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Adam Hamilton

Adam Hamilton

Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing…

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The Bust in Review

Seemingly sneaking up on us like a thief in the night, all of a sudden the final days of Anno Domini 2002 are rapidly waning.

Where on Earth did the year of 2002 go? I can hardly believe the incredulous message my calendars are conspiring to send me! Just as the old timers often warned me when I was a small child and eager for time to pass more rapidly, unfortunately the older I get the faster the years seem to careen by. Life feels like fast-forward on a DVD player!

Futile protests aside, the legendary Grim Reaper is indeed relentlessly marching on 2002, his wicked scythe sharpened to a razor's edge and a malevolent glee sparkling in his dark soul. 2002 is already as good as executed, with no hope of appeal or pardon.

As mortal humans bound by the threads of time, I think we pretty much all have the natural tendency to look back and reflect at this time of year. I know I certainly do. Yet, when I sit back in my chair and try to gaze out across the financial wasteland that was 2002, the perspective feels undeniably myopic.

The financial markets of 2002 were utterly dominated by massive strategic trends of an awesome magnitude that almost defied all rational attempts at description. Provocatively however, the seeds of all the monumental strategic trends that dragged the markets along kicking and screaming in 2002 were sown in earlier years.

What were the most important macro-strategic market trends of 2002?

I would argue they were stock markets down, dollar down, interest rates down, and gold up.

To study the strategic market activity of 2002 in proper context, we really have to step back and gaze far across the gaping sands of time to the actual trend births in earlier years. The stock markets began plunging in early 2000, the dollar topped in July 2001, Greenspan began forcing interest rates down in January 2001, and gold's glorious new bull market was born in April 2001.

From my perspective, the one common denominator behind all these mega-strategic trends of 2002 is the ongoing horrific US equity bust. Plunging stocks seem to command the prime linchpin position in driving all the other major trends.

The plunging stocks arguably led to the falling US dollar through direct and indirect pressure on multiple fronts.

As stocks fell, foreign investors began to realize that it made little sense to buy dollars and then lose them in the US equity bust. So they started selling dollars to repatriate their scarce capital. Also, as Greenspan's Fed brazenly manipulated short rates lower to vainly try and stop the bust, foreign holders of US bonds saw their dollar returns vaporize.

The plunging stocks certainly spawned the falling interest rates.

The very core of capitalism is the voluntary bearing of risk by investors and speculators in the hopes of earning a future return. Sometimes these risks don't pan out as originally hoped and investors and speculators lose their capital that they freely bet. This is all well and good and the way it should be, but the Greenspan Fed and spineless US politicians now oddly deem it unacceptable that anyone ever suffer pain in the markets. The Fed decided to violently manipulate interest rates down to near record-low levels, moral hazard and free markets be damned, to try and foolishly bail out rookie capitalists who can't handle a loss.

Even the wondrous new bull market in gold has been dramatically accelerated by the plunging US stock markets.

Plunging US equities lead investors to seek alternative investments and classic safe havens such as the Ancient Metal of Kings. The falling US dollar spawned by plunging stocks is causing the dollar/gold exchange rate, or the price of gold, to rise in the international free markets. In addition, the plummeting US interest rates spawned by falling stocks have driven real rates negative for the first time in decades, driving vast amounts of bond-market flight capital into gold's open arms.

Regardless of where one looks, the heavy hand of the brutal stock-market bust is heavily influencing all major strategic trends in the financial markets today.

Thus, when reflecting back on the markets of 2002, we thought it would be appropriate to take a look at the all-important US stock-market bust in strategic context. As it seems the ongoing bust is the prime mover and instigator of most strategic market-trend activity today, it is really important to understand this bust in light of historical precedent.

While everyone who has ever hazarded to read a single financial history book fully understands by now that the NASDAQ languishes in a classic supercycle bust, the venerable Dow 30 and S&P 500 are indeed trapped within this same massive bust. So rather than merely examining the NASDAQ we are also very interested in the bust behavior of the Dow 30 and S&P 500.

Our methodology for this end-of-year reflective comparison is simple. There have been two celebrated classic busts last century that we can compare our current ongoing stock-market bust to, the Dow 30 in 1929 in the States and the Nikkei 225 in 1989 in Japan. All three charts below have both the 1929 and 1989 bubble-bust episodes graphed under the current Big Three stock indices in the States.

