WHEN THE MARKET SPEAKS, LISTEN!There are two things that the past ten years should have made abundantly clear by now,

which is that a buy and hold strategy (B&H) is a recipe for disaster in a secular bear market,

and that one cannot ignore the message of the market when it is shouting at you. Knowing

the investment climate is pivotal as investment approaches have different outcomes in

different climates. A B&H approach is one of the best strategies to have during a secular bull

market (think 1982-2000), while a trading/market timing strategy is a better approach during

a secular bear market (2000-present). Given that we are still within the confines of a secular

bear market where real stock prices peaked in 2000, secular bear market rules apply and

risk management should become a top priority.

Disturbing Long Term Trends

As Mark Twain said, “history does not repeat itself, but it does rhyme.” There is a certain

rhythm to secular bear markets in that they often take a similar shape in magnitude and

duration. Secular bear markets can last anywhere from 10-15 years and I have created a

bubble composite based on three well known bubbles and secular bull market tops. The

bubbles I used were the Dow Jones from the 1929 peak (Great Depression), gold’s 1980 top

(beginning of The Great Moderation), and the Nikkei’s 1989 top (Japan’s Lost Decade).

Taking the average path of the three bubbles and overlaying the data with the NASDAQ’s

2000 market top showed that there was a likelihood that 2010 would contain the next major

market peak and that we would then have a long slide into the next low in 2013. The bubble

composite has been uncannily accurate and projected a market peak in the first half of 2010

followed by a short snap back rally before plunging back to the 2009 lows. Given the bubble

composite is an average of three paths the day to day noise is a bit filtered out though the

declining trend for the next few years is as clear as day and is not the least bit encouraging.

Data Source: Bloomberg

Data Source: Bloomberg

Some may be quick to dismiss a cycle composite created from prior bubbles to project future

market trends as past performance is no guarantee of future results, but there are other

disturbing trends that would tend to support the timing of a major market peak in 2010. For

example, the overall secular bear market trend in stocks since 2000 is as clear as day when

charting the relative strength of the S&P 500 Consumer Discretionary sector to the S&P 500

Consumer Staples sector. There has been a near perfect declining trend channel over the

course of the present secular bear market and declines in the ratio beginning from the upper

declining trend channel have marked the 2000 and 2007 tops and potentially the present top.

The ratio has not only turned down from the upper trend channel but it has also clearly

broken through its rising bullish trend line (green line) that began late in 2008, two bearish

confirming developments.

Source: StockCharts.com

While the secular bear market in stocks began in 2000, it appears the secular bear market in

our credit and consumption based society began in 2005. The S&P 500 Financial and

Consumer Discretionary sector’s combined weights in the S&P 500 bottomed in the early

1980s and with the increase in debt accumulation and consumption levels since than

increased in a well defined rising trend channel. This channel was decisively broken in 2008

and nearly retraced all of the relative performance gains accrued since the early 1980s in

short order. With quantitative easing by the Bernanke Fed a massive short covering in these

beat up sectors drove their combined weights back up to the declining trend channel that has

been in place since 2005’s credit bubble peak. The two sectors combined market weights

are turning back right at the upper trend channel and may be signaling credit bubble peak

round 2.

Data Source: Standard & Poor’s

Coming back to how history often repeats itself, another way to look at bubbles is their

market weight within the S&P 500 and there have been two major bubbles in the past half

century from which we can compare the present bubble in consumer related sectors (finance

and consumer discretion). Using the energy 1980 bubble peak and the technology 2000

bubble peak, the consumer related sector peak is right on schedule in which it’s final leg

down may continue for another two and half years with a bottom projected in the second half

of 2012. The image above and below should be taken seriously for those overweight the

consumer via the financial and consumer discretionary sectors.

Data Source: Standard & Poor’s

Risk Management

At the outset of this article was the point that a B&H strategy does not work well in secular

bear markets, where risk management of scaling out of the markets as they are peaking to

preserve capital is vitally important. The disturbing trends above suggests that investors put

on their risk management hats and move from focusing on capital appreciation to capital

preservation mode.

One risk management tool that has proven to be useful over the course of time is monitoring

the 12-month simple moving average (12-Mo MA) for the S&P 500. Sell signals are

generated with a monthly close below the 12-Mo MA and buy signals are generated with a

move above the 12-Mo MA. A long/short strategy using this simple risk management

strategy of shorting the S&P 500 on a sell signal and going long on a buy signal would have

produced superior returns over a B&H strategy going back to the last secular bull market

peak in 1966. Starting with $100K in each strategy would have led to $101K in profits from

the B&H strategy while producing $1.83M in profits from the 12-Mo MA system (ignoring

transactions and tax consequences). Another key attribute of the risk management system

versus the B&H approach is that you try to limit your losses (or max drawn down) by having

a sell discipline. As shown in the comparative table below, the max drawn down in

percentage terms was 13.24% over the nearly 50 year period with the 12-Mo MA system

while the B&H approach had a 52.8% max draw down.

