Stock Market Risk Remains at Historic Extreme

| April 29, 2012

Mainstream analysts maintain that stocks are “cheap” based on methodologies with very poor long-term performance histories such as the Fed model and forward earnings estimates. They also point to the extreme rebound off of the low in October 2011 as evidence that the economy is gaining strength. However, as we note often, short-term price behavior only has meaning when analyzed in the proper context afforded by the long-term view, so all investing and trading strategies should begin with a thorough understanding of the current secular environment. There have been five secular trends in the stock market since the crash in 1929, three downtrends and two uptrends.

The current secular bear market began in 2000 following a speculative run-up during the second half of the 1990s. As usual, market behavior clearly signaled that a secular inflection point was approaching and our Secular Trend Score (STS) issued a long-term sell signal in December 1999. Following the topping process in 2000, a prototypical secular bear market began and continues today.

Stock market secular trends typically last from 10 to 20 years, depending upon the nature of underlying structural economic trends. Since we are currently in the final stage of a debt expansion cycle that began 60 years ago, it is highly likely that the secular bear market from 2000 is still several years away from its terminal phase. The last time a structural deleveraging cycle accompanied a secular downtrend was during the Great Depression, and that bear market had a duration of 20 years. It is highly likely that the current secular bear will have a comparable duration.

The STS supports the hypothesis that this secular downtrend is far from over as the score has yet to return to positive territory following the sell signal in 1999. Secular inflection points develop slowly, usually over the course of 6 to 12 months, so the STS will provide plenty of advance warning when the next true investment opportunity develops in the stock market.

Secular trends are themselves composed of cyclical subcomponents, and the current cyclical uptrend began in March 2009. When they occur during secular bear markets, cyclical rallies have an average duration of 33 months. Therefore, at a current duration of 38 months, the bull market from 2009 is likely in the final stage of its development. Following the market crash in 2008, the latest cyclical rally has been characterized by violent moves higher and lower. The last extreme advance from October 2011 has produced a gain of 30 percent during the course of six months and it is highly likely that the next downtrend will be equally violent. Cyclical uptrend support is near 1,185 on the S&P 500 index and the forthcoming overbought retracement will likely return to that area, which is 15 percent below current levels.

With respect to cycle analysis, the rally phase of the intermediate-term cycle from November is now 22 weeks old and it has become extremely overbought. Of course, an overextended rally of this nature has a tendency to keep moving higher under the power of its speculative momentum, but when it finally breaks down, the correction will likely develop very quickly and retrace several weeks of gains in a matter of sessions.

The stock market now carries extreme risk from both long-term and short-term perspectives. The computer models that we use to generate our STS and our Cyclical Trend Score (CTS) analyze a large basket of fundamental, internal, technical and sentiment data, searching for highly likely inflection points in the secular and cyclical trends. Based upon more than 80 years of data, stocks are now in the riskiest one percentile of all historical observations. Another violent retracement similar in character to the 2010 and 2011 declines is coming; it is simply a question of when. The bigger question is whether the forthcoming high will mark the end of the cyclical bull market from 2009. As always, market behavior, along with diligently applied chart analysis, will provide the answer.

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Category: Commentary, Market Update

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