"Where?" Part IV: Secular and Cyclical Bull and Bear Markets

We've changed the format a bit on how we're approaching more educationally-oriented content to make the Dreddnomics for Dummies series the highlight. However, in the spirit of leaving nothing incomplete, we feel the need to wrap the "Where?" series up. This will be the final installment.

If you haven't been following the "Where?" series so far, we highly recommend checking out the first three parts of this series, which are available under the "Education" section of the blog on the right hand side. They are:

• Part I: Intro to Inflation
• Part II: Money
• Part III: Inflation, Deflation, Real, and Nominal Prices
  

In the last part of this series, we covered more on inflation, deflation, real, and nominal prices in brief. In reality, it's complicated subject, but there should be enough there to get you started.

In picking up where we left off, we looked at the Dow Jones Industrial Average in nominal terms (as it's priced when you typically see it, in US dollars) and real terms (Dow Jones price divided by gold in US dollars). The result is the Dow Jones priced in ounces of gold instead of dollars. For now, we will refer to this as the real price of the DJIA.

As a refresher, we're including the chart here again. Note that we changed the color of the DJIA priced in ounces of gold (right hand scale), only to make it easier to read. No data has been changed. Click on the image for a larger image.


Note that the nominal DJIA (blue line) has long periods where it generally trends up and peaks at about the same time as the real DJIA (red line). The nominal DJIA then either falls or trends sideways while the real DJIA falls like a rock. Keep this in mind for a bit later while we investigate the standard way of looking at secular bull and bear markets.

Secular Market Trends
Conventional wisdom states that since the forming of the Dow Jones Industrial Average index, the US has been through four long bull markets where the economy was good, stocks rose, and fortunes were made. It has also been through four (counting the current one we're in now) bear markets where the economy was terrible, stocks were lousy, and fortunes were lost.

Wikipedia defines a secular market trend as follows:

• A secular market trend is a long-term trend that usually lasts 5 to 25 years (but whose distribution is more or less bell shaped around 17 years, in the stock market), and consists of sequential primary trends.
  

Take a look again at that DJIA chart again. The general trend is up over time, but there are periods that are generally up and others that are generally dropping or flat for many years. These are the secular market trends. Given that these trends last for a decade or more, it pays to know which secular trend you're in and what to do when you're in it.

This is more obvious in the picture of the DJIA from the Wall Street Journal several months ago.


Note that the chart is divided into secular market periods of growth that last for many years which are defined as secular bull markets, and there are periods where the DJIA is flat or down which are defined as secular bear markets. For our purposes, we will stick with the dates in the chart to define secular bull and bear market periods for the rest of this analysis. [Side note. These are periods defined by conventional wisdom, which will suffice for now. This is not, however, how we believe they should be defined, and we will prove below. For now, this will suffice.]

We have recreated the same Wall Street Journal picture with a little bit more context. Below are two DJIA charts in linear and logarithmic form, respectively. There is no difference in the data itself between the two charts. The major secular bull and bear markets are shaded green and red, respectively. The periods are labeled with beginning and ending date, beginning and ending values of the DJIA, and percentage gain or loss for that secular period. Several historical dates are listed as references.



Note that the DJIA index was put into place on May 26, 1896. Prior to that there were no indices that measured stocks in aggregate. For the purpose of this analysis, May 26, 1896 is the beginning of time, though it was not the beginning of the stock market itself (or even the beginning of the first secular bull market).

A few things about the data are interesting.

First, the secular bull and bear markets are determined by the green, secular bull periods in which the DJIA gradually rises to some "peak" value. The red, secular bears begin when the DJIA crashes significantly from its peak and moves "sideways" for a sustained period of time.

Note that not all crashes beget secular bear markets. For example, the 1987 crash, while significant, recovered quickly and continued the long bear market of 1982-2000. It was not marked by a particularly weak economy of any duration, so it was actually the beginning of a cyclical bear market within a secular bull market. It was a sharp correction, but for savvy investors, it was the buy of a lifetime.

Second, you can see that the bull market periods are generally upswing periods. If you are invested at the beginning of a secular bull market, you can generally just buy the stocks and hold onto them with no trading. That, of course, is referred to as "buy and hold." If you would have invested at the beginning of each secular bull, you would have gained 149.78%, 495.1%, 947.50%, and 1369.76%, respectively, for each major secular bull. All you had to do was "buy the Dow" and come back 14.71 years later, on average, to collect your payola. Easy, eh?

Third, note that the secular bear markets are punishing. Had you invested at the beginning of each secular bear, you would have lost 37.96%, 75.62%, and 21.93%, respectively. Also, keep in mind that this is in nominal terms. As you'll see later, the losses are much larger when adjusted for inflation. Had you invested your life savings on August 30, 1929 and waited it out during the following secular bear market of 1929-1942, it would have been November 24, 1954 before you broke even again. That's over 25 years of waiting to get your money back.

In the secular bear market periods, stocks either fall or generally move sideways for decades. In the end you wind up losing money. Clearly, if you "buy and hold" during this period, you're in a lot of trouble.

