A Look at Bear Markets from 1960 to the Present

MARCH FEATURE APRIL 2018

WHERE ARE WE IN THE STOCK MARKET CYCLE? A Look at Bear Markets from 1960 to the Present

By Ricardo L. Cortez, CIMA®

he current bull market cycle is AA Nine of these declines have been Reserve (Fed) model, the price-book now almost a decade old and, associated with recessions; the aver- ratio, the price-sales ratio, and various Talthough mature by historical age decline in these recessions was dividend discount models. standards, an old Wall Street maxim 30.5 percent. reminds us that “bull markets do not die AA Five other declines of 19 percent or Monetary policy and credit conditions. of old age.” A change in macroeconomic more were not associated with reces- Monetary policy and credit conditions factors and/or internal market dynamics sions; the average decline in these are among the most important factors typically precedes or accompanies cases was 26.9 percent. in the determination of the long-term a change in the trend of the stock direction of the U.S. stock market. As market. The stock market goes through Four major factors—three qualitative the stock market and economic cycle cyclical ups and downs, but there is and macroeconomic and one quanti mature approaching a peak, the Fed usu- little historical consistency to length tative and technical—historically have ally begins to tighten monetary policy of expansions and subsequent bear provided repeatable signals at market through interest-rate increases and markets. Most recently, the stock market extremes.2 The four factors are: val other monetary tools at its disposal. declined 10 percent in early 2018 after uation, monetary policy and credit During the current cycle, for example, several years of rising prices and low conditions, investor sentiment, and one of the tools that the Fed used to pro- volatility. We will have to wait to see if momentum. vide liquidity to the system was this is merely a normal correction or the quantitative easing (QE). Currently in start of a more meaningful decline. In this article, we apply a four-factor 2018, the Fed is reversing this process investment process to stock market by a systematic reduction in its balance On the negative side, valuations are now peaks before the bear markets of the sheet, or quantitative tightening (QT). at historically elevated levels, investor past half century. We also offer a per- sentiment has reached new highs of spective of where we are in the current A variety of indicators are used to assess optimism (negative from a contrary investment cycle as compared with pre- monetary policy and credit conditions. point of view), and interest rates are ris- vious cycles. The rate of change of interest-rate ing. On the positive side, we have not movements; the difference between yet seen the signs of an economic con- First, let’s briefly review the four factors. short rates and long rates (the yield traction: Earnings remain strong, credit curve); the spread between the yield on spreads remain narrow, and the yield Valuation. Historically, at high points in Treasury securities and corporate, curve is still positive. Nonetheless, there the stock market cycle, valuation levels municipal, and high-yield bonds (credit is historical precedent for significant are elevated; at low points in the stock spreads); free reserves; and indicators of market setbacks in the absence of a market cycle, valuation levels are low. inflationary pressures are among the recession: 1961–1962, 1966, 1976–1978, We look for extremes in valuations to tell many indicators that we use. In addition, 1987, and 1998, for example. us when to be cautious and when to be the past decade has shown that global more optimistic about future returns. markets can have a major impact on the As of March 2018, there have been 14 Many metrics are available to assess U.S. stock market. Therefore, indicators significant stock market declines since equity valuation levels, including the of the actions of global central banks—in 1960.1 median price-earnings (P/E) ratio of the the United Kingdom, Japan, China, and S&P 500, Robert Schiller’s cyclically Europe, among others—that could affect AA For the total 14 declines, the average adjusted P/E (CAPE) ratio of 10-year U.S. policy and the U.S. stock market decline was 29.2 percent. normalized earnings, the U.S. Federal are important in this analysis.

