The Primary Trend

| October 5, 2005

The primary trend is the powerful, underlying current that shapes long-term price movements in the stock market. Also known as secular bull and bear markets, these dominant trends will dictate the direction of stocks for many years at a time. Primary bull trends are reflections of economic improvement, expansion, and, ultimately, excessive speculation, while bear markets are reflections of economic contraction, as the excesses of the previous bull market are eliminated by the corrective forces of the business cycle.

Because the purpose of bear markets is to eliminate the speculative excesses of the previous bull market, there is always a direct correlation between any given bear market and the preceding bull market. Therefore, a great deal can be inferred about the extent and duration of a particular bear market given the magnitude of the previous bull trend. For example, unusually long primary bull trends that result in excessively high valuations will usually be followed by comparablely long bear markets that take valuations to extreme lows. It is the nature of the business cycle. As in classical physics, for every action, there is an equal and opposite reaction. Every advance has a corresponding cost, and every debt must inevitably be repaid.

The Primary Bull Trend

The primary bull trend is driven by economic expansion, and is divided into three distinct phases.

Phase #1: Accumulation

Primary bull trends begin during periods of undervaluation and extreme investor pessimism. The investing public, and most of Wall Street for that matter, is convinced that the worst is yet to come, and it has little interest in owning stocks. As a result, equities are selling at P/E multiples of 10, 8, or even less, and the dividend yield on the S&P 500 is 6% or higher. Volume dries up, and stocks languish at a given level for months before slowly starting to move up. Negative fundamental news fails to adversely affect stock prices in a significant manner any more, and when sell-offs do occur, they do so on relatively low volume, while the subsequent rallies are accompanied by relatively high volume. Stocks are being accumulated.

According to Dow Theory, the first bull market buy signal occurs when both the Dow Jones Industrial Average and the Dow Jones Transports fail to make a new intermediate-term low, and then both make a new high during their subsequent rallies. In other words, the first pairs of higher lows and higher highs in both averages is where the first primary bull signal is generated. And this is a key point: according to Dow Theory, a bull signal must be confirmed by both averages in order to be considered valid. Oftentimes, one average will generate a buy or sell signal in the form of a new pair of extremes in the direction opposite to the current primary trend, but the move will not be confirmed by the other index. This non-confirmation is a warning sign, and Dow Theory dictates that they should not be acted upon, as they have historically proven to be deceptive more often than not.

The accumulation phase continues until the first major correction in the rally occurs. At this point, the vast majority of investors still does not believe a new primary bull trend has begun, and they see the correction as the next leg down in the previous bear market. Once the correction ends at a level appreciably higher than the previous bear market bottom, and then stocks begin to move high once again, the second phase of the primary bull trend begins.

Phase #2: Recognition

During the second phase of a primary bull trend, the investment community finally comes to believe that a bull market is, indeed, underway, and their participation fuels the advance. Economic conditions start to improve as well, as foretold by the first phase advance, which fuels the rise even further. This second portion of the primary bull trend is generally the longest, as both the market and the economy continue to show steady improvement over time. Of course, there will be numerous, oftentimes violent corrections, and many will believe that these secondary market moves are the start of a new bear market. In this manner, the bull trend checks the advance when prices move too far, too fast, enabling it to, in effect, reload for the next leg of the move up. While the corrections are typically sharp and steep, the uptrend itself is gradual, relentless, plodding. In essence, the primary bull trend “climbs a wall of worry,” and a healthy skepticism on the part of the investment community is always an essential characteristic of this trend phase.

The recognition phase of a primary bull trend ends when the second, major correction occurs. At this point, many participants become convinced that a new primary bear trend has begun, adding both to the extent and duration of the move down. However, the correction almost always ends with a high-volume “wash-out” day, and then the uptrend resumes on strong volume once again, heralding the start of the final primary bull trend phase.