In order to render the disparate raw data comparable across markets, eras, and nations, we distilled and refined it twice.

First, major bubble tops throughout history have not been kind enough to conveniently occur on the same day of the year. For example, the NASDAQ of 2000 topped on March 10th while the Dow 30 of 1929 topped on September 3rd while the Nikkei 225 of 1989 topped on December 29th. We wanted to perfectly match the topping days of each respective bust with its peers but could not do it with a conventional horizontal X-axis with specific dates.

To solve this problem we distilled the various bust data into weekly chunks surrounding the bubble tops. Week zero in the graphs below represents each bubble's top, perfectly matched with the other bubble apexes. 26-week markers (half years) extend back in time before the bubble tops as negative weeks, like a countdown to the bubble top, and run forward in time after the bubble tops as positive weeks. For example, -52 weeks indicates one year before the bubble tops and 104 weeks means two years after the bubble tops.

With our X-scale comparable, we turned our attention to the vertical Y-axis. Merely graphing raw historical data is not acceptable because it is not comparable. For example the Dow 30 topped at 381 in 1929 but the Nikkei 225 in Japan soared to 38916 in 1989, so a common Y-axis couldn't be used.

To address this issue we decided to convert each bubble and bust episode into a common indexed level. The pinnacle of each bubble was assigned the common value of 100 and then all the raw numbers were crunched to index the rest of the data off this shared top. In addition to solving the comparability problem the common indexing makes the graphs easier to read. A drop from a level of 100 to 80 indicates a 20% fall in any equity bust, so they are easy to compare and contrast across markets, eras, and nations.

Now that you understand how to interpret the somewhat unconventional graphs below, let's jump in. We'll begin with the ever-euphoric NASDAQ, which was the very nexus of speculative excess in the States and is the most comparable to classical historic equity busts.

It is quite provocative to compare the NASDAQ bust to the Dow 30 bust that commenced in 1929 and the Japanese Nikkei 225 bubble that topped in late 1989. While the NASDAQ has already far exceeded the immediate carnage of the relatively milder Nikkei bust, it continues to track the horrific stock market massacre of the early 1930s in the United States remarkably well.

At this stage of the game in the 145th week of its devastating Great Bear bust the NASDAQ is down about 73% since its bubble top, sickening by any standard. At the same week 145 the Nikkei was 'only' down 56% but the infamous Dow 30 of 1929 had plunged by a catastrophic 88%. The raw magnitude of these enormous losses almost defies belief. If investors haven't done their homework and happen to get trapped in one of these supercycle busts, their capital doesn't recover for decades after, if ever.

Tragically, if those approaching retirement age don't recognize a bubble bust almost immediately and sell out near the top, it's all over. They will not live long enough to recover their capital to retire peacefully. The young sometimes can recover if they are hypnotized and trapped by a supercycle bubble bust, but the old can't afford such colossal lapses in judgment. Time and time again the markets mercilessly obliterate the careless with extreme prejudice.

To recover from a 10% loss takes an 11% gain to be made whole again, no big deal. A 25% loss requires a subsequent 33% gain, which is usually still manageable. A 50% loss requires a double, or 100%, to merely get back to one's starting point. It is certainly not easy earning 100% in the markets in a short period of time, as any experienced speculator will probably agree.

But, if you are one of the tens of millions who has already painfully rode the kamikaze NASDAQ down 73% in the past 145 weeks since its March 2000 top, you have an unenviable Herculean task ahead of you. To recover your capital, just to get back to square one, from a 73% loss requires a monumental 270% gain. 270% gains don't just grow on trees and are extremely challenging to track down and bag.

Nevertheless, if you are a longsuffering glutton for punishment and remain in the NASDAQ now, you should sell immediately and get out of Dodge before the Great Bear really starts getting violent. Amazingly enough, the worst is almost certainly still yet to come!

A supercycle Great Bear bust has a single mission in life. It exists solely to destroy the manic euphoria rampant in general stock valuations during a bubble and maul stocks back down towards undervalued levels so the whole great cycle can begin anew like a phoenix from the ashes. While equity valuations on average run about 14x earnings over decades and centuries, they are bid up ridiculously high in a bubble when everyone lusts for stocks and they plunge to silly lows at a supercycle bear bottom when virtually everyone hates stocks with a passion.

