This is a repost of Plungers Original work on Bear Markets
Originally posted October 3 2013 .
I have learned probably the most important element in successful investing is understanding where we are in the phases of a bull or bear market. This is particularly essential when investing in precious metals, since it is such a deeply cyclical capital intensive sector. Due to its deeply cyclical nature if one does not know what phase we are in we can be set up for investment annihilation if we are long in phase three of a bear market. The third phase of a bear market is treacherous and it is precisely where I believe we are now entering. The good news is that knowing this allows us to protect ourselves and to later position our portfolios for the great family fortune buying zone that comes along only a few times in ones lifetime.
Frankly, what I have found is the majority of cycle opinion is simply wrong and most analysts don’t properly understand how a bear market unfolds. The scenarios these analysts present seem to make intuitive sense, but in reality the market just doesn’t unfold that way. Specifically, these analysts identify a “panic”, “selling climax” and the “capitulation phase” as an occurrence at or near the bottom of the bear market. This initially may make intuitive sense, however the reality is these phenomenon occur earlier and normally in the second phase NOT the third phase. One can examine previous bear markets and verify this fact. Knowing this is so critical because without this understanding one can be drawn into long positions, due to attractive pricing, just as the bear enters into the third and most lethal final phase…the annihilation phase of the bear market. In truth, there is a lot of junk analysis in describing how a bear market unfolds. Simply stated it just doesn’t hold up to what has really happened in the past. I formed my conclusions before I read how Edwards & McGee described what happens in these phases of a bear market and found it fascinating to discover they had run across this same finding that most analysts simply had it wrong. As a result my approach is consistent with what E&M have to say.
Before looking at some past bear markets it would be helpful to show why I assign the panic and institutional liquidation events to the second phase of a bear market. Typically most analysts will state something like this: “The third phase is the fear and capitulation phase, where investors are fearful and sell at the lows in a selling climax”. Sounds good, but thats not normally what happens and it leads one to misdiagnose the phases. You will see, that the majority of the panic selling actually occurs in the second phase, and it is confirmed by accelerated price action and volume.
The Point of recognition
The concept of the point of recognition is so important because it helps us identify where we are in the bear market. It comes at the point where collectively the masses transition from thinking they have been in a “correction” to realizing they are actually in a bear market. At this moment panic ensues and the market drops violently, often gapping down. The value of knowing this is, the POR usually occurs somewhere around the half way mark in a bear market. The Elliot guys are one of the few who seem to understand this and they depict it occurring in wave 3 of five ways down. You can see that’s about half way. We had our current POR last April at the time of the bullion bank stop run, this serves as one of the chief mile markers in the current bear market because it is such a crisp well defined event since everything lines up.
Consistent with Rambus’ theme of symmetry, the gold bull market also had a point of recognition on the upside in its 10 year bull market. This point occurred in Oct 2007 at $790. I remember it well, as it became clear to anyone that we were in a full blown bull market in gold. Prices gapped up reflecting urgent buying. I recently discovered an article written by Alf Field in October 2007 declaring the point of recognition in the gold market. In it he described how the public collectively realized we were in a full on bull market. Pretty fascinating stuff since that date and price has turned out to be just about half way in the duration of the 10 year bull market in gold and halfway on a logarithmic chart from $254-$1920.
Here is a link to the article:
Phases of a Bear Market
Phase #1 Distribution Phase
The Distribution phase actually begins late in the final phase of the preceding bull market. It is where farsighted investors foresee the end of the up cycle, they discern the peak of business conditions and begin to unload their holdings. The public, however remains active, yet over time the speculative froth is taken from the market and they experience an abandonment of their original hopes and the stocks they purchased at inflated prices begin to decline. Many regard this as the denial phase since investors stay bullish as many still are sitting on gains and the fundamentals still seem to be intact. News headlines continue to confirm their beliefs. Investors see price declines as merely buying opportunities and the “buy the dip” mentality remains intact from the previous bull phase.
Phase # 2 The Panic and Institutional capitulation phase.
This is where both E&M and my analysis departs from most analysts as we assign panic and initial capitulation to the second NOT the third phase. This phase also embodies the point of recognition, the moment where the masses collectively recognize it as a bear market and not just a correction. This second phase reflects selling due to decreased business and earnings. Investors concerns become urgent, ultimately causing a panic with downward prices accelerating into a near vertical drop. In the panic volume reaches climatic proportions. Once the panic completes there is often a long secondary recover (a bear market rally) or in weaker markets just a sideways movement.
It is normal for the second phase to be the longest in duration. Investors often perceive the secondary rally to have been the bottom of the bear market and their psychology often becomes focused on not missing the beginning of the next bull market.
Phase # 3 The distress selling or slow capitulation phase.
