Thoughts on the Markets
Oct. 10th, 2008 | 05:19 pm
It's been a crazy ride this week. Those of you who got out of stocks a while back or went short are probably thanking your lucky stars. Those who stayed invested are probably feeling a little queasy right now. There's also been some very weird behavior in other market sectors. Spot gold dropped like a stone today after seeing a big spike yesterday. The DJIA bounced through a 1,000 point spread today after it dropped below 8,000...twice, ending fractionally down but up a lot from the intra-day lows. Volatility is off the charts, all across the board. I've been sitting here looking at price charts all day, trying to sort it all out. I think I've reached some conclusions, and want to record them for posterity. My track record on this stuff is spotty, though, so you act on any of this analysis at your own risk. Having said that, I also do occasionally get it right (I managed to nearly double my portfolio in the last two weeks), and at one point in my life did this as my full-time profession.
First, market psychology. Take a look at this:
What you see here is the classic progression of the aggregate psychological state of a market...any kind of market, really. It has no endpoint or startpoint. It's a continuous cycle.
There's also something about this psychological progression that is not illustrated in this diagram: the market psychology progression you see here is self-similarly recursive at all time and magnitude scales. Actually, Benoit Mandlebrot noticed this too, but didn't ascribe it to the psychology of the market. He simply identified that a pattern was present and followed the principles of his own work in fractals. Within each move in market prices, this progression cycles at longer or shorter duration and larger or smaller magnitude. So, within the price movement you see while the larger trend is, say, "Panic", there will be smaller, shorter sub-cycles that progress through the gamut: momentary euphoria as things briefly look as if they've turned for the better, etc. The real progression of the cycle doesn't look like a sine wave, it looks like the stock market. That's almost tautological, since market prices record the psychological progression in a form that we can map and analyse. Needless to say, identifying these psychological progressions at any scale is far more art than science. However, the fact that it happens is broadly recognized. That's also part of the problem of identification. If nobody knew about this but me, it would be much easier for me to identify what's going on. As it stands, you've got billions of people trying to second-guess one another.
So, where are we in the psychological progression? To answer that question, we need to look at the market across multiple scales. I'll start with the largest one first, since that's easiest. You may want to periodically refer to this 100-year chart of the DJIA as we go. You'll note that this chart is plotted on a logarithmic, not a linear scale. That's important, since the only thing that really matters in market movements when we talk about trends this way is percentage changes in price levels, not linear prices. When people show you price charts with asymptotic spikes at the ends of them, remember that a big spike on a linear graph may not actually represent a huge percentage growth. Stick with the logarithms. They won't steer you wrong.
The equity markets in the US have been in a protracted bull market that began in either 1982 or 1975 depending on how you count it. If you go by price, 1975 was the price low and the actual end of the bear market folllowing the 1966 top. If you go by psychology, 1982 was the nadir. Both dates are important, as I'll elaborate in a bit. Those of you who were alive and paying attention to such things may remember the tone of the markets and our culture in general at the time. In both 1975 and 1982, pessimism was rampant. I want to focus on 1982 a bit more than 1975, partly because I was old enough to remember '82 clearly (I was only seven years old in 1975), and because the psychological state is what I want to focus on.
Once the Big Bull got roaring, many people seemed to conveniently forget that in 1982, the date the "buy and hold" analysts like to use as a benchmark for their "if you had bought then and held" scenarios, few if any investors were at all interested in putting their money in equities. Equities had been underperforming other markets for years with only occasional bright spots (such as the "nifty fifty" of 1972-1974). By the early 1980s, the markets' ability to regain optimism on upswings was completely exhausted. Doomsday predictions and apocaplyptic scenarios were very popular. Nuclear war and Soviet ascendence were assumed to be an "any day now" sort of proposition, and many people lived in dread. It was during this 1975-1982 period that survivalism came into vogue. The stock market was so far out of the public eye that for most people, it might as well not have existed. Another reason 1982 is often marked as a bottom is because that's when trading volume bottomed out. Few if any investors wanted to be heavily into equities. They didn't look like they had any kind of future at all.
With hindsight, of course, we know that this was a generational buying opportunity. 1982 marked the kick-off of the greatest bull market in American history...one that would ultimately come to rival John Law's Mississippi Scheme and the South Sea Bubble in magnitude. If you had put all your money in equities in 1982 and done nothing else for the next two-plus decades, you would have increased your portfolio by orders of magnitude, not just single-digit year-on-year gains. Some people did even better than that, and got famous for it.