As the graph above shows, general US stock valuations in terms of the crucial price-to-earnings ratio peaked at 32.6x earnings in September 1929 and ultimately plunged to only 5.6x earnings in June 1932. Massive secular bear markets exist to utterly destroy the fundamentally-unsound speculative excesses of the preceding bubble and drag stocks back down to fundamentally-sound valuations once again.

After its first post-crash bounce in mid-2000 the NASDAQ was still trading at 102.6x earnings, mind-bogglingly overvalued. Amazingly at the end of November 2002, just last month, the NASDAQ was still trading at 41.0x earnings, a frightening number still above the highest valuation of the 1929 bubble top! Yes, you read that right. Today even after an excruciating 73% plunge over the last 145 weeks the NASDAQ is still more overvalued than the Dow 30 in 1929 right before it crashed!

If you are still long the NASDAQ and this doesn't scare you, you aren't paying attention! The hyper-bearish Long Valuation Wave mean reversion will almost certainly force the NASDAQ back down under fair value in fundamental terms before this Great Bear is satiated and trudges back off into hibernation for another multi-decade slumber. And because of the wickedly asymmetric nature of attempting to dig out of gaping capital-loss holes, the most damaging of the losses still lie ahead.

I would guess there is a 95% probability that the NASDAQ will plummet more than 90% from its all-time bubble high in March 2000 before this is all over. Minus 90% occurs at a NASDAQ Composite level of 500. Pretty ugly eh? If a NASDAQ investor rides the bust down from over 5000 to under 500, he or she will need to earn an all but impossible 900% just to break even again! Ouch. 10x gains are exceedingly rare beasts. For all intents and purposes investors who foolishly squander 90%+ in a bubble bust are finished. They may never recover.

While the NASDAQ Bust in Review brings back many painful memories for battle-scarred tech investors, it is crucial to realize that in historical and fundamental terms we are not out of the woods yet. Until the NASDAQ stock valuations return back to Earth, well under 20x earnings, NASDAQ investors remain in extreme and immediate danger. Get out now while you still can if you remain trapped in this hellish NASDAQ carnage!

While most of the bubble-bust action has transpired in the hyper-speculative NASDAQ monster, the Dow 30 bust to date has been quite interesting as well.

Unlike the plummeting upstart NASDAQ, the venerable Dow 30 is only down 28% in its bust so far at its 153rd week. The Dow is slightly farther into its bust than the NASDAQ because it peaked earlier in January 2000, compared to the NASDAQ's March 2000 bubble top. The assumption could be advanced that the Dow 30 has weathered the Great Bear storm well, but I would humbly suggest that it is far too early to make such claims.

Remember, the job of a Great Bear is to purge speculative excess and mercilessly bludgeon stocks back down to attractive fundamentally-undervalued levels again. After its first bounce in early 2000 the elite Dow 30 was trading at 44.7x earnings, blisteringly high for elite mature companies. For comparison, the historic bubble level, marking extreme and immediate danger, is only 28x earnings. The Dow became fantastically overvalued during the late 1990s equity mania as well.

Unfortunately at the end of last month the Dow 30 was still trading at an unbelievable 24.4x earnings, which is almost still at classic bubble valuations! Yikes. Since the Dow is not comprised exclusively of relatively young 'growth' stock companies like the NASDAQ, the probability of the Great Bear pushing the Dow under fair value at 14x earnings in the coming years is almost a certainty. I would handicap it at a 97% chance.

I also found the correlation above between the Dow 30's bubble ascent and the Nikkei 225's very provocative. The blue and yellow lines above from 156 weeks before the tops to week zero, the very tops, are incredibly similar in slope and magnitude. Yet, following the tops, the Dow 30 somehow miraculously managed to trade sideways for years while the Nikkei 225 immediately began to fall and correct its preceding gross bubble excesses.

This massive drawn-out top in the Dow 30 is totally unique. In all my historical studies I don't recall ever seeing anything similar in history. Usually bubbles rocket up, top, and immediately crash. This Dow 30 bubble rocketed up, topped, and somehow miraculously loitered near its top for years afterwards. Very strange behavior indeed!