This is how we get to Dredd's Rules on Secular Markets:

• "Buy and hold" is for secular bull markets only
  
• Secular bear markets MUST be traded, so understanding timing is key
  

In general, secular bull markets last 14.71 years and secular bear markets last around 14.92 years, using the definitions of secular bulls and bear market periods as defined by the Wall Street Journal.

Some people will argue that the end of the secular bear market of the 1970s (the 1966-1982 period marked on the chart) actually ended when the stock market reached its low in 1974, shortly before the end of the Vietnam war. We wouldn't disagree. That's a reasonable way of looking at the secular bull and bear market periods.

Similarly, Some will argue that our current secular bear market didn't begin until the crash of October 2007 because the DJIA (and S&P) had reached new highs after the dot com crash of 2000. This is also a reasonable argument and legitimate way to divide up the secular bull and bear markets.

However, as we stated before, we're following the conventional bull/bear argument here. We have an entirely different way of breaking up the secular bull and bear markets that we'll discuss later that is based on the REAL price of the DJIA.

Cyclical Market Trends
Note that both secular bull and bear markets are made up of smaller periods where bull markets go down a bit or bear markets rise. Secular bull and bear markets, which are multi-decade phenomena, are made up of cyclical bull and bear markets. The definition and debate on what a cyclical bull and/or bear market is is well beyond the scope of this article. We'll come back to it another time. Suffice to say that in a secular bull market, the bear cycles pull the market back only a bit and provide the long term investor with a good time to buy stocks while the cyclical bull markets within a secular bull market advance the market to new highs. In a secular bear market, the cyclical bear periods are essentially crashes of significant magnitude and the bull markets are periods of sharp, but short recovery.

Where We Are Today
This brings us to the first answer, or at least first superficial answer, of the "where?" question. Where are we? We are in a secular bear market where buying and holding is not going to work. As of today, August 28, 2009, we are in a cyclical bull market within that secular bear (cyclical bull as designated by the Dow Theory and several other key market indicators). This cyclical bull appears to have started in March of this year. For many reasons such as the shape of the recovery from March, the fundamental economic situation, the cyclical period, and even the duration of the total secular bear market thus far, we do not believe that the secular bear market is even close to over, so we know that we must trade in and out of the market to do well. The key will be understanding when the cyclical bull period is ending. That is the primary reason we frequently comment on the market using technical analysis.

Dredd Approach to Secular Bear Markets
Secular bear markets are periods of extreme economic stress and are caused by different external factors. Of specific interest to us are the secular bear markets of 1929-1942 and 1966-1982 because they bear so much resemblance to the current secular bear market that we're in.

Much like today, the secular bear of 1929-1942 was caused by excessive debt that built up during the previous bull market after World War I. The market crash was caused by a forced deleveraging of debt. That bear market really didn't end in the United States until business production was ramped up for World War II. Unlike that period, the global monetary standard was gold, which put limits on the amount of money that could be created by the government.

The bear market of 1966-1982 had many causal factors, but inflation was the hallmark of that period. Much like today, the secular bear of 1966-1982 was a period of rampant money creation that culminated in the ending of the gold standard for the United States under Nixon in 1971.

"Stagflation" is the term coined to deal with the economic climate of the 1970s. It is essentially a description of a stagnant economic period with rising price inflation (which was, in fact, caused by rampant money printing, which we refer to as the real definition of inflation.)

Prior to the formation of the Federal Reserve in 1913, money and credit expansion was limited by the gold standard. Inflation was very low. If you look at the chart, you'll see this period was particularly marked by "sideways" market behavior where the market went up and down for almost 24 years. There was no crash--at least no obvious crash--as compared to the 1906-1921 and 1929-1942 periods.

This is where we start to look at things "differently" than most.

Let's look at the same linear and log charts from above, but with the DJIA priced in gold (real price of the DJIA) on the same graph in red.



Again, the blue line is the nominal price of the DJIA--the one that gets quoted frequently. The red line is the real price of the DJIA in ounces of gold, not in dollars. It's simply the nominal price of the DJIA divided by the nominal price of gold on the same day.

If you view these charts closely, you will see that we have shifted the green and red secular bull and bear market periods to coincide with the movements in the red (real) line, which in our opinion, is the real determining factor for when a secular bear will end.

Prior to the secular bear of 1929-1942, the nominal value of the DJIA and the real value of the DJIA were basically the same (in terms of pattern.) Then something interesting happens. In 1933, Franklin Delano Roosevelt formally devalued the dollar by confiscating gold, declaring a bank holiday and revaluing the dollar from $20.67 per ounce of gold to $35 per ounce of gold, a loss of 70% of purchasing power overnight. Prices rose 70% overnight. Frightening (but probably coming again to a country near you.)

Something else happened that was interesting at this point. The tracking of the real DJIA and the nominal DJIA breakdown, and have been moving further apart ever since. In short, in 1933, inflation in the US really started. Again, in 1971 (when Nixon removes the tie with the gold standard), it accelerates again. We'll see this more a bit later.

Note that we mentioned that some people will claim that 1974 was the real end of the 1966-1982 bear market. Based on the real price of the DJIA, we would disagree. In nominal terms, that may be the case. But in real term, the decline just continued--hidden by inflation.

