I have said before that picking the bottom is a loser’s game. It’s impossible – by definition we cannot know the bottom until a moment way beyond it.
However, that doesn’t mean that we can’t try and get close.
In fact, it turns out there is a huge amount we can learn about market bottoms, and certain phenomena to keep an eye on as markets fall.
Not to pick the bottom, but to help us get as close as possible.
My belief is that buying in market crashes should be gradual, repetitive and methodical. Pound cost averaging, you could say – where you invest regular amounts on a weekly, fortnightly or monthly schedule in the hope of getting a good average price.
So, I decided to read Russell Napier’s Anatomy of the Bear. He is a very well respected anaylst, revered almost, based in Edinburgh. He founded the beautifully names Library of Mistakes, a collection of books on financial history, and writes to investment clients about the economy and markets.
His book is a series of studies on the four biggest bear markets in history – 1921 (top left), 1929 (top right), 1946 (bottom left), and 1982 (bottom right).
He looks primarily at US markets where the historical data is the best. Those charts are for the S&P 500.
He wants us to think in 40-year periods. Which years gave investors the best returns over the next four decades? Answer: the bottoms of those four bear markets, at least that was true when he wrote it in 2005. That’s why this topic is so worthy of our attention, because it could help us get close to investing at the optimal times.
Even thinking in ten-year periods is hard enough though. Last week I asked readers how long you tend to hold positions for, and the general consensus was that we’d all like to be long-term holders, but that things tend to get in the way. Be it unexpected news from the company, markets freaking us out, real-world payments to make (schools, houses, bills), or just plain old changes of heart.
Did you know that there were a number of occasions in the last 100 years where the S&P 500 delivered negative ten-year returns?
Six times to be precise, depending on how you define it. It’s roughly a total of 70-80 months since 1928. That means that in the last century, you’ve had a 6.5% chance of negative returns over the next decade if you fail to heed Napier’s advice, and seek to invest close to the bottom, rather than the top.
The periods were for four years from February 1928 to February 1932. In January 1933, and Sept 1936. Bits of summer, 1968. Autumn 1972. And from winter of 1998 to January of 2001.
What’s more, after 1929, the index didn’t reach its previous high from that year until 1954. Twenty-five years in the wilderness…
It challenges our long-held idea that stocks always go up in the long run, at the very least. And this isn’t even accounting for inflation, which would put far more periods in the red.
Here is the chart.
And by the way, that chart is on a log scale – ie, the Y-axis is measured on an exponential scale.
With a normal, linear graph, here is exactly the same data with the same exact circle locations, for a bit of perspective:
The first chart is logarithmic – ie, it shows rises and declines in percentage terms, the second is linear. The first shows just how miniscule the latest crash was when compared to some of its predecessors, although it may look larger because of perspective on traditional linear charts.
Anyway, the book.
I won’t lie, it’s pretty thick. It could still qualify as a page turner, but only because I am very interested in the subject matter. I realise this is a book of financial history – mustn’t set the bar too high – but I do wonder whether it could be made a bit more readable.
It may not make the Christmas bestseller list is all I’m saying, but it’s far more valuable than any biography of a footballer, that’s for sure.
He goes into exceptional detail, and has clearly spent much time in the archives of the Wall Street Journal to discover what people were saying around the time of the great bear market bottoms.
The interesting conclusion from that is that it is not the case that the bottom is close when there is absolutely no good news, which is a commonly held view.
Rather, the bottom is at hand when investors perceive no good news. There is a subtle difference, and Napier goes to great lengths to point out various commentators and investors were pointing to positive indicators – but the market just refused to acknowledge that things were looking up (ie, the markets kept sliding).
Markets bottomed not when good news started to return, but when investors started to acknowledge that good news was good.
For example, he looked at four main indicators in Q1 2009 which helped him to call the bottom then, which were commodity prices, inflation, the copper price and corporate bond spreads.
Napier sees a stabilising of commodity and consumer prices as a key point, as it reflects stabilisation of demand in the real economy after a recession.
Copper is a key example. Here’s its chart in 2009. You can see that by around February/March 2009, copper had stopped its fall for a couple of months.
This was a key indicator in all four of the bear market bottoms in the book, because of its key role in industrial activity.
Where is copper now, then? Well actually, it’s still in the 2nd phase of a longer term decline:
It crashed early – in January of 2020 before the pandemic had hit the rest of the market. If I’d read this book this time last year, I might have been on it like a flash – seeing “Dr. Copper’s crash” as a sign that there was carnage ahead for equities market.
Now, it has rallied back to its February levels, but not broken through its downtrend. The next few weeks will be interested to watch, in terms of judging whether this rally is for real.
And you can look at other commodities too, but in Napier’s view copper is the most accurate.
One theory I like is that 2018 was the true crash, the true end of this bull market. Everything since is just central bank-driven liquidity rallies and bubbles. Copper roughly fits with this idea, but that story is for another time…
Back to the book, another key indicator is the auto industry.
I fear this may be less applicable this time round as coronavirus is likely to force people towards cars as they flee public transport and aircraft, so car sales may ironically be saved by the virus, even though vehicular travel fell sharply during lockdown.
Anyway, the sector is still worthy of our attention, as Napier shows.
Because all four bear market bottoms occurred during economic recessions, Napier looked for the best indicators that the real economy was picking up again.
Cars are a good example, as a major, staple purchase by individuals and families. If you’ve got enough money to buy a car, you probably have enough to think about buying some stocks too.
That’s why New England, an American state which has been the industrial heart of the nation for the long time, always bottomed first, and was a canary in the recovery’s coalmine.
The essence of these two ideas is that we must look to places other than equities if we want to find out how close we are to the bottom.
It reinforces the idea that stockmarkets are not accurate weighing machines, filtering news and forecasts into current prices, but psychologically impaired reflections of these things.
To be a few weeks or months ahead, you need to look at areas where investment is more professional and less retail, more determined by true economic forces of supply and demand, rather than speculation and greed, or fear.
Copper and the auto market are just two examples.
He looks at commodities more broadly, and also consumer price deflation/inflation’s role in all this. That’s significant because after two full decades of writing about the deflation, Napier has finally pivoted and in fact sees inflation in the developed markets hitting 4% in some places by the end of next year.
With TIPS – treasury inflation-protected securities – reflecting market belief that inflation will be around the 1.3% mark for the next decade in the US, and just around 3% in the UK (the highest), this would represent a serious inflationary shock.
In the last 40 years, investors have never had to deal with a sustained period of rising inflation. What a change that would be.
Anyway, before this goes on too long, I’m afraid I’m going to need to cut short. I will finish the book review next week.
There are still key parts of the book I want to explore – firstly the fact that there can be two types of bear markets: where prices fall dramatically; or, as in 1946-49, when earnings rise healthily, but prices remain flat or muted.
I also was most fascinated by the chapter on 1929 because wow, it is by no means the typical bear market – it’s spectacular.
The role of the American central bank is also prominent in the book and worthy of mention, as is the q ratio, or Tobin’s q, which features heavily in his analysis of market valuations.
It’s a great book, an epic, and there’s just too much to discuss so I’m sorry, but it’ll have to take over another issue!
Best wishes until then,
Editor, Southbank Investment Research
PS I saw this recently and it was a good reminder to share it. It’s the typical psychological progression of a bull market or bubble. I’ll let you make your own mind up about where we are, but you can probably guess what I think:
Source: Economic Times