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Friday, September 7, 2007

5 Root Causes of a Bear Market Sept 2007

Kirk Lindstrom's Interpretation of Bob Brinker's 5 Root Causes of a Bear Market First published May 31, 2007 here

This article examines Bob Brinker's 5 root causes for a bear market. Please post your questions in our comments section that follows.

First lets look at what Brinker listed as his "Five Root Causes" for a bear market back when he make his last call to reduce asset allocation to equities for an "unfavorable" market.

In Bob Brinker's January 2000 Marketimer he published his "Five Root Causes for a Bear Market."

I believe not enough of Bob Brinker's "5 Root Causes of a bear market" are present today so Brinker will remain bullish. Before I examine the causes in detail, lets look at them in an historical perspective.

The 5 root causes of a bear market, according to Bob Brinker, are:

  1. Tight Money:
  2. Rising Rates:
  3. High Inflation:
  4. Rapid Growth:
  5. Over Valuation:

In January 2000, Bob Brinker advised taking 60% out of the market because:

  1. Tight Money: He said the Fed was reducing M2 to slow growth - BEARISH and correct as economic growth collapsed. This chart of M2 money supply growth shows the Fed Cut it to below zero in early 2000.
  2. Rising Rates: He predicted higher long and short term rates to continue. This did not happen but it was - BEARISH for his model..
  3. High Inflation: He said the CPI was approaching 3% and import prices were up 5% which would further impact inflation. We didn't get high inflation, but this was BEARISH for his model none the less.
  4. Rapid Growth: Real GDP growth was approaching 5%. Bob felt the FED would use rates to try and slow this. This was BEARISH and correct.
  5. Over Valuation: Bob wrote: "We believe valuation levels in the U.S. market are stretched to the limit." BEARISH and correct. Market PEs were at record levels
All five of his root causes were BEARISH in January 2000. On the radio program at the time, he said he was not bearish, but the odds favored a decline over the market going up more than 5%.

Brinker recommended reducing the equity allocation from 100% to 40% in his model portfolio numbers one and two. He also lowered his Model Portfolio III (which is a balanced portfolio) equity allocation from 50% to 20%.

Here are some newsletter quotes from early 2000:

  • January 8 2000 Marketimer: "The Marketimer stock market timing model has turned unfavorable....We recommend raising a 60% cash reserve at this time."
    (S&P500 = 1402.13; DJIA = 11122.65, QQQQ=86.25)
  • February 2000 Marketimer: "The Marketimer tactical equity asset allocation change in January has placed subscribers in a strong position as the market continues to deal with several unfavorable factors....."
  • April 2000 Marketimer: "The Marketimer stock market timing model remains cautious as the second quarter gets underway........"
  • April 2000 Marketimer: "Marketimer recommends the following investments as our best ideas for 1999 I.R.A. contributions, which can be made through April 17, and Year 2000 contributions. Each investment should be selected based on your personal investment objectives and should be integrated as part of your overall asset allocation strategy managed from the top down.

    • Equity Funds: Aggressive:
      Janus Olympus JAOLX (Did so bad they shut the fund in 2006!)
      Strong Growth SGROX Growth: TIAA/CREF
      Growth Equity Vanguard Total Stock Market .
      Conservative: Fidelity Utilities: FIUIX
      International: TlAA/CREF International Equity
      Fixed Income: Ginnie Maes: Vanguard Ginnie Mae Fund

    These selections represent funds which we believe are excellent investment vehicles for each investment objective category. We recommend I.R.A. accounts as vehicles for tax deferred investment and we suggest maximizing the I.R.A. accounts available to you
    ."

In August of 2000, when the market was a bit higher, Brinker recommended taking another 5% out of equities for a 65:35 Equities-to-Cash asset allocation.