Phase #3: Euphoria

During the final phase of the primary bull trend, the healthy skepticism that had previously accompanied the advance finally disappears. A fully invested public becomes enamoured with stocks, and the majority comes to believe that the market can continue to climb indefinitely. In direct juxtaposition to the accumulation phase, the investment community becomes excessively optimistic, and stocks become correspondingly overvalued. Stocks attain P/E ratios of 20, 22, or higher, and the dividend yield on the S&P 500 typically moves below 3%.

Although business conditions continue to improve and future economic predictions are bright, the economic expansion has now become exceedingly speculative and excessive. Businesses take on too much debt and become more and more leveraged, setting the stage for the first phase of the next primary trend.

The Primary Bear Trend

The primary bear trend is driven by economic contraction as the excesses of the preceding primary bull trend are corrected, and it is divided into three distinct phases as well.

Phase #1: Distribution

Primary bear trends begin during periods of overvaluation and extreme investor optimism. The investing public, and most of Wall Street, are convinced that the best is yet to come, and everyone is interested in stocks. As a result, equities are selling at P/E multiples of 20, 22, or even more, and the dividend yield on the S&P 500 is 3% or lower. Finally, volume begins to dry-up on advances, and increase on declines. Positive fundamental news fails to advance stock prices in a significant manner any more, and when rallys do occur, they do so on relatively low volume, while the subsequent sell-offs are accompanied by relatively high volume. Unlike the first phase of a primary bull trend, this phase is extremely volatile. Violent sell-offs are followed by even more violent rallies, but eventually the selling volume overwhelms the buying. Stocks are being distributed.

According to Dow Theory, the first bear market sell signal occurs when both the Dow Jones Industrial Average and the Dow Jones Transports fail to make a new intermediate-term high, and then both make a new low during their subsequent downtrends. In other words, the first pairs of lower highs and lower lows in both averages is where the first primary bear signal is generated. Again, this is a key point: according to Dow Theory, a bear signal, like a bull signal, must be confirmed by both averages in order to be considered valid. As during the primary bull trend, non-confirmations are viewed as a warning sign, and Dow Theory dictates that they should not be acted upon.

Phase #2: Recognition

During the second phase of a primary bear trend, the investment community finally comes to believe that a bear market is underway, and their liquidation of stocks fuels the decline. Economic conditions worsen, as foretold by the first phase downtrend, which fuels the decline even further. This second portion of the primary bear trend is generally the longest, as both the market and the economy continue to worsen over time. Of course, there will be numerous, oftentimes violent reactions, and many will believe that these secondary market moves are the start of a new bull market. In this manner, the bear trend checks the decline when prices move too far, too fast, enabling it to, in effect, reload for the next leg of the move down. While the reactions are typically sharp and steep, the downtrend itself is gradual, monotonous, relentless. In essence, the primary bear trend descends a slope of hope, and continued optimism on the part of the investment community is always an essential characteristic of this trend phase.

The recognition phase of a primary bear trend ends when the second, major reaction occurs. At this point, many participants become convinced that a new primary bull trend has begun, adding both to the extent and duration of the uptrend. However, the reaction almost always ends with a series of low volume sessions, before the downtrend resumes on strong volume once again, heralding the start of the final primary bear trend phase.

Phase #3: Despair

During the final phase of the primary bear trend, the optimism that had previously accompanied the decline finally disappears. A sold-out public becomes thoroughly disgusted with stocks, and the majority comes to believe that the market will continue to decline for the foreseeable future. In sharp contrast to the distribution phase, the investment community becomes excessively pessimistic, and stocks become correspondingly undervalued. Stocks fall to P/E ratios of 10, 8, or lower, and the dividend yield on the S&P 500 typically moves above 6%.

Although business conditions show no signs of improvement and future economic predictions are grim, the economic contraction has now eliminated most of the speculative excesses of the preceding primary bull trend. Businesses have paid off their debts and strengthened their balance sheets, setting the stage for the renewal of the entire cycle, and the start of a new primary bull trend.

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