STOCK INVESTING 101

"Those who cannot remember the past are condemned to repeat it"
-George Santayna

Bull and bear markets are nothing new to the investing community, however a lengthy bear market may be a new experience to many of today's investors.    During a bull market investors work themselves into a climax of optimism that eventually peaks. During bear markets investors churn markets lower as pessimism grows. Eventually the market hits bottom as pessimism reigns supreme and the cycle begins again. But does history really repeat itself? 

NASDAQ IN 2000:

The Nasdaq bull market was destined to end at some point in time. After a decade of positive gains in the 1990's the Nasdaq market had worked itself into a frenzy. The market posted gains of over 90% from October 1999 to the peak on March 10, 2000.

Interestingly enough, another bull market ended on the EXACT SAME DAY 63 years earlier. The Dow Jones Industrial Average(DJIA) had worked it's way out of a hole in 1932 rising over 350% to peak on March 10, 1937.

From March 10, 2000 to May 24, 2000 the Nasdaq skidded 41%. Markets usually do not go straight down and a short-term rally developed from the May low to September 1, 2000 in which the Nasdaq climbed back 40%.

Meanwhile 63 years earlier the DJIA behaved in a similar manner although the swings were less volatile. The DJIA drifted 15% lower from March to nearly the same date in May before a short-term rally lifted the index 13% peaking on August 17, 1937.
The stretch from September 1, 2000 to December 31, 2000 was disastrous for the Nasdaq as the index dropped 42% relative to the September 1 close. In 1937 the DJIA had similar troubles. From August 17, 1937 to December 31,1937 the index dropped 36%.

In 2001 the Nasdaq rallied in January before falling in to a  low on April 4, 2001. In 1937 the DJIA rallied to mid January before falling to the low point of the bear market on March 31, 1938.

2. When do stock markets bottom?
History informs us that the end of the bear market usually precedes the end of the trough in the business cycle. As indicated by Jeremy Siegel in "Stocks for the Long Run", "Almost without exception, the stock market turns down prior to recessions and rises before economic recoveries. In fact, out of the 41 recessions from 1802, 38 of them, or 93 percent, have been preceded (or accompanied) by declines of 8 percent or more in the total stock returns index." Seigel goes on to state, "The average lead time between a market upturn and an economic recovery has been 5.1 months, and the range has been quite narrow." (Data since 1948)
Robert D. Edwards and John Magee describe The Dow Theory of the Bear Market in "Technical Analysis of Stock Trends". "Primary Downtrends are also usually (but again, not invariably) characterized by three phases. The first is the distribution period (which really starts in the later stages of the preceding Bull Market). During this phase, farsighted investors sense the fact that business earnings have reached an abnormal height and unload their holdings at an increasing pace. Trading volume is still high though tending to diminish on rallies, and the "public" is still active but beginning to show signs of frustration as hoped-for profits fade away.
The second phase is the Panic Phase. Buyers begin to thin out and sellers become more urgent; the downward trend of prices suddenly accelerates into an almost vertical drop, while volume mounts to climactic proportions. After the Panic Phase (Which usually runs too far relative to then-existing business conditions), there may be a fairly long Secondary Recovery or sideways movement, and then the third phase begins.
This is characterized by discouraged selling on the part of those investors who held on through the Panic, or, perhaps, bought during it because stocks looked cheap in comparison with prices which had ruled months earlier. The business news now begins to deteriorate. As the third phase proceeds, the downward movement is less rapid, but is maintained by more and more distress selling from those who have to raise cash for other needs. The "cats and dogs" may lose practically all their previous Bull advance in the first two phases. Better-grade stocks decline more gradually, because their owners cling to them to the last. And, the final stage of a Bear Market, in consequence, is frequently concentrated in such issues. The Bear Market ends when everything in the way of possible bad news, the worst to be expected, has been discounted, and it is usually over before all the bad news is 'out'."