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Had Brinker remained at 65% cash reserves until returning to fully invested in March 2003, he would have looked brilliant. Unfortunately, in October 2000 Brinker recommended putting 20 to 50% of cash reserves back into the market via the NASDAQ100 (QQQQ Bulletin ) for a counter trend rally despite saying his model had not given a buy signal. The QQQQ trade was a disaster, but his long term model was correct to predict further weakness because 2001 and 2002 were both down years for the markets.

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The markets bottomed in October 2002 and his model correctly gave him a bullish buy signal within 5% of the S&P500 bottom in early 2003. Since returning to 100% invested in March 2003, Bob Brinker has correctly remained fully invested with no QQQQ-like side trips to hurt his performance.

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Now, let's look at the 5 Root Causes of a Bear Market as of May 31, 2007:

  1. Tight Money. Economagic.com shows the growth of M2 Money Supply is positive at 9.72%. I rate this as BULLISH even though Bob has been upset with the Federal Reserve for raising the Fed Funds rate above 4.5% to its current 5.25%.
  2. Rising Rates: The idea behind this indicator is one of the ways to start a bear market is for the Federal Reserve to start a recession by going to far in raising rates. Brinker was correct that the Fed tightned too far in 2000 but so far in 2007, the Fed seems to have learned its lesson and is doing a great job.After the Fed raised rates to 5.25%, Bob said on the radio Saturday 06/03/06 that he thought the Fed had gone too far and will have to lower rates. He says they should have stopped at 4.5%. The Federal Reserve has raised short-term Interest rates from a low of 1.0% on June19, 2004 to their current 5.25%. After an historic 17 straight rate increases, the Fed has held rates steady at 5.25% . The 10-year Treasury bond remains "well behaved" at 4.90%. Bond investors have long term rates lower than short term rates as they believe the Fed will do what it takes to get core inflation back under 2.0%. Bob recently said "the Fed will eat crow " and lower rates to prove he was right all along about higher priced oil not being inflationary. I think that is like telling a fireman after they put out a fire "you didn't need to put water on the fire. It went out just as I said it would." You have to love Bob's modesty! I think Bob has had this indicator BEARISH while I have it as neutral or even bullish.
    Note, in past updates, I had this as BULLISH but I now think that was a mistake. I was using my interpretation of the data rather than Bob's interpretation of the data. Brinker has said many times he thinks the FOMC should have the Fed Funds rate between 4.0 and 4.5%, not its current 5.25% level, thus I think Brinker views this as BEARISH.
  3. High Inflation: Despite the inflationary pressures of higher food and energy, Federal Reserve monetary policy (including higher rates) has kept inflation from getting out of control . Sure higher priced commodities, especially oil, has core inflation above the one to two percent "comfort zone" for the Federal Reserve, but inflation is still well below the problem levels of the 1970's and 1980's. Unlike Brinker, I believe the Federal Reserve, led by Allan Greenspan and now Ben Bernanke, has done a fantastic job of deflating the housing bubble and limiting the inflation effects of higher priced oil without sending us into another recession. Overall, this is BULLISH
  4. Rapid Growth: This is not a problem. In fact, GDP has been below trend mostly due to the Federal Reserve keeping rates high to control inflation. Q1-2007 GDP growth was estimated to be only 1.3% after Q4-2007 came in at 2.5%. Today the government announced GDP came in at a very weak 0.6%, the lowest since Q4 2002 when it grew only 0.2%. On the radio, Bob said he is not calling for a recession. ECRI is calling for growth to improve, but they are not looking for rapid growth. BULLISH
  5. Over Valuation: In the June 2007 issue of "Kirk's Investment Newsletter," I wrote in "Standard and Poor’s estimates 2007 "Bottoms Up" operating earnings for their S&P500 index will be $94.11, up from $93.01 last month. At $1,501, this gives a price to earnings ratio (PE) of 16.0 on 7.3% earnings growth over 2006. The earnings yield, inverse of the PE, is 6.3% for 2007. The PEG, PE over earnings growth rate, is 2.2. The 10-year US Treasury bond is yielding 4.70%, well below the S&P500 earnings yield so the market is not over valued according to the “Fed Model.” Despite the recent record level of the S&P500 and the Treasury yield increasing to 4.90%, the PE and earnings yield are still quite BULLISH.

