Sunday, January 04, 2009

Napier's, Anatomy of the Bear: Lessons from Wall Street's Four Great Bottoms

I was researching Tobin's q-factor, which led me to Russell Napier's excellent book. I wanted to capture a few salient points (there are many) in Russell Napier's, Anatomy of The Bear. You can also listen to Jim Puplava's interview with Napier here. ( Jim has many terrific guests on. Great interviews you can listen to while you are cleaning your desk off and paying bills.) Napier says it best:

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. (p. 3)

Napier chose four bear markets (month equates to the bottom):
  • August 1921
  • July 1932
  • June 1949
  • August 1982
His choice was based on a singular criteria of the q-ratio, or the ratio of the stock price to the replacement value in assets, falling at or below 30%. It's worth noting that the article that grabbed my interest happened to be one that stated that the market had to fall another 50% for THIS bear market to equate to those. So the jury is still out as to whether or not that is the case. However, I wonder how that factor would equate to the Japanese stock market?

His book is essentially a field guide to the 'signs' of a bear market's bottoming process. Accordingly, if you have an interest in reading about the confluence of 'stuff' surrounding bear markets, I'd recommend your reading this book and plowing through it. While I enjoyed the book, but there are places where the writing could have been clearer and the data presented a bit more clearly. Nevertheless, there is much factual data that will give an investor some armament against the foolishness spouted by pundits.

Napier notes some key items to look for--I highlighted the first two because they were evident at each of the bear markets he studies--he particularly notes copper prices as the commodity to watch:

    • improving demand at lower prices for selected goods, particularly autos
    • commodity price stabilization
    • improving economci news being ignored by the market
    • rising volumes on a strong stock market
    • falling volumes on a weak stock market
    • a rising short interest
    • a final fall in equity prices on low volumes
    • reductions in Fed controlled interest rates
    • A rally in the government bond market
    • a rally in the corporate bond market
    • positive signals from the Dow Theory

    Russell smartly reminds us that all bear markets are different. I'm also going to state that what we are undergoing is a trans-generational move which effectively emasculates any's posturing of "In my 30 years in the market". I'm hearing much of that, and I'm going to say emphatically that in a trans-generations move, 30 years is an inside of that and therefore irrelevant. That's not to say that the market may just go the way that those pundits suggest--UP. BUT, my point is that 30 years v. a trans-generational move (should we be having one)doesn't quite cut the mustard.

    What I found most helpful was Napier's discussion of the interplay of government bond prices, corporate bond prices and the equity markets. While he did not provide a table, I will do so for you.

    Now, let's take a look as to when government bond prices bottom.

    Based on MY reading of the data table (Is that not a monstrous head and shoulders that can NEVER go below the neckline!), it appears to me that interest rates bottomed here: 2007-08-09 5.41. Accordingly, I'm going to call that date, the bottom in government bond prices (I've no idea if I'm using the right data). However, there is some credibility to that date as it was just a week before the FIRST systemic risk crisis in the money markets. I'm going to use the Dow Jones Composite Average rather than the DJIA. It's worth noting that the market TOPPED about 1 month ahead of the government bond market bottoming. Please click on these images to prevent blindness.

    To be true to Napier's use of the Dow Industrials, I provide that chart here:

    (I am lazily not bothering with corporate bonds.)

    Am I concluding that this is indeed the bottom? Truly, I do not know, but the exercise seemed a fair to conduct. Looking at the weekly volume patterns in both charts certainly lends some credence that we had a high volume sell off in Sept culminating in November of 2008. I'd also hazard a guess that given the great hedge fund unwind, we are UNLIKELY to see a re-visitation of these volume levels. However, we should expect to see some improvement over the weekly volumes. It does NOT appear to me that we've had a low volume sell off.

    I've flagged a number of interesting things in Napier's book which I'll share here in no particularly order. IN addition to chronicling what was happening in the monetary and interest markets, Napier chronicled WSJ commentary in the 2-3 months on either shoulder of the bear market bottom. My point in sharing a few of these things with you is that what his researched uncovered is at odds with some of the conventional wisdom. I'm including my summary of his points and the page number on which the thought is expressed. Any direct quotations of text will be within quotation marks. My own thoughts/questions will be in brackets.