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Investor sentiment. In our analysis, the stock market and economic cycle have occurred without a corresponding investor sentiment should be assessed near a peak, there are usually decreas- recession, as shown in table 1B. The from a contrarian point of view. When ing levels of participation in terms of average of these 14 market declines was investors are very optimistic, it is usu- both breadth and volume, which creates 29.2 percent lasting 325 days. ally the time to be cautious. When negative divergences. Models that are investors are selling heavily, it is usu- important in this analysis include the FACTORS AT PREVIOUS ally time to increase market exposure. percentage of stocks above their 10- MARKET TOPS One measure of investment sentiment and 30-week moving averages, VALUATION is the bullishness or bearishness of cumulative on-balance volume and In our process, equity valuations must stock market investment letters written breadth, measures of institutional flow be assessed within the prevailing eco- by market pundits, portfolio strategists, of funds, and divergences between the nomic and interest-rate environment. and individual investors. Put-call broad list of stocks and the major mar- There is always a competition for funds ratios, short interest, margin debt, and ket indexes. among stocks, bonds, and other asset stock market capitalization as a per- classes: If the expected return on bonds centage of gross domestic product HISTORICAL PERSPECTIVE falls, greater valuation will be accorded (GDP) are among the many indicators ON STOCK MARKET DECLINES equities; if the expected return on bonds that provide perspective on extremes in AND RECESSIONS rises, equities will be valued lower. investor sentiment. Most, but not all, stock market declines Valuations therefore must be adjusted occur in advance of U.S. and/or global for this competition for funds. Momentum. Healthy markets are dis- economic recessions. Table 1A shows all tinguished by a high percentage of nine stock market declines since 1960 One way to adjust P/E ratios for the stocks participating in the advance. that were associated with U.S. or global general level of interest rates is to During these times, measures of vol- recessions. There is also historical prece- combine the current level of trailing ume and market breadth confirm new dent for significant stock market 12-month P/E ratios with the year-to- highs in the major market indexes. As corrections of 19 percent or more that year change in the Consumer Price Index (or CPI, see figure 1). This adjust- ment shows that the high P/E ratios of Table SIGNIFICANT STOCK MARKET DECLINES SINCE 1960 1 the late 1940s ushered in a period of Year(s) Decline Duration (Days) more regular valuation cycles. A: Declines Associated with a Recession Historically, when P/E ratios reach 24x, 1960 17.4% 294 it is often a warning sign. This level was 1968–1970 35.9% 539 very useful in signaling the stock market 1973–1974 45.1% 694 declines of 1960, 1968–1970, 1987, 1980 15.9% 68 1990, 2000–2002, and the financial crisis 1981–1982 24.1% 472 of 2008–2009. As of January 31, 2018, 1990 21.2% 87 this measure stands at 24x, indicating 2000–2001 29.7% 616 overvaluation. But as figure 1 shows, this valuation is not as great as either 2000 2002 31.5% 204 or 2008 when adjusted for interest rates. 2007–2009 53.8% 517

Average 30.5% 388 Another way of looking at equity valua- B: Declines Not Associated with a Recession tions is stock market capitalization as a 1961–1962 27.1% 195 percentage of GDP, which is historically 1966 25.2% 240 similar to the median P/E ratio in that it 1976–1978 26.9% 525 was lower in the 1960s–1980s than in 1987 36.1% 55 the past 30 years (see figure 2). This measure indicates that we are nearing 1998 19.3% 45 the high dot-com bubble valuation lev- Average 26.9% 212 els of 2000. Applying a least squares Source: Ned Davis Research (NDR) Group. Based on Dow Jones Industrial Average declines associated with a recession (table 1A) or those with a decline of 19 percent or more (table 1B) since 1960. regression analysis to this indicator to see the underlying trend of the data Past performance is not indicative of how the index will perform in the future. The index reflects the reinvestment of dividends and income and does not reflect deductions for fees, expenses or taxes. The index is unmanaged and is not shows that valuation peaks have risen available for direct investment. higher during each cycle over the past

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Figure EQUITY VALUATIONS ADJUSTED FOR INTEREST-RATE LEVELS 1 R A A A R R A U F FT U E U E U

Sources: Ned Davis Research, Standard and Poor’s, Bureau of Labor Statistics. Monthly data, 10/31/1941–01/31/2018 (Log Scale). Past performance is not indicative of how the index will perform in the future. The index reflects the reinvestment of dividends and income and does not reflect deductions for fees, expenses or taxes. The index is unmanaged and is not available for direct investment. 2.125” x 2.25” 4.25” x 2.25” 6.7” x 2.25”