What do you think?

Sept 7, 2007 Update: I wrote the above five months ago. Did I make a mistake on any of these five indicators? I had all FOUR as BULLISH and ONE BEARISH the way Brinker looks at his model. TODAY, Brinker seems to think the Fed is going to lower rates and he seemed happy with Ben Bernanke whom he said made "rookie mistakes" in raising rates. So TODAY I have all five as BULLISH!

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Agree or disagree, I believe Bob Brinker will continue to be bullish.

Kirk Lindstrom

12 comments:

Honeybee said...

Thank you very much, Kirk.

Anonymous said...

This seems very correct. The market however keeps going down. It broke the buy point given by bob in his recent emails. I remain invested and am following the strategy, but it is very frustraiting. Do you think we should trim our positions just in case this call is as bad as the qqq call. Morriseyros@aol.com i welcome any emails.

Anonymous said...

With the Fed on our side finally, we can move higher. Bullish!

Rediron said...

1. TIGHT MONEY: That the Treasury just released a large amount of cash into the economy to belay the credit crunch demonstrates one of 2 things: either the supply was not enough and is now, or that it was enough and now there is now too much which would cause inflation pressure. I don’t know enough to answer whether we have too much or too little money supply and will have to defer to Kirk's experience on this one. But, although current money supply is probably not tight, I fear it could also be too loose and aggravate inflation. My guess is that the problem with the ongoing credit crunch that has expanded from the sub-prime mortgage crash is the fault of excessive rate hikes and not money supply and that the Treasury's action was therefore inflationary rather than helpful. Inflation devalues debt, making it easier to pay and that is good for all us debtors and bad for the banks (if you owe a 7% rate but pay with dollars adjusted inflation at say 3%, then your true interest rate is only 4%, YAY! A landlord will just raise the rent to pace inflation but the bank is stuck with the fixed rate). I would have to rate this one BULLISH to NEUTRAL.

2. RISING RATES: Rates have risen 17 consecutive times and the consensus is that the rates are too high. If the goal was to deflate a housing bubble, they have exceeded that goal put housing into a recession. When rates reached a level that discouraged speculators, it was a good thing, but when rates reached a level that forced average people into foreclosure, that's a bad thing. The high rates and foreclosures also caused a chain reaction that collapsed the mortgage industry. That the speculative end got cut down is OK, but that mortgage companies that didn’t speculate in sub-primes are going under is not good. Until rates are brought down into balance this has to be considered NEUTRAL to BEARISH.

3. HIGH INFLATION: Yes, the inflation has been held in check but it is still high enough to slowly eat at our wealth like a cancer. Inflation may not be 'bad' right now, but I doubt anyone thinks it is good and I am not sure why we cant theoretically have zero (the Fed thinks 3% is acceptable and it is generally above that depending on which measure we use). I would have to rate this NEUTRAL (see speech on inflation below).

4. RAPID GROWTH: I am not sure why they think this is a bad thing except that the Fed's misguided theory is that growth causes inflation and I think everyone is judging this backwards. Wouldn’t negative growth be bad? Growth considered on its own merits is very good such as increased wealth, incomes, jobs, corporate profits and their P/Es, etc. Therefore a good economy with growth, even rapid growth is good. Bad economic policy can cause inflation during periods of recession (known as stagflation) and growth just the same, and the rate of inflation is not tied to the rate of growth. Now, easy money is often a component of rapid growth that leads to excessive speculation which is harmful but you can have growth without easy money. But oversupply of money from an underlying bad economic policy is more likely the knife in the back that crashes a good economy rather than a result of a growth. The only reason given for why Rapid Growth is bad is that we know the Fed will raise rates to squash it, and that action is already evaluated in item 2. Until the Fed raises rates to shut down growth, growth remains inherently BULLISH. At the moment growth is average and the consensus seems to be that it is slowing. They have successfully raised rates to strangle the economy and I would consider the current slowing growth another NEUTRAL score,

5. OVER VALUATION. Gonna have to agree with the consensus on this one and wish I could figure out the numbers like Kirk's does. I still see an undervalued market due to the fantastic earnings increases of the past couple years. But, if the growth slows, then those profits will too and the P/Es on which the math is based can slip quickly. I will give it a BULLISH rating but I am starting to get nervous.