Investment Strategy Comparison: $100K invested from 01/1966-Present

Looking at the risk management strategy of the 12-Mo MA over specific time periods such as

secular bear markets shows its strength despite generating short-lived signals that may

reverse. For example, starting with $100K in 1966 and using a B&H approach to the 1982

secular bear market lows would have only produced a profit of $29.6K while using the 12-Mo

MA system would have more than doubled your money with $123K in profits. Your max draw

down would have been 46.74% with the B&H approach while the 12-Mo MA system would

have had a 19.40% max draw down.

The 12-Mo MA system has been even more of a phenomenal risk management tool in the

present secular bear market that began in 2000 as can be seen from the cumulative

profit/loss value shown in the bottom panel below. Starting with $100K in 200 using the B&H

approach would have produced a loss of $29.8K while a gain of $200K using the 12-Mo MA

system. The net result would be $70.2K under the B&H approach versus $300K using the

12-Mo MA approach ignoring transactional and tax consequences.

I bring up the 12-Mo MA risk management system as we closed below the 12-Mo MA

on the S&P 500 yesterday, producing the sixth sell signal in twenty years. Since 1990

there have been two whipsaws in which the sell signal was reversed in relatively short order,

producing negative returns. In the 94/95 mid-cycle slow down and 1998 Asian Currency

Crisis cases, quick monetary responses helped prevent these sell signals from becoming

major bear markets.

This is brought up as no system is a black box and has its faults in which the markets can

change course on a dime with the Fed involved, and prior Fed Chairman Alan Greenspan’s

actions came to be known as the “Greenspan Put.” In the two 1990s whipsaw cases the

“Greenspan Put” came into play in which interest rates were cut and the money supply was

expanded rapidly to help propel monetary assets upwards as shown below.

If the markets continue their downward route will the current 12-Mo MA signal be reversed?

There is a clear possibility for this if Bernanke becomes active in the financial markets

though his tool box is becoming empty as interest rates are essentially zero. Furthermore,

the money supply growth rates have all plummeted as consumers and businesses are not

interested in lever again by taking on more loans as there has been an attitudinal shift

towards debt by the U.S. consumer. If households aren’t willing to borrow and banks are not

willing to lend, then we may just have quantitative easing 2.0 on our hands ahead as the Fed

becomes the last buyer of resort in terms of assets as it buys US Treasuries with the Federal

government then handing out “free money” for this or that “Cash for _______” program.

When The Market Speaks, LISTEN!!!

In addition to the 12-Mo MA system there are other long term signals that when generated

should not be ignored. Another system I track is the weekly 15/40 exponential moving

average (EMA) signals on the S&P 500 and the S&P 500 to bond ratio. The 15/40 EMA on

the S&P 500 is on the verge of generating a sell signal and the stock/bond ratio 15/40

weekly EMA system has marginally generated a sell signal. The weekly RSI on the S&P 500

is also probing bear market territory (readings below 40). Looking at these three indicators

suggests that investors should be on high alert for further market weakness.

Source: StockCharts.com

In addition, I’ve developed an index that measures the general health of U.S. financial

markets by monitoring volatility in the money market, bond market, stock market, currency

market, and UST markets all in one indicator. Moves into negative territory since 1990 have

marked recessions or financial crisis and the fact that we turned negative in early May is not

a good sign for the stock market going forward.

Data Source: Bloomberg

Taking the disturbing trends mentioned above coupled with the growing list of long term sell

signals, investors should be listening to the message of the markets which are shouting to

pay attention as the stock market is in a high risk position. The S&P 500 is very oversold and

ripe for a bounce in the near term. For the market to reverse its bearish trend we would need

to see the S&P 500 rally above its June high of 1130 and its 50 day and 200 day moving

averages. A move above these levels would force a less bearish view on the markets.

However, if the 1130 area is not breached to the upside then the market remains in a bearish

trend and risk management should be practiced to limit losses. A drop into the 900s and

even 800s in the S&P 500 cannot be ruled out. That said, if a bear market really begins to

take hold, be on high alert for another game changer such as the first quantitative easing

program announced by the Bernanke Fed early last year that helped stem the prior bear

market.

 Chris PuplavaPFS Group, Fundamental AnalystPrimary Tel 858.487.3939Other Tel 888.486.3939Fax 858.487.3969PO Box 503147 San Diego CA 92150-3147 USAcpuplava @ puplava.com http://www.puplava.com