The three phases of a bull market: “Phase one is the rebound from the depressed conditions of the previous bear market. Here stocks return to known values. In the second and longest phase, shares advance in recognition of improving business and a rising economy. During the third phase, they spurt skyward on the hopes and expectations of a continuing rosy future.”
– Richard Russell, of The Dow Theory Letter, summarizing former Wall Street Journal editor William Hamilton’s observations on bull markets (quoted by John Hussman, “Phase 3: The Speculative Blowoff”, December 11, 2006)
As I was looking at decade long charts of the Dow, S&P 500 and Nasdaq yesterday I was struck by the similarity between 1998-2000 and 2006-07. And then just now I came across a recent Barron’s “Getting Technical” column by Michael Kahn, “History Paints a Somber Picture” (subscription required) (via Kirk) who sees a similar parallel.
Here is Kahn on the current market:
Let’s start with the current market from the peak seen last year in May. Over the following month and a half, the Dow fell about 8% and formed a technical pattern called a “double bottom”. This pattern is marked by a low, a small rally and a second decline back to the original low level where a solid base of support then forms.
When the Dow peaked last week [the week of Feb 26 – Mar 2], it had rallied for 148 days from last summer and gained just under 20%. Not too shabby.
Dow Jones Industrial Average, June 2006 – March 2007
Writing about 1998-99, Kahn continues:
… the correction of 1998, which lasted about a month and a half, culminated in a double bottom pattern and subsequent strong rally that lasted 149 days.
Dow Jones Industrial Average, May 1998 – October 1999
Comparing the two periods he writes:
While the size of the 1998 decline and the 1998-99 rally were twice as big as their current counterparts, the structure of the action appears to be very similar. If this model holds for 2007, then the market is in for a very choppy few months followed by the return of the bear.
Applying Hamilton’s 3 phase theory of bull markets we can situate ourselves this way:
Phase 1 “Rebound From Depressed Conditions” – March 2003 – February 2004: 2003 was a great year for stocks – helped along by the Federal Reserve dropping the Federal Funds rate down to 1% on June 25, 2003. The market found its bottom from the tech bubble and the ensuing recession and rebounded nicely.
Phase 2 “Recognition of a Rising Economy” – February 2004 – May 2006: 2004 and 2005 were steady, though not spectacular, years for stocks. During this period, the Dow rallied from around 10,700 to around 11,700 (about 9%) and the S&P from around 1150 to around 1300 (about 13%).
The housing boom picked up momentum and fueled the entire economy creating jobs, increasing people’s wealth from inflating housing prices and providing a stimulus to consumer spending. The Federal Reserve raised interest rates as the economy grew stronger, from 1% in June 2004 all the way up to 5.25% in June 2006.
The Correction of the Spring of 2006 : During the Spring of 2006, it became clear to everyone that the housing boom was losing its momentum and beginning to tail off. Fears emerged about the effects on jobs, consumer spending and the economy.
The Fed noted this in its May 10, 2006 statement (“The Committee sees growth as likely to moderate to a more sustainable pace, partly reflecting a gradual cooling of the housing market …..”) and raised rates for the last time on June 29, 2006.
The Dow and the S&P 500 each lost about 7% while the Philadelphia Housing Sector index lost about 30%.
Phase 3 “The Speculative Blowoff” – July 2006 – February 2007 (???): Without clear justificaiton, the market shook off the worries about housing and the economy and began to move up sharply. In this 8 month period, the Dow and S&P 500 each gained about 18% while the Philadelphia Housing Sector Index gained almost 35%.
Whether we are still in the speculative blowoff phase or have moved into a bear market won’t be known until after the fact. I could see the market blowing through the highs of last month in the short term and I could see it finding resistance near those levels and never breaking them this cycle. Overall, I tend to agree with Michael Kahn that “the market is in for a very choppy few months followed by the return of the bear”.
A Few Interesting Events Consistent With This Interpretation
(1) The Goldman Sachs IPO – May 4, 1999 – Interesting (isn’t it?), that Goldman went public during the speculative blowoff after the correction in the Summer of 1998 but before things got dicey.
(2) The Fortress Investment Group IPO – February 9, 2007 – Could Fortress be the Goldman Sachs of this cycle?
(3) News Breaks that The Blackstone Group Is Making Plans for an IPO – March 16, 2007 – Blackstone Co-Founder and CEO Steve Schwarzman sure seems to have changed his mind about the public markets in a hurry. I wonder why????