But, it took a while for the broader psychological trend to shift. Throughout the 1980s, pessimism slowly turned over to optimism. Among investors, optimism turned to euphoria as we pulled in the final years of the Reagan Administration. But, and this is important, the market by that time had not pulled in the broader majority of the public. The psychological progression hit a peak in 1987, only to come crashing down (I was standing in the Melbourne Stock Exchange on the day of the crash, and it was sobering event, but the market had turned prior to that day), but it only engaged and affected those people had been in on the first wave of what was to become a much larger and more broadly based progression. In fact, the speed with which sentiment turned negative in 1987 should have been a clue at the time that a much bigger bull was in the making. Also, go and look at the 1987 crash on the price chart I linked earlier. It barely even registers. If you compare it to the dip in 1929, you have to wonder what all the fuss was about. The fuss, of course, was about market psychology turning through its cycle on a smaller scale than the broader trend. In the case of 1987, it was a "surprise disappointment", which should have been another clue that there was more upside ahead.
The Soviet Union collapsed with a whimper, not a bang, and the Berlin wall was torn down by exultant crowds. The 1990s came. As the economy "staggered" back to its feet following some lean years in the early 90s, the broader market arced upward with breathtaking rapidity. Optimism began to permeate our society, moving toward excitement and thrill. Francis Fukuyama talked about the "End of History," a marked contrast to the apocalyptic visions of the early 1980s, and the United States was ascendent across the globe: sole superpower, mighty financial power, technological innovator. Speculative fiction turned from dark visions of post-apocalyptic futures predicted in the late 70s and early 80s to ecstatic conceptions of "singularities" and "extropianism" in the late 90s and early Aughts.
In the mid-1990s, as the trend launched through its midpoint, the public sat up and took notice, then dove in head first. This is typical of the trend establishment phase, whether in optimism to excitement or desperation to panic phase. By the time 2000 rolled around, Euphoria had definitely taken hold. Only, this is a psychological cycle on a very broad scale now, so this was not a momentary phenomenon, but one sustained for years, even as one market after another topped out and declined. The Euphoria was powerful enough that is permeated all the markets, cresting in one after another over a period of several years. At the time, in fact, even though I saw it and knew what it meant, I grossly underestimated its magnitude.
The euphoria is gone now, of course, but its echos are still very much with us even though we now have fear and uncertainty, with the larger psychology turning negative. One aspect of psychological trend changes is that the previous trend usually re-asserts itself strongly as the new trend is getting up and running, with a re-establishment reversal that exhausts the last remnants of the previous trend. That's why the 1966-1975 bear market had a "double bottom", with a major price low occurring in 1975 and a major sentiment low in 1982. The price low of 1982 was shallower, but the previous negative psychology of the down-phase of the cycle re-asserted itself with strength as it was on the way out.
The same thing happens at tops, of course, which is why I'm scrutinizing the markets so closely these days. I'm fully expecting a bull spike, with a temporary re-establishment of the euphoria. Of course, this assumes that it hasn't happened already, which I think could be argued is the case from the 2000 top to the 2008 top. Whether or not the 2000 top was the end of Big Bull, or the 2008 top was, will depend on whether or not you think inflation is skewing the price activity of the market in a significant way. This is also true for the 1975/1982 low, by the way. Since the actual magnitude of inflation is conjectural, this is a difficult call. I think it could go either way. In either case, there is no question to my mind that there is a "doubling" of sorts at market tops and bottoms.
Taking this notion of the temporary re-establishment of the previous trend following the turning point, the phenomenon often shows up in price charts as the notorious "head and shoulders" formation. It looks like this:
Now, consider two things. First, go back and look at that chart of the DJIA going back 100 years. Up at the top right hand corner, you see what the market has been doing during the last decade or so. That price chart formation clearly includes two price tops, with an interim market correction which dipped down to a price level of 8000 on the Dow.
This morning, the DJIA hit 8000...twice... and bounced off that price level hard. In technical analysis, we'd call that price support. Shorter term market psychology had become quite negative in informed circles as well, though awareness of what's going on has not prompted anything close to panic in the broader investing public yet. This suggests a strong possibility to me.
I think we may be seeing the formation of a large, multi-year "head and shoulders" style top, with the potential for a re-establishment correction upwards from this price region that will ultimately exhaust itself in the neighborhood of DJIA 11,000. Today's big closing upward spike in prices did not go high enough to confirm this interpretation, but it was a potential signal.
