"Anatomy Of A Bear"

THE ANATOMY OF A BEAR

Just exactly how does a bear market start anyway? What are some of the major contributing factors that we should be aware of that lead to “The Bear”? We certainly don’t want to hear it announced on CNBC. The timing in that case would be about six months too late to adjust our portfolios for maximized profits based on the downward market directional change. So, what do we look for?

Here are a few of the tell-tale signs:

Increasing government, consumer and corporate debt.
Rising interest rates and rising inflation.
Increasing unemployment, especially within a weak, short-term recovery.
Consumer sentiment decline.
Consumer spending decline.
Increasing credit card delinquencies.
Dollar devaluation.
Increasing rate of personal and corporate bankruptcy.
Investor confidence decline.
Increasing insider stock liquidation.
Major catastrophic global events.

Even a technical stock trading indicator such as entering a “Topping Pattern,” which usually precedes a decline, can be thrown into the mix. If you are really into far out predictions, you could study up on “The Kondratiev Wave.” Some say its 50 – 60 year cycles will soon have us entering a period of sever economic decline… more on that later. In any event, market changes don’t happen overnight. No one can really say for sure just exactly when a bull market stops and a Bear Market starts. The change may not be clear for up to six months after it happens. Unless… the rubber band is stretched beyond its maximum elasticity and snaps! Then a crash occurs… the house of cards caves in… the perfect storm materialized… all that stuff! If a crash is where the economy is headed, then we need to know that now. A few comparisons here will hopefully clarify how business cycles are shaped, molded and changed over time. But first, two important factors to consider:

We live in a global economy. It is a vast and complex system. It will not turn around on a dime. No one event will greatly influence the direction of a country’s economic status. It will take a majority of the signs listed above to reverse an economic trend that is firmly in place.
The U.S. Dollar has always been thought of as the world’s reserve currency. The Fed Chairman, who ever he was, could control, or try to direct the economy with dollar manipulation. That situation is changing. The world’s reserve currency will probably end up as a basket of currencies selected from the strongest world economic powers.

So with these thoughts in mind, let’s explore economic cycles. Economic or business cycles are divided into three basic parts:

The Real Estate Cycle
The Stock Cycle
The commodity Cycle

These major areas of investment all continuously cycle up and down. This process of cycling produces trends, either up or down.

The economy is either expanding or contracting. All the signs previously mentioned come into play in a great tug of war as they impart their influence on the cycles… Bull or Bear… Up or Down… Rising Dollar or falling dollar… lower inflation or higher inflation. They are all intertwined and influence each other. Cycles have varying time lines: hourly, daily, weekly, monthly or yearly – up to over half a century long. There is nothing as constant as change! Being able to predict that change and position yourself to maximize your profit is why it is important to understand “The Big Picture.” The most important influencing sign on the economic cycles is Interest Rates. Read chapter 8 of my first book, “The Novice Financier” for all the details.

So… “The Anatomy of a Bear” is really then the downward trending portion of the stock cycle. Its antithesis, “The Anatomy of a Bull” is the upward trending portion of the stock cycle.

An expanded explanation of these signs and each signs’ current influence on the economy follows:

Government Debt. It’s going up. Our government is spending more than it takes in. This debt is financed by selling U.S. treasury bonds, almost half of which go to foreign investors. But the interest income derived is low, so investors are beginning to look elsewhere for better returns. Regardless, we need to continue to finance over 1.5 billion dollars a day of new debt. The issuance of U.S. Treasuries adds dollars each day to the “World Dollar Pool,” thus diluting the value of the dollar. When the dollar goes down in value, the stocks and bonds held by foreign investors will be sold because those investors will not want to lose money when exchanging our currency for theirs. This foreign exodus from our markets will make our stock values fall.

Consumer Debt. It’s going up. As a nation we spend more than we save. The average family has 8 credit cards that carry a cumulative balance of $18K. I read that somewhere and it is really hard to believe, but I am sure that it’s probably true. As a nation, the U.S. consumer has an insatiable appetite for goods. If we as a consumer nation don’t get our financial house in order, surely increased personal bankruptcies, which are rising, will lead to possible economic disaster. Remember, 60% of the driving economic force in our country comes from you, the consumer. Without that input, the economy tanks. That fact is why our Federal Reserve chairman, Allen Greenspan, made it so easy to refinance our homes. We could then pull out lots of cash to spend on goods to keep the economy going. The trouble is, that sooner or later we will have to “pay the piper.” When that happens, well… the longer we wait, the harder the whole market will fall. Companies will sell less, produce less and make less profit. Their stock value will in turn fall.

