“Exit stage left. Pursued by a bear.” William Shakespeare, The Winter’s Tale

Why do we invest?

The true goal of every investor, surely, is to buy low and sell high (surely!).

Yesterday I wrote about Rusell Napier’s book The Anatomy of the Bear. (If you missed it, you can read it here.)

I will now continue and finish off my look at this book.

I mentioned that it’s an excellent bit of financial history, but it’s also an understudied topic, when you think about it. A better understanding of these moments or periods will help us to make the best possible investment returns for us, our lives, our children, our holidays, our retirements – whatever you’re investing for.

And Napier’s book takes us through the four best buying opportunities of the last century, for multi-decade returns.

In theory, trying to figure out how to buy at the bottom should be most investors’ number one aim, but it’s not. At the bottom, most people are panicking. Guess that’s just human nature.

I think we can do better, and so does Napier.

The work that went into this book (written in 2005) allowed him to predict an “end of the decade” recession “sometime after 2009”, and call the bottom when it came in, in Q1 2009.

Yesterday I looked at the long history of stockmarkets, to show that on six different occasions (of varying length), equity investors would have received negative returns over the following decade. This is what we must avoid.

Buying at the bottom is so much more lucrative, and we must not be impatient or greedy – two clear reasons why so many people tend to pile in very close to the top.

One of the most interesting things that came out of the book is the way he looks beyond just market prices to determine bull or bear markets.

Instead he looks at two key valuation metrics: the cyclically adjusted price-to-earnings ratio (P/E), or CAPE (championed by Robert Shiller), and the q ratio, or Tobin’s q.

It shows what the stock price of a company is relative to the replacement value of all its assets. It is a measure of intrinsic value. The lower the score, the more undervalued a stock is relative to the value of its assets.

Over his four big bears, the average time for stocks to go from their peak overvaluation to the trough of undervaluation actually takes nine whole years, or 14 if you exclude the exceptional 1929-32 bear.

Here is a great chart showing the q and CAPE scores (relative to their own average) until this year – you can see that the bear markets to 1921, 1949, and 1982 all took well over a decade, while 1929 was remarkably swift:

Source: Smithers

The range of P/E ratios (CAPE) has been quite wide at the four bear market bottoms – 4.7x in 1932 to 11.7x in 1949.

Q ratio has been much more narrowly focused around the 0.3x mark. That’s why he uses both, and prefers the latter.

You will not be surprised at the next point I’m going to make.

Look at that chart. Look at how fast markets, especially in the US and/or technology stocks, have rebounded after this crash. Markets remain near their highest valuations from the last century. Just take a moment to think about that. Never before have valuations been this high and not come steadily back down to earth, and never before has a revaluation of markets been resolved as quickly as two months. Sorry, spiel over, couldn’t resist…

Back to the bear.

I found it interesting to think of bear markets not in pure price terms, but in valuation terms.

1949 is a great example. It doesn’t look like much on a chart.

Source: Koyfin

It was a bear market where price declines were not that severe – 28.4% from the peak in 1946, but valuations fell much more sharply because corporate profits actually had a strong few years. That’s why 1949 was such a great buying opportunity, because when valuations started catching up, they had a lot of catching up to do, if you catch my meaning.

1982 is the same:

Source: Koyfin

Napier’s focus on valuation adds another factor. You might think that the bear market was just from 1980-82. But he argues it was a 14-year bear market, as valuations for the CAPE and q ratio peaked in 1968. Corporate profits rose for 14 years, but prices were exactly where they started 14 years on, and so it was a much longer bear market in terms of value.

There periods we must invest in are the ones in between, and here’s why. The 20 years after valuations bottomed in 1949 delivered a 660%+ return to the peak in 1968:

Source: Koyfin

That means that every ounce of returns between WW2 and 1982 came in a single 19-year block between 1949 and 1968. Everything else was just treading water.

This is why I found it very it such a thought-provoking book, the sense of time associated with all this is just great. History tends to do this, but you don’t often get good histories of the markets, and it forced me to widen my lens even further, and also to finally get what people mean when they say “history doesn’t repeat, but it rhymes”.

I also found it amazing reading contemporary commentary which sounds just like it does now, but was written just after the first or second world war. Remarkable!

Take this quote from June 1921, two months before the market bottomed:

We have hit the bottom, and when prices begin to rise slightly people will jump at the opportunity to buy. When industries, through the Federal Reserve, can obtain sufficient funds at reasonable rates to expand, foreign trade and foreign loans will automatically be taken care of.

Or in 1932, within weeks of Dow Jones valuations bottoming:

Wall Street generally continues to pay more attention to fears of possible adverse news than to concrete actions which have tremendous potentialities for long-term improvement.

In 1949:

New England, hit hard by business dip, sees hints of recovery. With a high proportion of consumer goods industries is usually the first section of the county to feel a business change for the better or worse.

In 1982:

Last month’s moderate rise in personal income, coupled with robust increase in consumer spending, provided fresh evidence that a consumer led recovery from the recession is beginning to take hold.

Anyway, here is a summary of his conclusions from his study of the four great bears, for those who wanted the short version…

Broad Money (M1) growth (ie, what we’re seeing loads of right now) is a poor indicator of bear market bottoms. Often it comes after them, and it would have told you to buy in 1980, leaving you well down by the time markets bottomed two years later.

Federal Reserve balance sheet watching is therefore not something that Napier believes is a good indicator that the market has bottomed.

Interest rate cuts are a better indicator, but in 1929 you’d have lost over 80% after the first cut in 1929, so it’s more effective in a traditional recession-linked market crash, in which the Fed acts late, rather than early (as it has done this time).

A stabilisation of prices, especially in commodities, and especially copper, after deflation during a bear market is a pretty good indicator for a bottom.

A bear market is a move from overvalued equities to undervalued – look beyond the headline price.

A recovery in government bonds prices precedes corporate bonds, and then equities. (I have wondered in previous articles whether this will still ring true.)

Bear market bottoms are characterised by an increasing supply of good news being ignored by the market.

Economic recoveries coincide with stockmarket recoveries, and the auto market provides the best early indicator of this, along with industrial states (New England often cited) and countries.

Many will suggest that a worsening fiscal position will prevent a bull market in equities – they will be wrong. Declines in corporate earnings will go on for months after the equity market has bottomed.

The end of a bear market is often characterised by a slump in prices on falling volumes. Rising volumes at higher levels will confirm this was a signal of the end of the bear.

Shorts will increase their positions rather than covering in the first few weeks of a new bull market (because of overconfidence in their bearish view).

He signs off with a bit of (long overdue) stylistic flair: “In the meantime, if you have to go down to the woods, keep your wits about you.”

Best for now,

Kit Winder
Editor, Southbank Investment Research

PS Napier, still a widely revered analyst, now predicts inflation above 4% next year in developed markets due to fully guaranteed government loans, pushed by commercial banks. He has spent the last two decades warning of continued deflation.

Albert Edwards, a Société Générale strategist who has stuck to a thesis of lower inflation for 14 years, also pivoted this month to predict inflation – although he thinks we get a year or two of deflation first.

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