Similarly, the 2003-2007 period was hidden by inflation. In nominal terms, the stock market reached a new high. But in real terms, the market has been crashing since 2000.

Inflation hides the real effects of what's going on in the economy. The deflationist camp does not understand this effect. You must absolutely understand that inflation must be taken into account when gauging markets. This will become more obvious in later charts.

[Side note: The blue/purple shaded area denotes a period where one could argue that there was the beginning of a secular bull market. It also coincides with the period in which Franklin Delano Roosevelt devalued the dollar. This shouldn't be surprising. People that had money realized money was worth much less and used that money to buy stocks, which is just a formal means of inflating.]


Let's go back to the very first chart with which we started this article.


It's the same chart as the the colored log chart above it, only using monthly prices instead of daily prices. The nominal DJIA (blue) is logarithmic, and the real DJIA (red) is linear so it shows up best visually. Here's the point. In every major secular bear market, the real price of the DJIA will show the end of the secular bear when 1-3 ounces of gold will "buy the DJIA." As an example, if gold stayed right were it is today (let's call it 950), then the secular bear would end when the DJIA reached 1100. Similarly, if enough inflation gets into the market and/or the USDX falls like a rock, we may see the DJIA at 20,000 at the end of the secular bear with gold at $10,000 + an ounce. Which direction it goes depends on the amount of inflation created.

A Closer Investigation of Secular Bear Periods
Since we're in a secular bear, let's break each of the major secular bear periods down for closer inspection in real and nominal terms. We're going to stick with the Wall Street Journal view of secular bulls and bears, just for convenience. First, the 1906-1921 secular bear.



The chart is linear because the time frame is relatively short and the machinations are not major. The red shaded areas are cyclical bears within the secular bear. The white areas are cyclical bulls within the secular bear. The blue line is nominal, and the red line is real. We will be consistent in this color coding schema for the rest of the charts in this article.

Note that the market is very regular and cyclical. This is a "normal" bear market, unpolluted by poor political policies and inflation. The real and nominal prices are really perfectly correlated. You'd have to trade the market to make money, but if you bought and held, the effects would not be devastating. However, if you bought at the beginning of a cyclical bull and sold at the beginning of a cyclical bear, you'd have done very well indeed.

Next, the 1929-1942, "Great Depression" bear market.

From 1913 on, with the creation of the Federal Reserve, the real and nominal prices have varied somewhat. However, they remained very close to one another until the 1933 formal devaluation of the dollar. You can see how the real and nominal market start to "decouple" strongly during this period, but are still tied together at a different exchange rate. They only get more decoupled from this point forward.

In this bear market, there was a long, major crash from 1929-1932, a strong but short bear market rally in 1932, another crash in 1933, the formal devaluation of the dollar that led to a cyclical bull market from 1933-1937, then an increase in taxes which led to another down leg that lasted until the US entered World War II.

You can see the effects of the Fed and government tinkering here already. The "solution" to the deflationary crash was to weaken the dollar. This has been the strategy ever since--today is no different. The currency always becomes the outlet for government intervention.

The devaluation works on the nominal market. Devaluation/inflation will make asset prices rise again, at the expense of the purchasing power of the currency (until it eventually destroys the currency.) However, note that increased taxation wrecked the recovery. Taxes matter.

Here's the 1966-1982 "Stagflationary" secular bear market.

We've had to add to this chart a bit to point out the profound differences of money printing over time. The red horizontal and vertical lines point to bear market periods in real terms while the red shaded areas show the bear periods in nominal terms.

In nominal terms, this market crashed, recovered, crashed, recovered, crashed bigger, recovered bigger, crashed even bigger, recovered even bigger, crashed for a long time, recovered quickly, and then crashed again to end it. Thus, in nominal terms, it looks a lot like the original 1906-1921 market with a very definite periodic response.

In real terms, however, it was one giant decline with a little over a year of cyclical bull market recovery, then a long decline again until the end.

The distortion of money printing is particularly insightful in this bear market.

But what about today?

What we see today is a mix of 1929-1942 and 1966-1982. Basically, it's the combination of a debt-based crash (Great Depression) with a lot of money printing (Great Stagflation).

Here's a close up of the 2007 to present period.

Our primary mission right now is determining when this cyclical bull market period ends. We use technical analysis and a proprietary model based on the historical movement of markets as shown above (plus we look at the S&P, NASDAQ, foreign markets such the Merval, Nikkei, etc).

Inflation adjusted market analysis works equally well and is also very illuminating. Perhaps we will do that another time.

Hopefully you have now realized a few important points:

• You cannot "buy and hold" during a secular bear market
• Gold will maintain its value throughout the cycle.
  
• The secular bear market will end when the DJIA:gold ratio is between 3:1 and 1:1
• The tactic used by the government will be to devalue the money to solve the problem through either formal devaluation or subtle, but effective, inflation. Printing money matters. It will affect your purchasing power and distort what is occurring. Understanding what is happening in both real and nominal terms is critical.

We're always interested in comments and requests. Feel free to shoot an email to us at dredd.every@gmail.com.