FINAL GRADE:
Looks like all my ratings average NEUTRAL and nervous. I am mostly out of growth and into staples with high dividends and commodity stocks with even higher dividends (oil, gas, miners) and also real estate (not REITs).

INFLATION SPEECH (RANT):
Inflation is a nasty thief that is caused mostly by the deficit spending and debt of our State and Fed governments. The simple oversupply of money by "printing" money backed by debt (treasury bonds/bills) and not real assets (GDP). That is why oil, property, gold, etc. are not inflationary because they are real assets and the asset does not disappear (if inflation is 5%, 5% of your house does not disappear, you still have the whole house and real assets usually increase their value in dollars by that same 5%). The values of real assets go up and down with supply and demand, which is not inflation and why I agree with Brinker that "high oil prices are not inflationary". Inflation is when the dollar loses value and it takes more dollars to buy the same asset and that is loss of wealth (if inflation is 5%, you DO lose 5% of any dollar based assets!). The Fed doesn’t have the courage or political clout to fight Congress' deficit spending problem and only has the option to fight the economy instead by hopefully ensuring that the creation of wealth (GDP) stays ahead of inflation rates. That the Fed believes that high growth = inflation is a farce and that is why they are usually wrong on what to do. The Fed is willing to stifle a good economy and sacrifice our jobs and our incomes to fight growth in the name of inflation instead of going after its true source. Creating wealth is not inflation because it creates an equal amount of real assets whereas deficit spending does not (it creates a debt and/or excessive wealth in the form of 'printed' money supply without the creation of an asset.

SEE ALSO the writings of:

a) recently passed economist, Milton Friedman - it was his economics that President Reagan put into action and spurred the worst economy since the great depression into best economy the world has known for 3 decades.

b) economist Peter Schiff, http://www.financialsense.com/fsu/editorials/schiff/archive.html

c) Stephen Todd (Todd Market Forecast): http://www.forbes.com/2006/06/20/fed-inflation-recession-in_st_0620soapbox_inl.html?partner=yahootix

"The Fed fancies that by raising rates, they combat inflation. Actually, just the opposite is true. Short-term borrowing is a cost of doing business for many firms. If that cost is raised, you have only three choices. One, you absorb it and take in less profits. Two, you raise prices. Three, you cut back production. The latter two are inflationary, and all three are bad for the financial markets. Raising rates actually causes inflation!"

Rediron said...

Oh, and thanks honeybee, kirk and all cause i have learned a lot from your contributions.

Kirk Lindstrom said...

Hi Rediron

Thanks for your alternative way of looking at the data.

"I am not sure why they think this is a bad thing except that the Fed's misguided theory is that growth causes inflation and I think everyone is judging this backwards. Wouldn’t negative growth be bad? "

Have you ever worked in high tech? During times of rapid growth, companies need workers and processors for computers that are in short supply... so the prices go up due to supply/demand laws. Even tellers to take deposits at banks from the workers making money become hard to hire so they get paid more to switch jobs. This all causes inflation. So the Fed has to slam on the breaks by raising rates which then causes the boom to bust.

I hope you come join us at facebook. The discussion forum is easier and better. See the top of this forum for instructions on how to join.

smile_1 said...

Honey,

Thanks for re-posting this article.

Looks like you have some good discussion here from Anonymous, Rediron and Kirk.