Figure VALUATIONS TRENDING UPWARD

2 Stock Market Capitalization as a Percentage of Nominal GDP

166 03/31/2000 = 167.1% 166 NDR Estimated value of 3900 U.S. common stocks: $30. 81 trillion 151 U.S. Nominal Gross Domestic Product (latest figure): $19. 74 trillion 151 138 Current ratio for 01/31/2018 ( ): 156. 1 % 138 125 05/31/2007 = 125.4% 125 Value of S&P 500 Index constituents: $24. 10 trillion 114 U.S. Nominal Gross Domestic Product (latest figure): $19. 74 trillion 114 Current ratio for 01/31/2018 ( ): 122. 1 % 104 104 95 95 Linear regression trendline 86 08/31/1929 = 85.7% 01/31/2018 = 100.0% 86 () 78 01/31/1973 = 76.8% 78 11/30/1968 = 73.8% 11/30/1936 = 70.7% 71 12/31/1965 = 69.5% Very Overvalued 71

65 Norm Since 1925 = 63.3% 65 59 59 02/28/2009 = 57.6% 54 54 49 49 45 45 41 10/31/1990 = 42.0% 41

37 Very Undervalued 37 34 09/30/1974 = 35.2% 34

31 07/31/1982 = 31.4% 31 28 28 NDR Estimated Fixed-Weighted GDP December 1924–February 1946 25 06/30/1932 = 26.3% Chain-Weighted GDP used after February 1946 25

23 Calculation uses NDR Estimated Common Stock Market Capitalization of U.S.-based Companies 23 Dow Jones Total Stock Market Capitalization used from January 1973 through September 1980 21 NYSE Market Capitalization used prior to January 1973 21 19 19 04/30/1942 = 18.9% 192 5 193 0 193 5 194 0 194 5 195 0 195 5 196 0 196 5 197 0 197 5 198 0 198 5 199 0 199 5 200 0 200 5 201 0 201 5

Source: Ned Davis Research. Monthly data 12/31/1924–01/31/2018 (Log Scale). Concept courtesy of Jim Bianco.

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Figure THE YIELD CURVE 3 A A T A

E R T T T T

Sources: Ned Davis Research, S&P Dow Jones Indices. Monthly data 01/31/1948–01/31/2018 (Log Scale). Past performance is not indicative of how the index will perform in the future. The index reflects the reinvestment of dividends and income and does not reflect deductions for fees, expenses or taxes. The index is unmanaged and is not available for direct investment.

Figure ASSET CLASSES AND SECULAR TRENDS 4 U EAR U EAR U EAR U EAR U A R A A A T A T EAR U EAR U A T T A T T

EAR U U EAR U EAR U

R R T A T

Sources: Ned Davis Research, S&P Dow Jones Indices. Monthly data 01/31/1900–01/31/2018 (Log Scale). Yields sources: pre-1919 - A History of Interest Rates by Sidney Homer and Richard Sylla, 2005, 4th edition, Hoboken, NJ: John Wiley & Sons, Inc. (Annual Average); from 1919 to present - Federal Reserve (Annual Close). Past performance is not indicative of how the index will perform in the future. The index reflects the reinvestment of dividends and income and does not reflect deductions for fees, expenses or taxes. The index is unmanaged and is not available for direct investment.

