Comment 64: US Stock Market(3). Endings of bear markets. (Dec. 10, 2008)

The current bear market of stocks has started in the fall of 2007. On the face of the advancing bear market Wall Street gurus have been paraded on financial media, mainly offering bullish cheer leading to entice investors to buy stocks. After the first financial firestorm, induced by the grand liquidity squeeze, hit in August of 2007, the prevailing theme was the "decoupling theory". The theory says in essence that the "globalization" scheme trumpeted by free market economists, politicians, and Wall Streeters is actually a bad joke. There is no such thing called the global economy but only disconnected economic entities on the globe. Those decoupling theorists promote China as the economic superman, and claim that the fast growing China will save the world even if US falls into a recession; strong China will continue to buy from US firms listed on the US stock markets and will lift the prices of those US stocks. Thus the decoupling theorists claim that the US stock markets will continue to go up in spite of trivia like subprime mortgages, the house of cards of derivatives, the panicking Federal Reserve Board and the Treasury Department, financial firestorms, SIV, CDO and so on. Many investors listened to the decoupling theorists and bid the stocks to a record high in the fall of 2007. The decoupling theorists were devastated only when China's stock market plunged even more severely than US stock market.

Most bear markets do not consist of one single drop of stock prices. The stock market will turn down, will catch a breath and stage a phase of consolidation with a counter rally or a stagnation period, and then will resume its fall. During the Great Depression, US stock market in terms of Dow Jones Industrial Average, experienced seven to eight such consolidation phases and then hit the bottom. In the current bear market the first consolidation phase lasted about one month near the end of 2007, and the market resumed the second leg of drop as the year end liquidity squeeze of 2007 set in (see Comment 53 for details). The second consolidation phase started near the end of January of 2008 when the Federal Reserve Board lowered short-term interest rates drastically, and the consolidation phase lasted until the end of May of 2008. It was the undoing of Bear Stearns that ignited the third leg of plunge of stocks. As US Government bailed out Bear Stearns the third phase of consolidation started in mid July of 2008 and continued until the mid September of 2008. The meltdown of Wall Street as depicted in Comment 59 sent the stock market into the fourth leg of a sharp drop. After that drastic fourth leg of fall, the fourth phase of wildly gyrating consolidation set in (see Comment 62 for details about this consolidation phase). The fourth consolidation phase started after the panicking rescue efforts launched by US Treasury Department and the US Congress, and lasted until early November of 2008. The fifth leg down is triggered by the unwinding of yen-carry trades as US Dollar falls sharply against Japanese Yen. Currently the stock market is in its fifth consolidation phase. At each consolidation phase, major financial media were always able to line up many Wall Street gurus to pronounce the bottom of the stock market and urge investors to buy stocks. In this fifth consolidation phase, the situation is exactly the same. We are naturally interested to know when the bottom of the current bear market will be reached. Unlike the gurus of Wall Street we do not believe that stock market is disconnected from the real economy. The bear market will reach its bottom when the real economy starts to turn from bad to better. The question is the exact timing. Is it really true that stock market has some magical power and can predict the coming recovery anywhere from a few month to one year ahead of the time as Wall Street gurus are promoting or such claims are just a baseless self promotion of Wall Streeters? The best way to answer this question is to look at the records of past bear markets associated with the past economic recessions and see what lessons can be derived from such an objective study. This Comment is devoted to this line of analysis, but should be considered as the first installment of this continuing effort.

The quarter to quarter growth rate (annualized) of real GDP is used as the measure to gauge the economic condition as a whole. Since the quarter to quarter growth rate of real GDP is quite jumpy, four quarter moving averages of the growth rate are calculated and are plotted as the green curve in the graph at the right; the scope of the graph extends from 1960 to the third quarter of 2008. When the green curve dips close to or below 0%, the economy is considered to be in a recession. The lowest point of the green curve during a recession is labeled as "1", "2", .... , "7" in green respectively. The quarterly lows of Dow Jones Industrial Average are plotted as the red curve in the same graph at the right. Since Dow Jones Industrial Average has changed more than 10 times in the forty-plus years covered by the graph, the conventional logarithm of quarterly lows of Dow Jones Industrial Average is used to plot the red curve. The dip in the red curve associated with each dip in the green curve is labeled in red as "1", "2", .... ,"7" respectively. The two dips on the red curve labeled as "B", one at 1961, and the second at 1987, are not associated with economic recession directly so will not be discussed here, though each dip with "B" has good reasons to appear.