Regarding valuation we have discussed this issue at facebook under the "Valuation Methods" forum. Care must be taken to not over-extrapolate using the Fed Model since as Hussman pointed out here: http://www.hussmanfunds.com/wmc/wmc070820.htm a 1:1 parity of earnings yield to 10 year treasury yield is not the norm. Intuitively most investors can see this, but it bears mentioning here.

For those lurking here feel free to join this discussion and add your comments or discuss it more in depth at the Bob Brinker Discussion Forum or the Valuation Methods - Stocks, Indices, ETFs, Mutual Funds, Bonds Forum at facebook.

To request an invitation to facebook simply click on the link in the upper right corner.

"Request Invitation to facebook discussion group".

Thoughts of a genius mind said...

Great Post. I was one of the gullible one's who subscribed to Brinker's Markettimer. I took his advice getting out right before the dotcom crash, but I was going to do that anyway. Anyone could tell the market was going down. When he did his QQQs, I only put a little money at risk so I didn't lose that much, glad I didn't but I did his one stock pick where he had a seat on the board, and I lost my shirt. Now I subscribe to Morningstar - Much Much better. After awhile you figure Bob out, and you want to stay far away

Thoughts of a genius mind said...

Great Post. I was one of the gullible one's who subscribed to Brinker's Markettimer. I took his advice getting out right before the dotcom crash, but I was going to do that anyway. Anyone could tell the market was going down. When he did his QQQs, I only put a little money at risk so I didn't lose that much, glad I didn't but I did his one stock pick where he had a seat on the board, and I lost my shirt. Now I subscribe to Morningstar - Much Much better. After awhile you figure Bob out, and you want to stay far away

smile_1 said...

Thoughts of a genius mind,

With your background in accounting, I imagine after a couple years listening to Brinker gets a little stale.

I would say Brinker offers some value if he can continue making his long term cycle calls as he did in 1982, but blew it with 1987, "tweaked his model" then got back in around 1990 or so good call afterwards to stay bullish till 1stQ of 2000 and although he missed the actual bottom @10/02 got back in @ March or so of 2003. If you can filter out the ego and fluff from the some of the meat.

I have not listened to the entire Moneytalk program in years, but his 3rd hour guests sometimes are quite interesting. For example he had a guest on Nassim Nicholas Taleb who I think was a former quant runner had some interesting things to say about randomness and exogenous or outside events (what he calls black swans). With your background in accounting you might enjoy this: http://www.fooledbyrandomness.com/quant.html

Anyway there is a lot out here available just a click away the trick is drawing a little bit of discerned knowledge from a lot of good sources and then thinking for yourself as you have done.

Rediron said...
This comment has been removed by the author.
Rediron said...

Kirk, All,

YAY for the more balanced Fed rates! This should help keep the market estimate on the positive side.

I agree that there are price increases as you explained but your example 'lifted all boats' and benefited all those that you named (companies that sell the product, companies that sell to those companies, employees for all those companies, and the whole service industry that supports those higher paid employees, real estate, etc.).

My point is that there are 2 kinds of inflation.

1. The kind in your example is one of prosperity. Increase in demand is the catalyst here.

2. The other creates poverty - all boats sink, the value of your income sinks, your dollar buys less, employees are not getting income increases that keep pace with or exceed the inflation growth, demand slips because commodities are unaffordable. Demand is not the catalyst but rather excessive money supply and debt burdens. And it can occur in both a growth market and a recession when it is called stagflation.

I do not see how the Fed could ever increase rates enough to counter the negative inflation caused by excessive government spending backed by only by debt. Any attempt to raise taxes to support that excessive spending would cause a recession and you all remember the stagflation of the 70s - high tax rates 70% and high inflation at the same time.

At the moment, you can outpace inflation by owning the right assets and investments, but, if they raise tax rates on gains, they would wipe that out.

I say all this expecting and hoping to be challenged cause i dont understand how all this works and i am compiling ideas from lots of sources and throwing them up on the board. This is part of the learning experience.