"Last week, I explained the three stages of a typical bear market. First, we go through the non-belief stage when investors buy declines on dips and ignore outside noise such as falling housing prices and the subtle money shift from small caps to large caps. This is the early stage of a flight to safety.
The second stage is worry as surprising disappointments in the financial sector cause investors to shift money from equities into Treasury bonds, marking the latter stage of a flight to safely.
The third stage is the recognition of a crisis. Normal sector rotation ends and global fundamentals are meaningless as a bearish stampede blows away assets at any price. Fears of another depression mount and eventually a global rescue plan unfolds.
Finally the crisis passes, and the dawn of a new bull market shines light on the debris left behind by the passing bear. The clean-up gets underway and the healing or basing process begins."
Stock mayhem takes cue from Pulp Fiction
October 17, 2008 Bill Carrigan
Last week, while visiting a branch of Union Securities at the height of the stock market selling spree, I was confronted by the branch manager who asked: "Are you scared yet?"
I paused and searched for an answer. I then recalled a line from the restaurant scene in the film Pulp Fiction when Jules (Samuel L. Jackson) was confronted by Pumpkin, a robber who points a gun at his face.
Without blinking, Jules replies: "Hate to shatter your ego, but this ain't the first time I've had a gun pointed at me."
Without blinking, I replied, "I am concerned, but this ain't the first time I've been mauled by a bear market."
Last week, I explained the three stages of a typical bear market. First, we go through the non-belief stage when investors buy declines on dips and ignore outside noise such as falling housing prices and the subtle money shift from small caps to large caps. This is the early stage of a flight to safety.
The second stage is worry as surprising disappointments in the financial sector cause investors to shift money from equities into Treasury bonds, marking the latter stage of a flight to safely.
The third stage is the recognition of a crisis. Normal sector rotation ends and global fundamentals are meaningless as a bearish stampede blows away assets at any price. Fears of another depression mount and eventually a global rescue plan unfolds.
Finally the crisis passes, and the dawn of a new bull market shines light on the debris left behind by the passing bear.
The clean-up gets underway and the healing or basing process begins.
This clean-up or basing period can last for several months – the 9/11 crisis took about nine months to repair. The bottom is first built by the market leaders – financial, technology and telecom, which bottomed in mid 2002. The market laggards – materials and energy – built bases through mid-2003.
We are now probably in that basing period. The broad indexes look to be forming a bottom, though commodity-related stocks could continue to deflate as commodities continue to weaken.
Two important tests loom.
The first test is for the major stock indexes and sub-indexes not to violate the panic lows posted last Friday.
The second test would be the return to natural market rotation – like the lows of 2002-2003 – a condition caused by investors moving in and out of various stock groups.
If over the next few weeks the lows of October 10 hold then a return to sector rotation is likely as investors focus on the economy.
You can see examples of sector rotation by looking at weekly or monthly charts of the various TSX sectors such as the financial, consumer, technology or materials sectors. In the normal course of the business cycle the financial and consumer sectors will lead the broader market indexes and the materials and commodity sensitive stocks will lag the broader market indexes.
Investors should incorporate sector rotation studies into their investment decision process by doing a quick scan of the TSX sub-groups or stock sectors.
One example is to compare the monthly closes of the TSX information technology index to the monthly closes of the TSX energy index in order to spot a lead and lag relationship.
Our two plots extend back to 2002 and clearly illustrate that the technology sector leads the energy sector to the upside and to the downside. Note the price peaks of the tech index in 2004 and again in 2007, well ahead of the energy price peaks of 2005 and 2008.
Note also the tech index is down to long-term support at the 2002-2003 base, giving us a compelling reason to own the TSX technology index and to avoid the TSX energy index.
Bill Carrigan is an independent stock-market analyst. His Getting Technical column appears Friday.