I suspect the ultimate bust reckoning is still yet to come for the Dow 30, and because it is now so long overdue odds are high the Dow's valuation mean reversion will be swift and brutal. It will trap countless Dow 30 investors unaware and create vast fortunes for the active Dow shorts like us. The Dow 30 cannot cheat fundamental gravity forever!

I truly wish we had some Nikkei 225 valuation data to share with you for comparison, but we have been searching for it for a long time now and have so far failed in our efforts to secure it. If you possess such data, monthly index P/E ratios and monthly index dividend yields for the Nikkei 225 from the mid-1980s to the mid-1990s, please drop me a note and perhaps we can work out a mutually-beneficial deal. If we can secure some Nikkei 225 valuation data, we will definitely publish an essay analyzing it in the future.

Finally, I would like to close 2002 with a brief look at the flagship US equity index, the enormous and hugely important S&P 500, in comparison with the usual-suspect classic equity bubbles.

The elite S&P 500 topped a couple weeks after the NASDAQ in March 2000, so it is now in its 143rd bust week. It has fallen about 41% so far compared to the 56% in the Nikkei 225 at this stage in its own bust. Like the Dow 30 above, the boom in the S&P 500 in the 3 years preceding its top closely paralleled the trajectory and pace of the notorious Nikkei episode in Japan. However the S&P 500 has lagged the Nikkei in its post-bubble bust to date.

Even though the S&P 500 has fallen quite far for such a massive and pivotal index, unfortunately it still appears to have a long way down to go. Note that the flagship index was still trading at an incredible 25.7x earnings at the end of November 2002, almost still officially in bubble territory at 28x earnings! Just as it has in every previous Long Valuation Wave cycle, I fully expect the S&P 500 to bottom at a P/E under fair value at 14x earnings, probably approaching undervalued 7x levels.

Yet again current extreme overvaluations and classic bust studies are conspiring to launch desperate warning flares for investors to heed suggesting the bottom has not yet been witnessed in the broad S&P 500 index. I don't believe there has ever been any major long-term bottom in stock-market history occurring at a stellar mid-20s P/E ratio. The S&P 500 will not be the first index to violate this ironclad historical market truth.

Interestingly, the more you study booms, bubbles, bursts, and busts throughout history, the more you are struck with how closely they seem to rhyme as Long Valuation Wave cycles endlessly repeat themselves. Booms are inevitably followed by busts, manic euphoria and rampant overvaluations are followed by widespread gloom and very cheap stocks. Regardless of what market, what era, what nation, or pretty much anything, these cycles are remarkably similar wherever and whenever they occur.

Today's investors and speculators need to carefully consider the ramifications of classic bubbles and busts.

Classic busts don't end until stocks are fundamentally undervalued again. Period. I have yet to see an exception to this immensely powerful rule. If you sense an unfolding bust, the best thing to do if you are an investor is to sell and get out and if you are a speculator is to throw massively short. Great Bears don't quit mauling stocks until they reach undervalued levels and the vast, vast majority of stock investors vow to never buy another stock again as long as they live. We aren't even close to this point of ubiquitous despair yet in the States!

When viewed from historical, technical, and fundamental valuation perspectives, the Big Three US stock indices all witnessed bubbles in the late 1990s and early 2000 and they are all now sojourning through classic bust periods. With the NASDAQ, Dow 30, and even S&P 500 still vastly overvalued in fundamental and historical terms, it is foolish to buy and hold at this stage in the game.

Discretion is the better part of valor, and investors ought to be exceedingly cautious about going long general stocks until general equity valuations are once again under fair value. Only then will The Ultimate Bottom for this particular brutal bust period be in sight.

With the benefit of the crucial strategic perspective gained from examining The Bust in Review for 2002, we are much better armed to make some strategic predictions for 2003. As this essay is already waxing far too long, I will write on the major market trends we expect to see next year in the new January 2003 issue of Zeal Intelligence to be published on January 2nd.

In the newsletter for our subscribers I will discuss the strategic market trends we expect to see materialize in 2003 as well as offer specific trading strategies on how to ride them for potentially legendary profits for both investors and speculators.

Thank you so much for all your wonderful business and feedback in 2002! I am deeply grateful for the opportunity to serve you. 2002 was an amazing year and 2003 promises to be even more exciting!

The Zeal team and I warmly wish you a wonderfully blessed and fantastically profitable 2003! May God bless you mightily in the New Year!

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