by David Robertson, CFA
June 2022
Anatomy of the Bear: Lessons from Wall Street's four great bottoms, by Russell Napier is one of the truly great investment books, and also a timely one right now. Napier studied the history of the four great bear markets in the twentieth century in order to identify patterns investors could use to better navigate such challenging environments. The study was conceived as a "field guide" for financial bears.
Much of the emphasis of that book, however, was on identifying the end of the bear markets - to determine when it was safe to get back in the water. Now, after having experienced an incredible bull market run, the more relevant goal for investors is to determine if a new bear market is beginning. Once again, we can use history as a guide. Once again, there are useful patterns to pick out. Once again, we have an important question to answer: Are we entering a major bear market?
What kind of bear?
For starters, it is important to get a definitional detail out of the way. Financial media often describes selloffs of twenty percent or more as a bear market. That is not what we are talking about here. Twenty percent selloffs can happen for cyclical reasons, for technical reasons, or for not much reason at all. In the context of normal stock volatility, a twenty percent selloff is just not a very unique or informative occasion.
Rather, a bear market for purposes of this discussion is a much bigger ordeal. It is the kind of phenomenon that can last years. In fact, "it usually takes a long time - about 14 years - for stocks to travel from peaks of overvaluation to depths of undervaluation." It is a process that can "shred a portfolio and seriously damage your wealth," and therefore is worth the effort to avoid. Conversely, successfully investing near a bear market bottom can make investment careers and juice retirement fund returns.
Bad behavior
One of the reasons bear markets can be so extensive and pernicious is because investors repeatedly expect the worst to be over when it is not. Indeed, a major bear market is more of a process than a discrete event. As John Hussman describes in his latest note, "Making Friends with Bears Through Math", mistaking one for the other can be hugely problematic:
June 2022
Anatomy of the Bear: Lessons from Wall Street's four great bottoms, by Russell Napier is one of the truly great investment books, and also a timely one right now. Napier studied the history of the four great bear markets in the twentieth century in order to identify patterns investors could use to better navigate such challenging environments. The study was conceived as a "field guide" for financial bears.
Much of the emphasis of that book, however, was on identifying the end of the bear markets - to determine when it was safe to get back in the water. Now, after having experienced an incredible bull market run, the more relevant goal for investors is to determine if a new bear market is beginning. Once again, we can use history as a guide. Once again, there are useful patterns to pick out. Once again, we have an important question to answer: Are we entering a major bear market?
What kind of bear?
For starters, it is important to get a definitional detail out of the way. Financial media often describes selloffs of twenty percent or more as a bear market. That is not what we are talking about here. Twenty percent selloffs can happen for cyclical reasons, for technical reasons, or for not much reason at all. In the context of normal stock volatility, a twenty percent selloff is just not a very unique or informative occasion.
Rather, a bear market for purposes of this discussion is a much bigger ordeal. It is the kind of phenomenon that can last years. In fact, "it usually takes a long time - about 14 years - for stocks to travel from peaks of overvaluation to depths of undervaluation." It is a process that can "shred a portfolio and seriously damage your wealth," and therefore is worth the effort to avoid. Conversely, successfully investing near a bear market bottom can make investment careers and juice retirement fund returns.
Bad behavior
One of the reasons bear markets can be so extensive and pernicious is because investors repeatedly expect the worst to be over when it is not. Indeed, a major bear market is more of a process than a discrete event. As John Hussman describes in his latest note, "Making Friends with Bears Through Math", mistaking one for the other can be hugely problematic:
Aside from ignoring valuations and market internals, one of the behaviors that will get you eaten in a bear market is placing too much confidence in any single "capitulation." Speculative episodes typically unwind in waves. The steeper the starting valuations, the more waves one typically observes.
In each of the examples he provides of bear markets in 2000-2002, 2007-2009, 1973-1974, and 1929-1932 the clear pattern is of multiple bouts of declines of twenty percent or more. In other words, a major bear market is comprised of a cluster of smaller "bear" markets.
This is an idea Rudy Havenstein also recently elaborated on in a Substack piece. He takes the point a little further. It's not just that a major bear market is comprised of several instances of selloffs; it is also comprised of several instances of substantial rebounds, i.e., "bull" markets!
This is an idea Rudy Havenstein also recently elaborated on in a Substack piece. He takes the point a little further. It's not just that a major bear market is comprised of several instances of selloffs; it is also comprised of several instances of substantial rebounds, i.e., "bull" markets!
If we assume that a decline of over -20% is a bear market, and an advance of over +20% is a bull market, it is shocking how [sic] to realize how confusing that period must have been for investors. The decline from the 1929 top to the 1932 bottom was a secular bear market, but also within that period there were six cyclical bear markets and five cyclical bull markets. Eleven reversals in 32 months!
This is what makes navigating such an environment so challenging! Investors are repeatedly challenged to determine if the latest "bear" market is the last one or if there are more to come. Further, investors must also be prepared for some pretty wicked rebounds along the way too.
A big part of the problem is that most investors do not go into a secular bear market preparing for multiple selloffs and rebounds. Instead, they go in thinking once the (most recent) selloff is over, then it's back to the races. On this point, Hussman provides some useful insight:
A big part of the problem is that most investors do not go into a secular bear market preparing for multiple selloffs and rebounds. Instead, they go in thinking once the (most recent) selloff is over, then it's back to the races. On this point, Hussman provides some useful insight:
Bull markets train investors to think in terms of single, V-shaped selloffs followed by advances to fresh highs. In bear markets, it’s best to quickly abandon that thinking, preferably until market internals improve.