Looking at this, there are two price levels that will confirm or deny this interpretation. On the one hand, if the DJIA manages to get itself up over 9,520, there's a very good chance that it's going to make its way up into the low 11,000 range before the larger downward trend really gets rolling with its full and broad establishment of negative psychology. In this case, the market could easily bounce around in the 9,000 to 11,000 range for years until it manages to trap all the remaining bulls and whipsaw all the bears, getting ready for a really major downswing to follow. On the other hand, if the DJIA makes a strong break below 8,000 (say, below 7,500...the low range of this major price support level), then the expected "head and shoulders" scenario will likely not materialize. In that case, we're probably going to see big downward moves until the next price support levels are reached. Those are down in the range of 3,750, 2,500-2,000, and 700-1,000 respectively. There really isn't much by way of price support between 7,500 and 3,750. In any event, whatever happens with temporary trend reversals and whatnot, those price support levels will still stand, the ultimately downside target for the DJIA below 1,000. That represents a full correction of the larger psychological cycle, which must happen before the next big positive phase start up. Of course, it took twenty-six years to get from the last major negative sentiment extreme to the major positive sentiment extreme. The negative phase of this broader cycle could easily take twenty or more years to play out. A lot can happen in twenty years.
Which is why its important, even for the super-bears who I know are reading this, to keep in mind that even in major bear markets there are opportunities to make a lot of money...and not just by going short. Not many people are aware of this, but the biggest five-year percentage gain in the DJIA took place right in the middle of the Great Depression, from 1932 to 1937. The only other bull moves that even come close to that are the 1992-2000 phase of the Big Bull and 1921-1929 upside blow-off. So, even though I am broadly bearish on the US stock markets (if you run those numbers above, you'll see that I'm predicting a 72% to 94% total drop in the DJIA before this is all over), I am on the lookout for bull counterswings. They're going to happen. Bears who aren't ready for them are going to get whipsawed. And bulls who fall prey to them, thinking that this is all over long before it really is, will wind up doubling down on a losing bet if they haven't got their eyes on the exits.
As for the endgame, we'll know that the negative psychological trend has exhausted itself not just when prices get into the target ranges I've noted above, but when a few other things happen as well:
1) The general public will have long abandoned the stock market and the reputation of stocks as worthwhile investments will be destroyed,
2) The "buy and hold" investing philsophy will have become a laughingstock,
3) Apocalyptic visions will become all the vogue, and doomsday will seem to be only a heartbeat away,
4) The "Panics" and "Crashes" (yes, I used the plural) that precede the ultimate bottom will have long passed.
There's also a non-trivial chance that we'll see a bear progression that looks a lot more like the 1966-1982 market than the 1929-1932 market, only MUCH bigger. Whether or not that happens depends a lot on what the government does in response to all this.
I can say all this with some confidence, yet hesitate to put any dates on it because human psychology is fairly predictable in its results, if not its timing.
All of which still doesn't tell me whether or not I should unwind my shorts and go long any time soon. For now, I just have to wait and see...letting market, and the broader psychology that drives it, tell me what it's going to do next.
First, market psychology. Take a look at this:
What you see here is the classic progression of the aggregate psychological state of a market...any kind of market, really. It has no endpoint or startpoint. It's a continuous cycle.
There's also something about this psychological progression that is not illustrated in this diagram: the market psychology progression you see here is self-similarly recursive at all time and magnitude scales. Actually, Benoit Mandlebrot noticed this too, but didn't ascribe it to the psychology of the market. He simply identified that a pattern was present and followed the principles of his own work in fractals. Within each move in market prices, this progression cycles at longer or shorter duration and larger or smaller magnitude. So, within the price movement you see while the larger trend is, say, "Panic", there will be smaller, shorter sub-cycles that progress through the gamut: momentary euphoria as things briefly look as if they've turned for the better, etc. The real progression of the cycle doesn't look like a sine wave, it looks like the stock market. That's almost tautological, since market prices record the psychological progression in a form that we can map and analyse. Needless to say, identifying these psychological progressions at any scale is far more art than science. However, the fact that it happens is broadly recognized. That's also part of the problem of identification. If nobody knew about this but me, it would be much easier for me to identify what's going on. As it stands, you've got billions of people trying to second-guess one another.
So, where are we in the psychological progression? To answer that question, we need to look at the market across multiple scales. I'll start with the largest one first, since that's easiest. You may want to periodically refer to this 100-year chart of the DJIA as we go. You'll note that this chart is plotted on a logarithmic, not a linear scale. That's important, since the only thing that really matters in market movements when we talk about trends this way is percentage changes in price levels, not linear prices. When people show you price charts with asymptotic spikes at the ends of them, remember that a big spike on a linear graph may not actually represent a huge percentage growth. Stick with the logarithms. They won't steer you wrong.