Corporate Debt. It’s going up. During the past few years when interest rates have been low, corporations have refinanced or taken on more debt. As rates rise over time, the markets will gain in value as corporate growth, production and profits increase. However, when profit margins are strong for an extended period of time, such as now, and a company has taken on too much debt at too high a rate, the inevitable happens. A competing company might undercut their price, thus reducing profits. Unable to compete under a heavy debt service load, the company must give up market share or even worse, go out of business. The end result is that their stock value in turn will fall.

So you can see that debt of all kinds is an important contributing factor to the start of a bear market. If you couple increasing debt with a stock market that is already fully valued and throw in a bunch of analysts that still exhibit a “Bubble Mentality” left over from the late 1990’s, you could be off and running at the start of a new Bear Market.

Rising Interest Rates and Inflation and Their Relationship to Debt. Well, it seems to me that the Fed used up all of its “silver bullets” when it lowered interest rates during the 2001-04 period in an attempt to “stop the bleeding” and hopefully turn the markets around. There was no wiggle room left with the rates at 1%. Besides, lowering rates really only stimulates economic growth in an economy that is relatively debt free. That’s not us! So, now what happens? Well, we need those foreigners to buy dollars in order to purchase U.S. Treasury Bonds in order to finance the debt, in order to keep the whole thing afloat! Pretty soon we have to figure out how to affect a soft landing rather than a nose-down crash.

Here is a novel idea… Let’s spend less than we take in! Wow! Why didn’t I think of that before? That’s a great idea. What do you mean, “We can’t do that”? Oh, I see. The politicians won’t allow it. Well, I guess they must know what they’re doing. Still, if we lower the trade deficit, won’t interest rates go down and economic growth go up? Isn’t that good? It may even help lower the trade deficit if the nation as a whole starts saving. Does anyone out there still know what that means? Savings? Couple that oddity with a “Buy American – Boycott China” promotion and we might take a bite out of the “twin towers,” otherwise known as the Federal Budget Deficit and the U.S. Trade Deficit. Then, if we can convince the French to buy Sonapa-Noma…er… I mean, Napa-Sonoma Wine (old, bad joke) we will really shift the balance of power. But alas, back to reality…

The economy is heating up. The GDP (Gross Domestic Product) is growing rapidly and with it, inflation and interest rates will rise. If inflation rates keep rising above the short term interest rates, you can bet the Fed will continue its measured, methodical rate increases. Better interest rates (higher) could again attract the foreign investor to buy our bonds thus maintaining our frantic paced debt financing. However, this process dilutes the dollar. The falling or weaker dollar has one side benefit. It makes our export goods more competitive on the world market. The downside to rising rates/ falling dollar is that some stocks such as construction and automotive stocks, which have relied heavily on low rates to pull them out of the last downturn, will most likely not do well. Rising consumer price inflation always takes a bite out of your wallet. Your options are to spend less or go into more debt. Presently, the CPI (Consumer Price Index) is rising at a rate of over 4% per year. Is your salary going up at that rate? Many investors retreat from the markets to “safe havens” at these times and that pushes stocks down. Gold anyone?

Increasing Unemployment, especially within a weak short term recovery, which we seem to be experiencing now, casts shadows on the strength of the economy and it ability to sustain itself. We have in place what is termed a “jobless recovery.” Companies found every way possible to increase production, growth, profits and dividends except through hiring. I personally believe that employee burn-out from overwork is not far behind the double digit corporate profits posted last year. This recovery is a weak one leaving investors waiting for the next shoe to drop.

Consumer Sentiment has a powerful influence on the economy. If we as a nation get the “spending jitters” then our entire economy feels the pinch. The Bush tax refund incentives stimulated spending for awhile. That money is gone. Low rate borrowing is diminishing. I think we are starting to feel uneasy. Our consumer sentiment is declining. What follows hand-in-glove in none other than a…

Consumer Spending Decline. Remember that 60% of the driving force of our economy comes from you, the consumer. When you stop spending, the economy goes into a decline, manifesting itself in a Bear Market.

Increasing Credit Card Delinquencies. One way to prolong consumer spending and thus keep the economy rolling along is to encourage the use of credit card spending. We seem to be very adept, as a nation, at this process. We can attest to this fact by the ever increasing credit card delinquencies. What are we thinking? We know they will never be paid off. Where is our sense of moral and ethical values? Financial lunacy is what is happening here.

