuries rose from 6% in 1970 to 15.84% in September 1981 and sent
bond prices tumbling; the 1973–1974 Hong Kong stock bear market, which
brought the Hang Seng Index down by 90% to its December 1974 low at
150; the great sugar bear market, which sent prices down from 70 cents per
pound in 1973 to 2.5 cents in 1985; or the Japanese bear market post-1989,
when the Nikkei dropped from 39,000 to less than 8,000 in April 2003.
Moreover, major market lows are associated by investors with total despair
and panic among market participants, depression in the asset class that was
subjected to the bear market, bankruptcies in that sector, and overwhelming
negative sentiment.
But, as Russell Napier shows in his recently published book Anatomy of the
Bear — Learning from Wall Street’s Four Great Bottoms the key element in
undervaluation can also be a period of time “when the advance in stock
prices has failed to keep pace with the economic and earnings growth”
within the system (The book – an excellent read - is available from
Amazon.com or from CLSA directly. Contact victoria.tang@clsa.com).
Napier shows, for instance, that at the market low in 1921 the Dow Jones
Industrial Average was no higher than it had been in 1899 — 22 years
earlier — while nominal GDP had increased by 383% and real GDP by
88%! Similarly, by August 1982, the Dow Jones Industrial Average was no
higher than it had been in April 1964, and was down by 70% in real or
inflation-adjusted terms. According to Napier, August 1982 represented the
fourth-best buying opportunity for US equities in the last century, aside from
1921, 1932, and 1949 (see figure 4). The important message one might
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take from Napier’s book is that it usually takes a long time — about 14
years — for stocks to travel from overvaluation to undervaluation, and
that the nominal low in stock prices isn’t always the best time to buy
equities. What is more important is the real level of equity prices and
various valuation parameters that indicate deep undervaluation. Thus, while
the Dow Jones bottomed out on December 9, 1974 at 570, and stood at 769
at its August 9, 1982 low, in real terms the Dow had lost another 15% since
the 1974 low.
I am mentioning this because it is possible that the October 2002 lows for
the US stock indices will hold in nominal terms. However, as I have shown
above, the Dow has been declining in gold terms since 2000 (see figure 1)
and is, in my opinion, likely to continue to do so for many years.
As a side, Russell Napier has filled a void with Anatomy of the Bear,
since, to my knowledge, it is the first book to trace the swings from
undervaluation to overvaluation and back to undervaluation, of US stock
prices over the past 100 years. The book also provides much food for
thought. If equity prices swing back and forth between overvaluation and
undervaluation, other asset markets such as real estate, commodities, and
bonds will do the same. Thus, I suppose that, in the same way that US bonds
were grossly overvalued in the 1940s, Japanese bonds were grossly
overvalued in June 2003, when the yield on JGBs had declined to less than
0.50%. At the same time, the April 2003 low for the Nikkei Index at less
than 8,000 may have been the best buying opportunity in Japan of this
generation. In fact, the 2003 lows in Japanese equity prices and interest rates
have similarities to the 1940s’ lows in US equities and interest rates. After
the 1940s, US stocks rallied into 1973, but bond prices collapsed into 1981.
Similarly, the stock market rally in Japan, which began in 2003, could last
for many years and be accompanied by a significant bear market in Japanese
bonds, which would drive local institutions and Japanese households out of
their overweight bond and cash positions, which benefited during the 1990s’
deflation, and into equities and real estate. Moreover, if, as Napier explains,
1921, 1932, 1949, and 1982 provided outstanding buying opportunities for
achieving subsequent high returns that tended to last for a minimum of eight
years (1921–1929), but usually for much longer (1982–2000), then I suppose
that — taking the late April 2003 low of Japanese equities as a generational
low — the bull market in Japanese equities could easily last until at least
2010 or even longer, and in the process significantly outperform US equities.
Another lesson from Napier’s book could very well be that other Asian
equity markets, relative to other assets, remain grossly undervalued despite
their post-1998 recovery. After all, many Asian stock markets, whether in
US dollar terms or in real terms, are still down by more than 50% from the
highs reached between 1990 and 1994.
Lastly, if, as Napier outlines, it takes about 14 years for equities to make
the journey from overvaluation to undervaluation, the severity of the
commodities bear market from 1980 to the turn of the millennium — about
20 years — is evident. Put into the proper perspective, in real terms
(inflation-adjusted) commodity prices were, in the 1998–2001 period, at the
lowest level in the history of capitalism (see Figure 5). And, although I
expect some industrial commodity prices will suffer from a significant phase
of profit taking in 2006, given the fact that commodity bull markets tend to
last anywhere from 20 to 30 years, we may just be at the beginning of an
extended rise in the price of natural resources.
There is another point I should like to add to Russell Napier’s excellent
study, which I strongly recommend investors to read. In a world of rapid
monetary and credit expansion, an undervaluation of the Dow Jones might
occur, with a Dow Jones at 36,000, 40,000, or 100,000 or more — a stock
price level that was predicted by several analysts in 1999. How so?
At present, the Dow is at around 11,000 and the price of gold is at $590.
Let us assume that, as a result of Mr. Bernanke’s more efficient paper money
printing machine (incidentally, a machine that has been in operation since
the formation of the Federal Reserve Board in 1913 and which accounts for
the dollar’s 92% loss in purchasing power since then), the Dow Jones rises
to 36,000 in the next few years. (It won’t take another 100 years for the US
dollar to lose another 92% of its purchasing power; more likely is 10 to 20
years.) If this were the case, the price of gold could rise from $550 to
$3,600, which would bring down the Dow/gold ratio from currently about 19
to 10; or, in an extreme case, gold could rise to $36,000, which would bring
down the Dow/gold ratio to only 1 (as was the case in 1932 and in 1980)
Thus, in nominal terms, the Dow would have trebled from the present
level, but lost significantly in real terms — a possibility that I regard as very
likely. In this respect, we shouldn’t forget that during the German
hyperinflation period between 1919 and 1923, share prices rose sharply in
paper mark terms but tumbled in dollar terms (then a strong currency),
because the rate of the paper mark depreciation against the US dollar
exceeded the local share appreciation. Thus, by October 1922, an index of
shares in local paper mark terms had increased from 100 in 1918 to 171
billion, while in dollar terms the same index had dropped from 100 to 2.72!
Needless to say, the 1918–1923 German hyperinflation was devastating for
paper mark cash and bond holders.
Now, I am not necessarily predicting that we shall soon experience
hyperinflation rates in the US, but when the Dow Jones and the US housing
market will decline by 10%, it is very probable that Mr. Bernanke will put
the money printing presses into high gear in order to fight asset deflation.
So, US asset prices including homes, stocks and bonds could depreciate in
real terms and against precious metals.
Still, as I indicated last month, aside from bonds, all stock and
commodity markets seem to be now overbought and vulnerable to a
sharp correction. In fact, whereas I am extremely negative about bonds
in the long term, I believe that for the next three months or so, bonds
could actually outperform equities and also commodities. From figure 6,
we can see that equities have formed a rising wedge against bonds since
2005. More often than not, a rising wedge leads to a sharp downside
reversals. This would not necessarily imply that bond prices will rally much,
but the wedge might be broken on the downside by a sharp downturn in
equities.
For this reason, my advice remains to be extremely defensive. Most asset
markets including stocks and commodities are extremely overbought, and
there is far too much speculation in all investment markets. Therefore,
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severe downside volatility, also in precious metals, should not be
surprising in the period directly ahead.
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