The equity markets in the US have been in a protracted bull market that began in either 1982 or 1975 depending on how you count it. If you go by price, 1975 was the price low and the actual end of the bear market folllowing the 1966 top. If you go by psychology, 1982 was the nadir. Both dates are important, as I'll elaborate in a bit. Those of you who were alive and paying attention to such things may remember the tone of the markets and our culture in general at the time. In both 1975 and 1982, pessimism was rampant. I want to focus on 1982 a bit more than 1975, partly because I was old enough to remember '82 clearly (I was only seven years old in 1975), and because the psychological state is what I want to focus on.
Once the Big Bull got roaring, many people seemed to conveniently forget that in 1982, the date the "buy and hold" analysts like to use as a benchmark for their "if you had bought then and held" scenarios, few if any investors were at all interested in putting their money in equities. Equities had been underperforming other markets for years with only occasional bright spots (such as the "nifty fifty" of 1972-1974). By the early 1980s, the markets' ability to regain optimism on upswings was completely exhausted. Doomsday predictions and apocaplyptic scenarios were very popular. Nuclear war and Soviet ascendence were assumed to be an "any day now" sort of proposition, and many people lived in dread. It was during this 1975-1982 period that survivalism came into vogue. The stock market was so far out of the public eye that for most people, it might as well not have existed. Another reason 1982 is often marked as a bottom is because that's when trading volume bottomed out. Few if any investors wanted to be heavily into equities. They didn't look like they had any kind of future at all.
With hindsight, of course, we know that this was a generational buying opportunity. 1982 marked the kick-off of the greatest bull market in American history...one that would ultimately come to rival John Law's Mississippi Scheme and the South Sea Bubble in magnitude. If you had put all your money in equities in 1982 and done nothing else for the next two-plus decades, you would have increased your portfolio by orders of magnitude, not just single-digit year-on-year gains. Some people did even better than that, and got famous for it.
But, it took a while for the broader psychological trend to shift. Throughout the 1980s, pessimism slowly turned over to optimism. Among investors, optimism turned to euphoria as we pulled in the final years of the Reagan Administration. But, and this is important, the market by that time had not pulled in the broader majority of the public. The psychological progression hit a peak in 1987, only to come crashing down (I was standing in the Melbourne Stock Exchange on the day of the crash, and it was sobering event, but the market had turned prior to that day), but it only engaged and affected those people had been in on the first wave of what was to become a much larger and more broadly based progression. In fact, the speed with which sentiment turned negative in 1987 should have been a clue at the time that a much bigger bull was in the making. Also, go and look at the 1987 crash on the price chart I linked earlier. It barely even registers. If you compare it to the dip in 1929, you have to wonder what all the fuss was about. The fuss, of course, was about market psychology turning through its cycle on a smaller scale than the broader trend. In the case of 1987, it was a "surprise disappointment", which should have been another clue that there was more upside ahead.
The Soviet Union collapsed with a whimper, not a bang, and the Berlin wall was torn down by exultant crowds. The 1990s came. As the economy "staggered" back to its feet following some lean years in the early 90s, the broader market arced upward with breathtaking rapidity. Optimism began to permeate our society, moving toward excitement and thrill. Francis Fukuyama talked about the "End of History," a marked contrast to the apocalyptic visions of the early 1980s, and the United States was ascendent across the globe: sole superpower, mighty financial power, technological innovator. Speculative fiction turned from dark visions of post-apocalyptic futures predicted in the late 70s and early 80s to ecstatic conceptions of "singularities" and "extropianism" in the late 90s and early Aughts.
In the mid-1990s, as the trend launched through its midpoint, the public sat up and took notice, then dove in head first. This is typical of the trend establishment phase, whether in optimism to excitement or desperation to panic phase. By the time 2000 rolled around, Euphoria had definitely taken hold. Only, this is a psychological cycle on a very broad scale now, so this was not a momentary phenomenon, but one sustained for years, even as one market after another topped out and declined. The Euphoria was powerful enough that is permeated all the markets, cresting in one after another over a period of several years. At the time, in fact, even though I saw it and knew what it meant, I grossly underestimated its magnitude.
The euphoria is gone now, of course, but its echos are still very much with us even though we now have fear and uncertainty, with the larger psychology turning negative. One aspect of psychological trend changes is that the previous trend usually re-asserts itself strongly as the new trend is getting up and running, with a re-establishment reversal that exhausts the last remnants of the previous trend. That's why the 1966-1975 bear market had a "double bottom", with a major price low occurring in 1975 and a major sentiment low in 1982. The price low of 1982 was shallower, but the previous negative psychology of the down-phase of the cycle re-asserted itself with strength as it was on the way out.