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© 2018 Investments & Wealth Institute, formerly IMCA. Reprinted with permission. All rights reserved. MARCH FEATURE | oktA Lo a Bear Markets from 1960 to the Present APRIL 2018 century. Therefore, it follows that valua- recessions (1949, 1954, and 1957) where level of interest rates because the hold- tions may eclipse the 2000 levels before the yield curve did not invert. The short ing of cash positions will, at least in part, a significant market peak and downturn and sharp declines of 1962 and 1987 be influenced by the prevailing level of in the current market cycle. also had neither an inverted yield curve the yield on short-term securities. nor a recession. A negative yield curve In summary, although nominal valua- is usually a good indicator of a recession Figure 5 shows the level of U.S. stock tions are high by any measure, interest and subsequent stock market decline. mutual fund cash adjusted for interest rates are extremely important in assess- On the other hand, significant declines rates for the past 50 years. During the ing the relative level of equity valuation. have happened in the absence of an 1960s, cash levels were generally high. Higher interest rates, in our opinion, are inversion. Nonetheless, the lowest relative levels of the key to signaling the next bear mar- cash were evident at the stock market ket, according to this analysis. As of this One factor that is common to most peaks of 1960, 1962, 1966, and 1968– writing, short-term interest rates are at important stock market declines is a rise 1970. As inflation and stagflation their highest level since 2008 and the in interest rates. Before virtually every increased in the 1970s, cash levels 10-year U.S. Treasury note recently has stock market top and subsequent declined again before the stock market climbed to its highest level since the decline, with or without a recession, tops of 1973–1974, 1976–1978, 1982, spring of 2014. We would therefore rate there has been a rise in interest rates 2000–2002, and 2008–2009. equity valuation to be negative with before the market top. Figure 4 is a respect to future valuation levels. long-term look (since 1900) at the S&P As of February 2018, this indicator is in 500, the yield on long-term U.S. govern- neutral territory despite the fact that vir- MONETARY POLICY AND ment bonds, and commodities prices. tually all other measures of sentiment CREDIT CONDITIONS Longer-term secular trends in interest (not adjusted for interest rates) are nega- We believe in the principles of pioneer- rates are evident in the data, but there tive. We believe that a cautious market ing market analyst and investor Marty was an increase in interest rates before view should be maintained due to the Zweig, including the principle of “don’t virtually every stock market decline of current high levels of investor optimism. fight the Fed.” When the Federal Reserve 19 percent or more, including the non- The last piece of the puzzle is likely to is easing monetary policy and credit recessionary events. No one knows how be a general increase in interest rates, conditions are accommodative, it pro- high interest rates must rise before they which then would likely precipitate an vides a healthy environment for equities. negatively affect economic activity, but interest rate-adjusted low level of cash A tightening of Fed policy eventually rising interest rates are a negative factor in mutual funds. creates a poor environment for equities in our process. Growing credit spreads and sometimes indicates an economic coupled with rising rates might be an As is the case with valuation, investor recession. indication that we are nearing the end of sentiment measures must be seen in a this economic cycle. broader economic context. A rise in An inversion of the yield curve—which interest rates would push these indica- we define as the spread between the INVESTOR SENTIMENT tors, which are already in negative yield on the long-term U.S. Treasury We look at investor sentiment from a territory, to levels that would indicate a bond and the yield on the three-month contrary point of view. As of early 2018, more significant market top. Interest U.S. Treasury bill—often has preceded the level of bullish investor sentiment is rates appear to have begun this climb or accompanied both a recession and a the most optimistic it has been in many already. Investor sentiment therefore stock market decline of 19 percent or years, which is a negative indicator for must be judged to be in negative more. Figure 3 shows the yield curve the stock market. territory. since the late 1940s. The yield curve has inverted—i.e., moved below zero, as seen One indicator of investor sentiment is MOMENTUM in figure 3—before all recessions since the level of cash in mutual funds. A high Another key tenet from Marty Zweig is 1960 except for 1990. The 1990 reces- cash position indicates that investors are “don’t fight the tape.” When momentum sion was short—only 87 days—as was fearful of the market, which is positive is strong, the market’s advance is broad- the subsequent stock market decline. for the stock market from a contrarian based with the majority of sectors One of the shortest stock market point of view. A low cash position indi- participating in the advance. On the declines without a recession was 1987, cates that mutual funds have put most of other hand, when the major market aver- which lasted only 55 days, but it was their cash to work already, which is usu- ages are rising but the rest of the market also the steepest decline without a reces- ally negative for the stock market. As is not confirming the new highs, it is sion, at 36.1 percent. Before 1960, it is with valuation measures, it is important usually a sign of impending weakness interesting to note that there were three to adjust cash positions for the general for the market as a whole. Virtually all

INVESTMENTS & WEALTH MONITOR 39

Figure LEVEL OF U.S. STOCK MUTUAL FUND CASH ADJUSTED FOR INTEREST RATES 5

A R A T A A T T AA A R R R A R R R F A R R

Sources: Ned Davis Research, S&P Dow Jones Indices, Investment Company Institute. Monthly data 01/31/1960–12/31/2017 (Log Scale). Past performance is not indicative of how the index will perform in the future. The index reflects the reinvestment of dividends and income and does not reflect deductions for fees, expenses or taxes. The index is unmanaged and is not available for direct investment.