I like to refer to this as the annihilation phase because true devastating destruction can occur to investors who refuse to be objective students of the market. This is when the purging occurs that the bear has been setting up for in the previous two phases. Investors who sell during this phase or even hold on through it are unlikely to retain the psychological frame of mind to make money in the following bull market. They are just too devastated and can no longer function due to the shock of the final decline, they bare too much emotional damage. As mentioned most analysts claim this phase is characterized by panic capitulation, however it is more accurate to describe it as discouraged or distress selling over time by investors who held through the earlier panic. This selling is often driven by investors who simply need the cash. The end of the third phase is often marked by what I describe as comical selling, it is where investors are willing to sell at ridiculous levels far below the true known value of the company. This event usually marks the final end of the bear market and this selling event can go on for up to two weeks. It represents clearly recognizable investor annihilation, both financially and emotionally. Prior to this phase the cats and dogs have long since gotten liquidated and smashed and in this final event the better grade stocks, the ones still with liquidity will get hit. This is the fabled time when the blue chips are “on the bargain table” and is when we want to be in cash and mentally prepared to roll.
Past Bear Markets
Before we analyze todays bear market lets take a look at the massive 5 year cyclical bear market in the HUI of the late 90’s then review the general stock market bear of 2000-2002.
The PM bear of 1996-2000 was the bookend of the 20 year secular bear market in gold. Truly devastating, as it was an endless 5 year death march losing 84%. I have marked the dividing lines separating each phase so we can see how the psychological phases are reflected in the price action.
Phase 1. The downtrend lasted about one year finishing with a sharp 2 week spike-up. It was a slow gradual decline reflecting building concern, but clearly no panic in the price action. This is consistent with investors holding onto their hope and living in denial.
Phase 2. This phase fits what we know about second phases. It includes the Point of recognition, leading to a panic, and quickly followed up with a bear market rally. Classically it is the longest phase and it is punctuated with bear market rallies. Clearly one can see how selling has become more urgent and is no longer the gradual decline we had in the first phase.
Phase 3. One can see the character change of the price action in this phase. The market can no longer gather the strength to engage in a typical 5-7 week bear market rally. All it can do is brief violent short squeeze spikes with no follow through. The last half of the third phase is simply an exercise of market annihilation, where no one gets out alive. This price action delivers a blunt force trauma to investors so they will never be able to go near this sector again. It will take the next generation to be participants in the following bull market. It is imperative for serious investors to avoid being long in this phase of a bear market. That’s why it is so important to be a student of the market and understand where we are at.
The general stock market cyclical bear of 2000-2002 is best reflected using the S&P 500. It best reflects the character of the market as opposed to the NASDAQ, DOW or the NYSE. Rambus has mentioned how the PM sector actually has the cleanest most symmetric charts and I find this to be true. The phases and price points of the S&P are not as clearly defined as the previous HUI bear, but its actually not a bad example.
Phase 1. This phase also lasted about one year and one can easily see from the price action that there was a lot of hope in this market that it would regain its old highs. I clearly remember this time, I had read books like Schiller’s “Irrational exuberance “ and other well informed authors who clearly laid out the case for a devastating bear market ahead. It was so obvious to me, and I used to talk to co-workers nearing retirement and try to warn them. Universally, my comments were not met with differing opinions but with outright hostility. People simply did not want to hear it, they were true believers, fully invested both financially and psychologically. This was denial on steroids. By late 2000 with the market down almost 20%, people were starting to become concerned.
Phase 2. The price action in early 2001 clearly started to take on a different character. The selling became more urgent and investors reached a point of recognition in Feb-Mar 2001 which was confirmed by price action and volume. And just in case you didn’t get the message it was rammed home for a second time in September with the 9/11 attack. In a way the attack served up a second POR for the really dense and stubborn. At this point there was no denial the market was in trouble, although there were plenty of ignorant ones who misdiagnosed our problems as being caused by the attacks. As typical, after the POR, the market staged a bear market rally (after both POR’s) that was fairly strong and consistent with being in the second phase for extent and duration.
Phase 3 This phase lasted 7 months and underwent a stunning 35% decline. Again the character of this decline was different with the previous two phases and consistent with the take no prisoners-no one gets out alive type of selloffs we find in third phases. This was shock and awe for investors who had refused to get out due to the conditioning of the previous 18 year bull market.
One last element to discuss before we move on to our current bear market and that is the concept of duration. Amateur market watchers often delineate the difference between a bear market and a correction as an arbitrary 20% line. This concept started about 15-20 years ago and has absolutely no utility to it. Some commentator mentioned it and it has since been parroted so many times that the media actually thinks it has some type of predictive value. It leaves out the quality of duration. So in reality the crash of 1987 really was not a bear market, as it had no duration. It is better classified as “the great correction”. Similarly, I don’t classify the PM decline of 2008 as a bear market, it was more of a liquidity event, a sort of great correction. It only lasted 7 months and never served to correct the excesses of the previous bull market it was not drawn out enough to do the bears work, so it is best understood as a corrective liquidity event even though the decline was severe and even in excess of many full duration bear markets. What it didn’t do was develop and pass through the three phases we have described.