The same thing happens at tops, of course, which is why I'm scrutinizing the markets so closely these days. I'm fully expecting a bull spike, with a temporary re-establishment of the euphoria. Of course, this assumes that it hasn't happened already, which I think could be argued is the case from the 2000 top to the 2008 top. Whether or not the 2000 top was the end of Big Bull, or the 2008 top was, will depend on whether or not you think inflation is skewing the price activity of the market in a significant way. This is also true for the 1975/1982 low, by the way. Since the actual magnitude of inflation is conjectural, this is a difficult call. I think it could go either way. In either case, there is no question to my mind that there is a "doubling" of sorts at market tops and bottoms.
Taking this notion of the temporary re-establishment of the previous trend following the turning point, the phenomenon often shows up in price charts as the notorious "head and shoulders" formation. It looks like this:
Now, consider two things. First, go back and look at that chart of the DJIA going back 100 years. Up at the top right hand corner, you see what the market has been doing during the last decade or so. That price chart formation clearly includes two price tops, with an interim market correction which dipped down to a price level of 8000 on the Dow.
This morning, the DJIA hit 8000...twice... and bounced off that price level hard. In technical analysis, we'd call that price support. Shorter term market psychology had become quite negative in informed circles as well, though awareness of what's going on has not prompted anything close to panic in the broader investing public yet. This suggests a strong possibility to me.
I think we may be seeing the formation of a large, multi-year "head and shoulders" style top, with the potential for a re-establishment correction upwards from this price region that will ultimately exhaust itself in the neighborhood of DJIA 11,000. Today's big closing upward spike in prices did not go high enough to confirm this interpretation, but it was a potential signal.
Looking at this, there are two price levels that will confirm or deny this interpretation. On the one hand, if the DJIA manages to get itself up over 9,520, there's a very good chance that it's going to make its way up into the low 11,000 range before the larger downward trend really gets rolling with its full and broad establishment of negative psychology. In this case, the market could easily bounce around in the 9,000 to 11,000 range for years until it manages to trap all the remaining bulls and whipsaw all the bears, getting ready for a really major downswing to follow. On the other hand, if the DJIA makes a strong break below 8,000 (say, below 7,500...the low range of this major price support level), then the expected "head and shoulders" scenario will likely not materialize. In that case, we're probably going to see big downward moves until the next price support levels are reached. Those are down in the range of 3,750, 2,500-2,000, and 700-1,000 respectively. There really isn't much by way of price support between 7,500 and 3,750. In any event, whatever happens with temporary trend reversals and whatnot, those price support levels will still stand, the ultimately downside target for the DJIA below 1,000. That represents a full correction of the larger psychological cycle, which must happen before the next big positive phase start up. Of course, it took twenty-six years to get from the last major negative sentiment extreme to the major positive sentiment extreme. The negative phase of this broader cycle could easily take twenty or more years to play out. A lot can happen in twenty years.
Which is why its important, even for the super-bears who I know are reading this, to keep in mind that even in major bear markets there are opportunities to make a lot of money...and not just by going short. Not many people are aware of this, but the biggest five-year percentage gain in the DJIA took place right in the middle of the Great Depression, from 1932 to 1937. The only other bull moves that even come close to that are the 1992-2000 phase of the Big Bull and 1921-1929 upside blow-off. So, even though I am broadly bearish on the US stock markets (if you run those numbers above, you'll see that I'm predicting a 72% to 94% total drop in the DJIA before this is all over), I am on the lookout for bull counterswings. They're going to happen. Bears who aren't ready for them are going to get whipsawed. And bulls who fall prey to them, thinking that this is all over long before it really is, will wind up doubling down on a losing bet if they haven't got their eyes on the exits.
As for the endgame, we'll know that the negative psychological trend has exhausted itself not just when prices get into the target ranges I've noted above, but when a few other things happen as well:
1) The general public will have long abandoned the stock market and the reputation of stocks as worthwhile investments will be destroyed,
2) The "buy and hold" investing philsophy will have become a laughingstock,
3) Apocalyptic visions will become all the vogue, and doomsday will seem to be only a heartbeat away,
4) The "Panics" and "Crashes" (yes, I used the plural) that precede the ultimate bottom will have long passed.
There's also a non-trivial chance that we'll see a bear progression that looks a lot more like the 1966-1982 market than the 1929-1932 market, only MUCH bigger. Whether or not that happens depends a lot on what the government does in response to all this.
I can say all this with some confidence, yet hesitate to put any dates on it because human psychology is fairly predictable in its results, if not its timing.
All of which still doesn't tell me whether or not I should unwind my shorts and go long any time soon. For now, I just have to wait and see...letting market, and the broader psychology that drives it, tell me what it's going to do next.