Figure DOW THEORY SIGNALS (HISTORICAL PERSPECTIVE)

6 A R T A A TA T A TA A A

Sources: Ned Davis Research, S&P Dow Jones Indices. Daily data 06/23/1977–02/13/2018 (Log Scale). Past performance is not indicative of how the index will perform in the future. The index reflects the reinvestment of dividends and income and does not reflect deductions for fees, expenses or taxes. The index is unmanaged and is not available for direct investment. This chart is provided to show the historical performance of suggested Dow Theory signals. The determination of a signal is subjective and is often determined after the signal date by a consen- sus of sources and opinions. This chart should not be used in real time for market guidance.

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Figure VOLUME SUPPLY AND DEMAND

R R

Sources: Ned Davis Research, S&P Dow Jones Indices. Daily data 12/31/1981–02/13/2018. Past performance is not indicative of how the index will perform in the future. The index reflects the reinvestment of dividends and income and does not reflect deductions for fees, expenses, or taxes. TheR index is unmanaged A and is Tnot available for direct investment. A R R major market declines, including all 14 the health of the market A (see figure 6). When volume demand is greater than periods noted previously and most mar- Based upon the (subjective) rules volume supply, which suggests that ket corrections of 10 percent or more, presented in figure 6, the history of investors are enthusiastic about the have been preceded by some diver- buy and sell signals is helpful. Since market, the S&P 500 historically has a gences between the major averages and 2016, both averages have been in higher gain per annum. When volume the broad list of stocks. sync and therefore have indicated a demand is less than volume supply, healthy market. which suggests that investors are cau- There are many ways of looking at tious about the market, the S&P 500 momentum and divergences. One Another important factor in assessing historically has a lower gain per annum. of the simplest methods is the Dow the underlying strength of the market theory, which was derived from 255 and potential divergences is through an The bottom portion of figure 7 plots the editorials in the Wall Street Journal analysis of up and down volume in the ratio of the 10-day total of the number written by Charles H. Dow (1851– market (see figure 7). “Volume supply” of advancing issues to the 10-day total 1902). Following Dow’s death, several is the smoothed total volume of declin- of the number of declining issues. of his colleagues gave the theory a ing issues and “volume demand” is the When advancing issues outnumber more formal structure (Dow himself smoothed total volume of advancing declining issues by a wide margin over never used the term “Dow theory” issues using Broad Market Equity a 10-day period, it generally indicates a nor did he ever present it as a trading Series (BMES) All-Cap Volume data. significant shift in market momentum system). The Dow theory measures The results in table 2 represent the per- and tends to be followed by further the divergence between the perfor- formance of the S&P 500 when the gains. The NDR Multi-Cap Institutional mance of the Dow Jones Industrial volume demand crosses above and Equity Series universe, which uses only Average (DJIA) and the Dow Jones below volume supply. common stocks drawn from all U.S. Transportation Average (DJTA). When one average hits new highs and the Table S&P INDEX PERFORMANCE (DECEMBER 31, 1981 TO other does not, a divergence is created. 2 FEBRUARY 13, 2018) The divergences between the aver ages create buy and sell signals, but, despite NDR Volume Demand is % Gain/Annum % of Time Dow’s colleagues’ rules, these signals Above NDR Volume Supply 11.57 78.80 are often subjective. Nonetheless, Below NDR Volume Supply –0.52 21.20 divergences are important, and this Buy/Hold 8.89 – simple rules-based method of measur- Sources: Ned Davis Research, S&P Dow Jones Indices. Daily data 12/31/1981–02/13/2018. Past performance is not indicative of how the index will perform in the future. The index reflects the reinvestment of ing them demonstrates the type of dividends and income and does not reflect deductions for fees, expenses, or taxes. The index is unmanaged and is not divergence we look for to determine available for direct investment.