So, there are different rules for different contexts. In a broader bull market, it normally does make sense to buy the dip, i.e., V-shaped selloff. In major bear markets, however, investors need to be much more careful.
Big bear or little bear?
What characterizes one from the other? A useful start is with Napier’s description of the conditions of a major bear market bottom:
Big bear or little bear?
What characterizes one from the other? A useful start is with Napier’s description of the conditions of a major bear market bottom:
By watching the financial bears, we can observe the point at which a number of potential factors come together to signal the market can only get better. Those factors include low valuations, improved earnings, improving liquidity, falling bond yields, and changes in how the market is perceived by those who play it.
One point is this characterization exposes why major bear markets have so much staying power. The reason is extremes have been reached across multiple dimensions. It's not just a singular issue with valuations, for example, but valuations, and earnings, and margins, and liquidity, and bond yields. It also demonstrates that major/secular bear markets are qualitatively different from cyclical ones.
The same goes for major bull market tops: Extremes are reached along many different dimensions. Multiples are too high, and profit margins are too high, and earnings quality is deteriorating, and a number of assets need to get written down, and liquidity is falling, and bond yields are rising. Indeed, each of these conditions exists today.
Bear in the spotlight
None of these conditions, however, have emerged out of nowhere. I have been writing about them for years as have a number of other analysts and commentators.
For example, "The trouble with bubbles” documented “crazy investor behavior” and how it became manifested in excesses with IPOs and SPACs. “The bursting bubble of BS” discussed how “airy promises” and “vision” were used to promote businesses and exaggerate growth expectations.
"Do you believe in magic" described many of the "different ways in which illusions about financial performance can be created" and "Now you see them, now you don't: The magic of non-GAAP earnings" chronicled the use of non-GAAP numbers to flatter performance.
So, why now? If so many of the preconditions of a major bear market have been converging for some time, why did the selloff in stocks really only start this year?
Napier has a good answer for this question too: "The key strategic conclusion from this book is that swings in equity valuation are driven primarily by changes in inflation." In other words, inflation serves as a "key catalyst to instigate such reversion".
I highlighted the inflation threat a couple years ago in "The emanation of inflation", which also featured insights from Russell Napier. At the time Napier highlighted a “shift in the way that money is created”. As a result, he warned, “investors need to prepare for a new era of inflation.”
Two years later, it is not at all surprising to Napier or other students of financial history, that inflation is proving to be fairly resilient. Nor is it surprising that stocks began selling off when a disturbance in the price level became evident.
Conclusion
Major bear markets warrant the attention of investors because they can cause so much damage to investment portfolios. In addition, investors should be especially concerned now as so many of the preconditions of a major bear market currently exist.
One additional element to watch out for is a recession. All four major bear market bottoms of the twentieth century occurred during recession so that would be an important piece of confirming evidence.
Also, fiscal and monetary policy remain important wildcards. Clearly, the desire to intervene is high and the threshold for doing so is relatively low. Changes in either fiscal or monetary policy can materially alter current trajectories.
Finally, a key ingredient for managing bear markets is behavioral. As Hussman notes, "You make friends with bears by understanding them, and by avoiding behavior that will get you eaten." Recognizing that inflation changes the game, and therefore the playbook, can help avoid a lot of pain. It can also help position you to take advantage of opportunities on the other side.
The same goes for major bull market tops: Extremes are reached along many different dimensions. Multiples are too high, and profit margins are too high, and earnings quality is deteriorating, and a number of assets need to get written down, and liquidity is falling, and bond yields are rising. Indeed, each of these conditions exists today.
Bear in the spotlight
None of these conditions, however, have emerged out of nowhere. I have been writing about them for years as have a number of other analysts and commentators.
For example, "The trouble with bubbles” documented “crazy investor behavior” and how it became manifested in excesses with IPOs and SPACs. “The bursting bubble of BS” discussed how “airy promises” and “vision” were used to promote businesses and exaggerate growth expectations.
"Do you believe in magic" described many of the "different ways in which illusions about financial performance can be created" and "Now you see them, now you don't: The magic of non-GAAP earnings" chronicled the use of non-GAAP numbers to flatter performance.
So, why now? If so many of the preconditions of a major bear market have been converging for some time, why did the selloff in stocks really only start this year?
Napier has a good answer for this question too: "The key strategic conclusion from this book is that swings in equity valuation are driven primarily by changes in inflation." In other words, inflation serves as a "key catalyst to instigate such reversion".
I highlighted the inflation threat a couple years ago in "The emanation of inflation", which also featured insights from Russell Napier. At the time Napier highlighted a “shift in the way that money is created”. As a result, he warned, “investors need to prepare for a new era of inflation.”
Two years later, it is not at all surprising to Napier or other students of financial history, that inflation is proving to be fairly resilient. Nor is it surprising that stocks began selling off when a disturbance in the price level became evident.
Conclusion
Major bear markets warrant the attention of investors because they can cause so much damage to investment portfolios. In addition, investors should be especially concerned now as so many of the preconditions of a major bear market currently exist.
One additional element to watch out for is a recession. All four major bear market bottoms of the twentieth century occurred during recession so that would be an important piece of confirming evidence.
Also, fiscal and monetary policy remain important wildcards. Clearly, the desire to intervene is high and the threshold for doing so is relatively low. Changes in either fiscal or monetary policy can materially alter current trajectories.
Finally, a key ingredient for managing bear markets is behavioral. As Hussman notes, "You make friends with bears by understanding them, and by avoiding behavior that will get you eaten." Recognizing that inflation changes the game, and therefore the playbook, can help avoid a lot of pain. It can also help position you to take advantage of opportunities on the other side.
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