    • Extreme undervaluation in the market: I partly produced by a final downdraft in prices. The second contributor is the failure of stock prices to keep up with economic and earnings growth. (p 37) [I do not see that we have the second contributor yet. It's also worth noting that there can be large gaps (2 decades in 1899-1921) of GDP growth without a commensurate increase in the earnings of companies--Napier notes a 130% increase in earnings v a 738% increase in GDP in 1881-1921 period. ]
    • Napier calls into question the aphorism "buy when the news is bad". "The Wall Street Journal in the summer of 1921 was teeming with news and well-informed opinion that the economic contraction and with it the bear market in stocks was ending." (p.44). Specifically he opines that ". . . waiting for an absence of good news before buying stocks would not have been wise."
    • Price stability is at the core of factors signaling the end of a bear market. Napier specifically notes that "the most accurate forecasts of the end of the bear market came from those who focused on the change in the trend in prices." He also notes specifically auto sales (demand response to lower prices) and copper prices. [I'll add that my focusing on the decline in the industrial metal prices helped me conclude that the good times were over. Industrial metal prices are starting to now recover. I watch Stock charts $GYX, which currently shows some recover. How long it will last will unfold in the fullness of time).
    • A final bottom is generally made on low volume (in contrast to the popular adage). (p 68). [This observation lines up well with Selden's comment that the market generally rises from a period of dullness--market tops are violent; market bottoms are dull. Could we then be seeing JUST a year long workout of a top with more to follow? 'More to follow' would certainly fit with some of the direr predictions (e.g. L. Yamada's 400-600 S&P).
    • In 1932, the Fed started a wholesale purchase of treasuries (as they are doing now) and that scared foreign investors thinking that the dollar would be devalued against other currencies, thus they wanted to liquidate their dollar reserves. [I believe that the moves of other currencies against the USD is one of the most important things for us to watch. We are not a producer nation any more--we are a service based economy. The countries that produce stuff (everyone BUT the US) will want their currencies cheap relative to ours. So perhaps we will not see a dumping of Treasuries as many fortell.]
    • Napier notes that the move from overvaluation to undervaluation can take well over a decade--and that the 1932 bear market was the exception, not the rule. (p. 116)
    • Napier notes " There is often ample good and improving economic news at the bottom of the market. This all suggest the risk to investors at these extreme times may not be as great as often assumed. An investor need not buy equities based on his forecast that the economy will start to improve in six-to-bnine months. At the great bear market bottoms there is likely to be growing evidence the economy is already on the mend." (p. 264)
None of the above is meant to be a comprehensive review of the book, but rather some points of interest to get your noggin thinking. I think that this book would be an important part of your investor education, and I hope that you will consider buying it.


russell1200 said...

There is still too much churn in the economic developments to get a very good read. There are still a number of problems hanging over the banks that have not come into play in a strong way: commercial lending to mid-size banks that had been squeezed out of the residential lending market for one.

The action following 1932 was viewed as a bear rally. It did not last. Exogenous money supply factors helped to kill it, but those are just the types of problems you would expect to occur when rallying out of weakness.

Stock valuations tend to suffer in high inflation time periods. But they also suffer in times of deflation because you can make "real" money by just stuffing cash in the mattress.

Unless real economic trends don't improve a lot in 2009 it is hard to see any rallies as being anything but a rally our of weakness.

Leisa said...

I believe that the worse is yet to come. And Napier notes that the markets along with the economy turn at the same time. His evidencing that contemporaneous turn with a flow of good news indicating such (as economic indicators lag).

The last kick in the stomach in 1932 certainly roiled many who thought that the previous decline was the bottom. Lots of bottom callers out there. I'm expecting a dullard bottom, and goodness nows we've not seen that. (But I've no experience at all with bottom watching). And, we've not seen the low volume bottom yet. The equivolume charts were useful in seeing that.

Bonds, cash and to a certain extent gold seem to be the deflation trade. That is the road map that I have followed. Nevertheless, I'm trying to get controlled exposure to the bear market rallies.

Anonymous said...

1) Donald Coxe, in his friday 1/16/09 telecon (minute 29+), passed along that Andrew Smithers, a Tobins Q practioner, has recently said "yes, stocks are now generally below the Q radio".

2)I don't know Coxe's reference to this recent Smither's doc, but if you Google "inside listening in welling", you'll find a PDF of Kate Welling's (Welling at Weeden) interview with Smithers back on 5/26/2000 (BTW, Kate always conducts a great interview, with guests that are relevant to the economy / markets du jour ). In the interview, Smithers states "Bottoms don’t seem to be as easily predictable
using Q as tops. Because we’ve only really
had four bottoms in the last century. That isn’t a
great deal of data and so it is going to be extremely
difficult to know at what level you should re-enter the
market. Should it go back only to a reasonable level,
or overshoot, and could that overshoot be vicious?
There’s nothing to stop it from behaving equally
unpleasantly on the other side."

3) regarding your Japan question, from Smither's site, we have the rhetorical:
"Is the Japanese Stock Market Cheap?

We think not. (Report No. 317 "International Stock Market Values." 12th September, 2008 explains why)." (As at 24th September, 2008 the Nikkei 225 index stood at 12115.03 and the TOPIX at 1167.97).

But as of today, 1/19/09, the N225 sits at 8230, with Topix at 818!

4)There are several Smither's writings wrt Japan in the Archives portion of his site at, as well as a 2007 Welling interview "Cushion, What Cushion":

5) per your / Napier's focus on copper prices, I note that in the 3 wks YTD09, both $Copper and $GYX are low, stable / range-bound on

6) I am noodling on the impact of a credit collapse, and accounting lapses hampering our ability to use Tobin's Q (i.e. I can't imagine a CPA honestly defending the presence of off- balance sheet" assets to an investor/owner). IMO, excessive debt in all sectors is not easily / honestly resolved except perhaps with time (measured in y-e-a-r-s)

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