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exchanges (i.e., excluding non-common As an example, mutual fund cash levels rates, yet more-serious divergences issues such as closed-end funds, pre- adjusted for interest rates show that this have yet to arise. If more serious diver- ferred stocks, etc., and including measure of investor sentiment is nega- gences arise in 2018, such as the major non-NYSE stocks), is designed to give a tive, but not quite as negative as it was market averages outperforming the clearer view of true market breadth. in 2000–2002 or 2008–2009. None broad market and an increase in down- theless, rising interest rates would likely side volume, it would turn our When the models of upside and down- move this metric in a negative direction momentum models negative. Coupled side volume cross, it often signals a for the stock market. Indeed, this indica- with the negative readings in valuation, change in the trend in the market. For tor is now falling to levels that are the monetary policy, and sentiment, these example, the last time downside volume most negative in a decade. factors would complete the picture of a rose above upside volume was in late high probability of economic weakness 2015. The S&P 500 sub sequently and accompanying stock market decline declined 14.5 percent into February in the next 12–24 months in our view. 2016. As of February 2018, upside vol- . . . although an inverted ume remains above downside volume. If yield curve is not always a Ricardo L. Cortez, CIMA®, is the co-chief supply rises above demand in the future, executive officer of Broadmark Asset it would indicate further caution. precursor to larger stock Management, where he is responsible market declines, the yield for day-to-day business activities and SUMMARY AND CONCLUSION curve is still positive, which sales and marketing; he is a member Although nominal equity valuations are of the investment team and serves historically high after adjusting for inter- buttresses the argument as the firm’s chief risk officer. He co- est rates, they are still below their that the stock market has manages the Salient Tactical Growth 2000–2002 and 2008–2009 levels. not yet begun to discount Strategy. He earned a BA cum laude Nonetheless, equity valuations must be from Queens College, City University deemed to be negative by any historical a recession. of New York. Contact him at standard. Further interest-rate increases, [email protected]. even without any corresponding rise in stock prices, would drive this indicator Finally, market momentum has been ENDNOTES further into negative territory. strong in recent years with broad partici- 1. These include all declines associated pation. The DJIA and the DJTA have with recessions and all other declines of 19 percent or more since 1960. The monetary and credit picture is more been in sync, and therefore bullish, since 2. Our investment process was created in the mixed. The recent swift rise in interest 2016. If the DJTA begins to significantly 1980s by Chris Guptill, chief executive officer of Broadmark Asset Management, rates, anticipated hikes in the fed funds underperform the DJIA (or vice-versa), and builds upon the work of Marty Zweig, rate, and continuing reduction in the it would be a negative signal. Likewise, Ned Davis, Robert J. Farrell, Edson Gould, Fed’s balance sheet all indicate a defini- measures of volume have not yet indi- and others. tive move toward a tightening monetary cated that selling pressure has overcome Investing involves risk, including a possible loss of principal. Past policy, which is typically negative for buying pressure, although they are mov- performance does not guarantee future results. stocks. On the other hand, credit ing in that direction. Broadmark Asset Management (“Broadmark”) is a registered spreads remain narrow. Credit spreads investment advisor. The views expressed contain certain forward- looking statements Broadmark believes these forward-looking usually widen before more significant In summary, our analysis indicates that statements to be reasonable, although they are forecasts and declines, which has not happened yet. we are in the late stages of the economic actual results may be meaningfully different. This material represents an assessment of the market at a particular time and Also, although an inverted yield curve is and stock market cycle. Valuation and is not a guarantee of future results. This information should not not always a precursor to larger stock sentiment are negative and, although be relied upon by the reader as research or investment advice market declines, the yield curve is still the monetary and credit picture is still regarding any particular security. positive, which buttresses the argument mixed, a continuation of the recent rise Prices, quotes and other statistics have been obtained from that the stock market has not yet begun in interest rates likely would have a neg- sources we believe to be reliable, but Broadmark cannot guarantee their accuracy or completeness. All expressions of to discount a recession. It is important ative impact on our monetary and credit opinion are subject to change without notice. Charts are shown to note, however, that a continuing rise factors as well as valuation and senti- for illustrative purposes only. in interest rates likely would move these ment. Momentum has been positive Indexes shown for illustrative purposes only. It is not possible to indicators closer to negative territory. for the past few years. The market’s invest directly in an index. recent early 2018 weakness could create The specific securities identified and described do not represent Investor sentiment is at historically divergences. Utilities and real estate all of the securities purchased, sold, or recommended for advisory clients, and the reader should not assume that elevated levels of bullishness, which is investment trusts already are beginning investments in the securities identified and discussed were or negative from a contrary point of view. to weaken as the result of higher interest will be profitable.

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