One concept to understand is the "Principle of Confirmation" As described by Edwards and Magee The Principle of Confirmation states that the "The Two Averages Must Confirm - This is the most-often questioned and most difficult to rationalize of all the Dow principles. Yet it has stood the test of time; the fact that it has "worked" is not disputed by any who have carefully examined the records. Those who have disregarded it in practice have, more often than not, had occasion to regret their apostasy. What it means is that no valid signal of a change in trend can be produced by the action of one Average alone." And "It is not necessary that the two Averages confirm on the same day. Frequently, both will move into new high (or low) ground together, but there are plenty of cases in which one or the other lags behind for days, weeks or even a month or two."

In Andrew Tobias book titled "The Only Investment Guide You'll Ever Need" Tobias quotes Dr. Martin Zwieg on Market behavior. "One reason that so many investors get overloaded with stocks at market tops is their ill-founded reasoning: 'Business looks good.' It always looks good at the peaks. With prospects ripe for continued gains in earnings and dividends, investors optimistically lick their chops in anticipation of further market appreciation. But something goes astray. Business gets too overheated; the scramble for borrowed money to keep the boom rolling grows more intense, pressuring interest rates upward. The Federal Reserve, spotting increasing inflation, begins to tighten monetary growth, further exacerbating the surge in interest rates. Then, as short-term money instruments such as Treasury bills become more yield -attractive, the stock market begins to groan as the switching away from stocks accelerates, aided in no small part by the illiquidity in overly optimistic investors' portfolios [investors, that is, who have spent all their money on stocks already, and now have no more cash with which to buy any more]. 

Tobias continues"Yet, most folks just continue holding their stocks-or worse, buying more-because 'Business looks good.' Finally, many months later it becomes apparent that business has slowed down…but it's too late for most investors. 'Optimism' gives way to 'hope' that the business slowdown won't become a recession. But the drop in stock prices rocks consumer confidence, business dips some more and recession is reality. The stock market slump becomes a rout and investors' "hopes" are finally dashed. Seeing that a recession is in progress, investors "know" that earnings will slump; in "panic" the sell their stock, absorbing huge losses. Finally, all that selling, amid tons of pessimism, improves stock market liquidity building a base for a new boom in the market…one which always begins before business turns up"

Will the trough of the stock market once again precede the trough of the business cycle?

3. Selling below the 200 moving day average
Jeremy J. Siegel, author of "Stocks for the Long Run" describes a buy-sell strategy of buying stocks whenever an index is 1% above the 200 day moving average and selling whenever an index (he back-tested the DJIA) is 1% below the 200 moving day average. He writes, "there is no question that the 200-day moving average strategy, even with transaction costs, avoids large losses while reducing overall gains only slightly…The timing strategy participates in most of the winning markets and avoids most of the big losing markets…" Siegel writes that investors would have missed the Great Crash of the late 20's and the October 19, 1987 Crash.
Investors using this technique would not have avoided the March 2000 sell-off of the Nasdaq, however the strategy would have taken investors out of the Nasdaq market very early in September 2000 avoiding months of agonizing losses.

4. Investor Sentiment
Investor Sentiment is a commonly used form for judging bear markets and bull markets. Bull markets historically peak during the height of optimism and Bear markets trough during the height of pessimism. One method of monitoring investor sentiment is the put/call ratio. The put/call ratio is one investor sentiment ratio that measures the fear and greed of investors. As fear rises so does the put/call ratio. The higher the put call ratio the higher the level of pessimism. Norman Fosback in his book "Stock Market Logic" describes low readings as bearish indicators and high readings as bullish. He writes, "Bearish readings tend to be a bit early relative to market turns, but bullish readings frequently coincide to the very day with market troughs. The Market Logic Put/Call Ratio is one of the most sensitive and valuable of all market indicators now in use."
In March and early April 2001 the put/call ratio made a bullish move by spiking above 100% on three occasions, the five year high was 110% set in during the "Asian Crisis" in October 1998.

 Martin Zweig's Book "Winning on Wall Street" indicates, "The second very bearish condition for stocks is ultrahigh price/earnings ratios. The price/earnings ratio is the market price of the stock divided by the last twelve months of earnings per share…. Very low P/E's, in the 6-8 zone, tend to be bullish for the long run, while P/E's, in the upper teens and twenties generally reflect excessive speculation, gross overvaluations, and poor future stock price performance."

"Those who cannot remember the past are condemned to repeat it"
-George Santayna

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