The low point of the red curve marked as "1" precedes by one quarter the low point of the green curve marked as green "1". Superficially one may think that the bottom of Dow Jones Industrial Average was reached one quarter ahead of the bottom of the real economy. However, this is a misconception. The green curve is four quarter moving average. The event associated with the dip at the green "1" actually happened roughly two quarters ago. In this sense the bear market bottom related to the recession was formed one quarter after the real economy had hit the bottom. Exactly the same conclusions can be drawn for the bear market bottoms and the bottoms of real economies labeled as red and green letters "3" and "6" respectively. For the cases of "2" and "4", the troughs on the red curve precedes the corresponding troughs on the green curve by two quarters. Considering that the green curve is based on four quarter moving average, the bear market bottoms of "2" and "4" were reached in the same quarters of the troughs of real economy respectively. The troughs of "5" on red and green curves coincided at the same quarter, indicating that the bear market bottom was reached two quarters after the real economy had hit the bottom. From the examinations of bear markets "1" to "6" there is no evidence that stock market is capable of forecasting the bottom of the real economy in a recession. Bear market bottoms are reached in most cases one or two quarters after the real economy had hit the recession low. Only in a few cases bear market bottoms were reached in the same quarters of the trough of the real economy. This behavior of bear market bottom is perfectly consistent with our common sense. Smart money in the stock market knows that after the bear market a prolonged bull phase is awaiting. There is no urgency that stocks must be bought at the exact bottom of the real economy. The prevailing mood of smart money is better to be careful than sorry. That is the reason why bear market bottoms are formed often slightly trailing the trough of the real economy. Only ignorant amateur investors dazzled by the sweet talks of gurus, and some gurus blindsided by their own words will jump into the advancing bear market and buy stocks prematurely.

The case of the last recession associated with the burst of the dot-com bubble, labeled as "7" on the graph provides another interesting example. The trough of green curve was reached at the fourth quarter of 2001, implying that the bottom of the recession was reached in the second quarter of 2001, ahead of 911 tragedy; the 911 tragedy did not affect the green curve very much. The bottom of the bear market labeled as red "7" was reached in the third quarter of 2002, five quarters after the trough of the real economy. A close inspection of the red curve reveals the existence of a shallower dip at the third quarter of 2001. This shallower dip in the red curve is purely the result of the temporary shock of 911 on the stock market. If there were no 911, the red curve would have simply declined slowly through the period and connected smoothly to the bear market low at red 7. The prolonged delay of the bear market bottom from the trough of the real economy was due to the strong disbelief of Wall Street that the dot-com bubble was able to burst and the Street was in the mood of denial for more than a year after the real economy had reached the bottom and had started to recover. It was when the recovery hit an air pocket and the growth slowed down temporarily in 2002, Wall Street finally woke up from the dream of denial and sold off to form the bear market low at the third quarter of 2002.

From the analysis of past bear markets and economic recessions covered in the graph, we can say the following about this bear market: If someone wants to claim that the Nov. 20 low of the stock market is the bottom of this bear market, then the person must assume that the real economy must have hit the bottom in the third or the fourth quarter of 2008. If one assumes that the trough of the real economy will be reached in the second quarter of 2009, then he/she has better anticipate a bear market bottom in the range of the second quarter to the fourth quarter of 2009. If the trough of the real economy is set at the fourth quarter of 2009, then the bear market bottom will be reached in the range of the fourth quarter of 2009 to the second quarter of 2010, and so on. Also cannot be ruled out is the scenario like the case of recession "7" in the graph; when the recovery hits a temporary air pocket one year or later from the bottom of the recession, Wall Street will finally wake up from the dream of denial and sell off in panic. Thus a much lower absolute bottom of the bear market will be formed.