The above table chronicles the history of the cyclical bull and bear markets in the gold stocks over the last 55 years. We have had 6 total cyclical bear markets in that period (not including the 2008 event). There are a few important conclusions we can draw even though this is a limited data sample.
First, bear markets that occur within the context of a secular downtrend tend to be much longer than those that are embedded in a secular uptrend. The previously outlined late 90’s bear is a good example of this. In fact this table outlines 3 bears in secular uptrends and 3 bears in secular downtrends. The uptrend bears lasted on average about 31 months, while the downtrend bears lasted about 44 months, again a limited data sample, however this makes intuitive sense that the downtrend bears would be longer. As a general rule a bear markets duration lasts about 25%-33% of the length of the previous up cycle. Since our previous bull in the HUI ran from Nov 2000 to Sept 2011, just short of 11 years we could gauge our expectations for a bear market to run maybe 32-42 months using this principle. Interestingly enough, this falls within the past durations of other bears, so it provides a reasonable working theory. We are presently 25 months into our current bear market, assuming the June low was not the bottom, that low was a 67% decline in the HUI.
Bear Market GDX 2011-2014?
I have constructed the above chart as a working hypothesis using the event mile markers which this bear has established and the investor psychological events to estimate where we are in the current cycle.
Phase 1. This looks like a classic phase one segment. We all remember the psychology and the fundamentals of this period, the FED was engaged in QE #2 and the printing was going to propel gold upward forever. The HUI had fully recovered its 2008 crash losses and it seemed obvious gold was to continue its rise. The price action reflects the continuance of hope as there are no bouts of panic or accelerated selling. Any discussion about the decline was described as a “correction”. Recall the summer 2012 bear market rally psychology: everyone was enthused and convinced the bull market was back on, after all the rally had tacked on a 42% gain from the May lows. FED messaging during this period, you will recall, was centered on constant rumor planting that QE3 was coming. The message was you had to be in the market because QE3 was coming. This is the same game they played during the crisis of 2008 planting rumors on thursday afternoons that a FED stimulus was going to be announced on monday, thus causing hedge funds to cover and sparking a rally. So in the summer of 2012 there were several false QE deliveries, but finally it came in late September in the form of QE to Infinity, what could be more bullish! This completed the end of phase 1. characterized as denial and maintaining hope.
Phase 2. One can see the character change immediately manifesting itself as a relentless slide. It is amazing how far down a market has to decline before goldbugs finally turn bearish. Some anecdotal markers I can relate are quite telling. In late November 2012 at the San Francisco gold show I never heard the word “bear market” uttered by anyone. The gold market was still referred to using the word “correction”. Unbelievably, in March 2013 at a different conference with the market down 40-45% speakers and attendees refused to characterize the market as a bear market, it was still a correction, although a deep correction.
In February, I posted a comment on another newsletter website describing us in a bear market and got promptly ridiculed and corrected by the membership while the newsletter writer showed me a 10 year chart of gold stating its upward trend was proof of a bull market. This psychology all changed however, with the bullion bank stop run of April 2013. This was the classic point of recognition in this bear market. It was now accepted and understood that this was a bear market, although it was blamed on the manipulators. The panic is easily recognized in the charts with confirming volume. According to script the next event came on cue which is of course a typical second phase bear market rally. I had great expectations for this rally, however it flamed out short of my expectations, indicating to me that the downward undertow is more severe than most realize. The fact however, that this rally lasted 8 weeks and delivered 41% indicates that it was a typical second phase B-M rally since third phase rallies tend to be shorter more spiky short covering events. A final note on the psychology that exists currently, I would describe as typical second phase. A review of most gold bug commentary is focused mainly on securing a position for the resumed bull market ahead since we are in a bottoming phase of the bear market. Check out Morris Hubbartt’s commentary on 321 gold for a real sense of this. In the past, major cyclical bear markets do not end until this type of mental state gets purged.
Phase 3. First off I emphasize anything can happen and this bear could end tomorrow. I fully understand the physical supply shortage and China’s buying frenzy which is cornering about 40% of annual production. I have seen this frenzy with my own eyes in Beijing, its real. It continues to be an enigma to me how prices can decline with inventories depleting and demand growing. It is what it is however, and I suspect the bear market ultimately ends suddenly with a weekend rerating of gold and if you are not in it….well, you lose.
The projected decline I have drawn would be consistent with what has happened in the past. Even though we have already declined over 60% we have not gone through an annihilation phase with the comical selling I described. Investor psychology is still focused on being long and securing a position for the upcoming bull. In April and late June we had 1-2 days of distressed selling, but we have not yet had that 1-2 week period where even the blue chips, the Franco’s, Silver Wheaton’s or the Gold Corps just get shredded and get sold well below known values. I have to think that time still lays in front of us especially when we consider the duration arguments, the psychology and the H&S price objective levels we see in the Rambus charts.
The exciting thing to me is I feel we are in the small minority that can see this and can thus be in a position to deploy when those stocks truly are on the” bargain table” and that’s how family fortunes can be made.