Dollar Devaluation. There is no question about the fact that the dollar has been going down in value over the past few years. Just listen to the complaints of the U.S. tourists going to Europe. They are saying that everything costs a fortune! Cheaper dollar. Just yesterday, the Chinese government announced that they no longer wanted to tie the Yuan to the dollar. Rather, they are thinking about a basket of currencies, particularly the Euro/Yen to peg the Yuan to. This change is just another indication that the dollar is losing its grip on being the world’s reserve currency.

Increasing Rate of Personal and Corporate Bankruptcy. This problem is spiraling out of control in an ever increasing concentric circle. The debt encouraged and created over the last decade requires additional debt just to keep the whole thing afloat. The Federal Reserve Board is running out of ways to re-inflate the economy. Easy credit has fueled this housing boom, both new and refinanced. Consumer spending went along for the ride. In my opinion, a slight bump in the road will push many into bankruptcy. This year and next, the experts predict that there will be more personal and corporate failure as interest rates rise.

Investor Confidence Decline is reflected in the money that has moved to the sidelines in the stock market this year or has moved over to the commodity markets in anticipation of better returns there. You see this move in the form of reduced trading volume. Further, we know that when the dollar declines, foreign investors will pull out of stocks and bonds to protect their capital.

Increasing Insider Stock Liquidation. There have been numerous studies done recently that indicate a vast majority of “insiders” are selling rather than buying. Who really knows better what is happening inside the corporate walls other than the CEO, COO, CFO, V.P., etc? If they thought that their company was going to be accomplishing great things this year or next, do you think that they would be dumping their personal shares? I think not.

Major Catastrophic Global Events such as the dramatic increase in energy consumption, coupled with decreasing supply have put the pinch on our available spending cash. It costs more now to drive your car, heat your home, and run anything electric. The C.P.I. is on it way up and with it the inflation it measures. What goes down is the profit and in turn the share price of companies that guzzle energy in the process of doing business. Think about airlines, plastic manufacturing companies and electricity generating companies.

So where is the economy going? Will we continue the Bull Market of 2003-04, or slip into a Bear Market? How do you interpret the signs? You decide.

DEFINITIONS


Balance of Payments (International transactions) – The dollar value of trade in goods, services, income, unilateral transfers and financial assets either above (credit) or below (deficit) a zero dollar line.

Consumer Price Index (CPI) – A measure of the cost of goods and services used to calculate inflation.

Consumer Sentiment – The general feeling of consumers about the state of the economy.

Consumer Spending – A measure of the goods and services purchased in an economy. It is estimated that the consumer accounts for 60% of the economy’s driving force.

Current Account – aka “The U.S. Trade Deficit” is the combined balances on trade in goods, services, et al., of international transactions.

Debt – Government, corporate or consumer in nature is a measure of the dollars owed for goods and services rendered.

Deflation – The rate at which the general level of prices for goods and services is falling an economy.

Depression – A period when total excess supply overwhelms the total demand resulting in falling prices, unemployment and economic contraction.

Dollar Drain – The impact of importing more than is exported. The money required to finance the import removes dollars from the economy.

Dollar Valuation – The amount of goods a dollar will buy at any point in time compared to other currencies.

Gross Domestic Product (GDP) – The sum of gross value added by all U.S. producers.

Gross National Expenditure – The sum total of all household consumption, government consumption and domestic investment.

Inflation – The rate at which the general level of prices for goods and services is rising in an economy.

Interest Rates – The nation’s monthly effective cost for debt capital.

Investor Confidence – The general feeling of investors about the bearish or bullish state of the market.

National Savings – The sum total of private savings and public spending.

Recession – A temporary downturn in the economic activity, usually defined by two consecutive quarters of falling gross domestic product.

Stagflation – A period of slow economic growth, high unemployment and rising prices.

Stagnation – A period of slow economic growth.

Stock Market Volatility – The amount of money changing hands in terms of shares traded that amounts to a substantial percentage change in market value. This volatility seems to be associated with the liquidity of the securities and is high when stocks are in decline or during a recession.

U.S. International Trade Deficit or Surplus – The difference in the value of our nations imports over exports (deficit) or exports over imports (surplus).


I have drawn liberally from information contained in the following web sites to develop most of the above definitions:

http://www.bls.gov/bls/inflation.htm

http://www.bea.doc.gov/bea/di1.htm

Parry Laird
The Novice Financier
http://www.thenovicefinancier.com