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July 12, 2002

S&P 500 Slow-Motion Crash
by Adam Hamilton

For as long as humans have enjoyed huddling around a warm campfire and enjoying fellowship with their friends, people have always craved a good story. From the epic poetry of legendary Greek storyteller Homer of almost three millennia ago to modern sagas like George Lucas' Star Wars series, there is nothing like a good story to lift our spirits!

While epic stories have taken many different forms through the ages, one could argue that among today's most popular heroic storytelling formats is that all-American staple, the action movie.

Being a guy, I have to admit I love action movies. While television generally annoys the heck out of me, it is such a wonderful diversion to go catch a movie on the giant silver screen and be transported to a different world for a couple exciting hours. Although a good heroic story is crucially important to make a stellar action flick, the real star is truly the actual action sequences themselves.

One of my all-time favorite action movies is 1999's amazing "The Matrix." If you are one of the few people left in the First World who haven't seen it yet, it is a surprisingly deep tale about a dark future where humanity is trying to escape from a virtual-reality simulation created by artificial intelligence to enslave them. I liked the movie so much I saw it multiple times in the theaters!

While "The Matrix" was graced with several phenomenal action scenes, the now famous over-the-top lobby scene takes the cake. Our hero Neo and his gorgeous sidekick Trinity embark upon a daring mission to infiltrate a building where the bad guys are holding the good guys' leader, Morpheus, hostage. Neo and Trinity calmly walk into the lobby of the bad guys' skyscraper, security stops them, and some resulting magnificent movie mayhem explodes onto the screen.

Neo and Trinity proceed to whip out more firepower than the Canadian Army could deploy and an amazing symphony of destruction ensues. Legions of bad guys swarm into the lobby to try to stop our heroes, but they deftly dodge bullets and shoot back with inhuman precision to cap the bad guys. One of the coolest parts about the whole lobby scene is the breathtaking slow motion!

Time dilated, a relentless hail of bullets spews forth from various weapons, staccato muzzle flashes like strobe lights, carving explosive holes all over the granite walls. Spent brass cascades out of the breeches of automatic weapons and bounces on the hard shiny marble floor. Our heroes nimbly avoid the blizzards of lead from return fire with acrobatic flair and don't even break a sweat.

The signature Matrix lobby scene, in glorious slow motion, is truly an awesome masterpiece of adrenaline and testosterone, dramatically raising the bar by which all future action movies will be judged. The phenomenal slow-motion effects in "The Matrix" remind me a lot of the S&P 500 over the last couple years, which appears to be struggling through a slow-motion crash.

I fully realize that "crash" is a very strong word full of all kinds of very definite connotations, but I really can't think of any other way to articulate what is happening in the mighty flagship US equity index other than calling it a "slow-motion crash." The S&P 500 reached its all-time closing high of 1527 on March 24th, 2000, only two weeks after the doomed NASDAQ bubble popped. As of July 10th, 2002, the mighty S&P 500 had plunged a gut-wrenching 39.7% in only about 27 months, a wicked decline for such a prominent broad blue-chip index.

Bear markets are normal and healthy and fully expected after typical bull markets. Following a supercycle bubble however, a fearsome Great Bear beast much more vicious than a garden-variety bear market rears its razor-sharp claws. From a strategic perspective of a couple decades or so, the enormous S&P 500 bubble of the late 1990s and its current slow-motion crash through which investors are suffering become very apparent. The right end of this chart sure doesn't look like a normal bear market!

The white-dotted trendlines outline the long S&P 500 strategic trend that ran from the early 1980s to the mid-1990s, only briefly broken during the heady euphoria surrounding the infamous 1987 stock market run-up and resulting one-day crash. Around 1995, the slope of the already mature S&P 500 rally suddenly leaped northwards, screaming towards the heavens like a ballistic missile unleashed from its concrete silo. With the magnitude of this slope change and the resulting parabolic rise and now fall of the index, it is difficult to argue that the S&P 500 was not in classic bubble territory.

The enormity of the S&P 500 bubble can perhaps best be illustrated by comparing it to a normal healthy market return line, marked in yellow above. For over a century the average capital gains portion of the returns on equities has averaged 7.4%, the inverse of the historical average P/E ratio of 13.5. Obviously this 7.4% line will end up at different levels depending on what year it is started, but it is still an important proxy for a normal market. It illustrates the slope of a healthy bull market in average terms, which the S&P 500 bubble deviated about as far as possible from.

As I have discussed in many past Zeal essays, I still believe the most important factor in spawning the stock market bubbles of the late 1990s was the incredibly dangerous and reckless actions of the goofy private central bankers who control the US fiat dollar, the bureaucrats at the Federal Reserve. The first arrow in the graph above points to a massive change in the slope of the broad M3 money supply around 1995, indicating an enormous increase in monetary growth rates in the United States.

Whenever the wizards at the Fed run the proverbial printing presses to create more fiat dollars out of thin air, those inflationary dollars have to seek out a new home and a great deal of them begin bidding competitively on the already overvalued US equity markets. It is no coincidence that the S&P 500 bubble really ignited after the Fed began aggressively goosing US money supplies in the mid-1990s!

M3 is shown above in red, indexed to a baseline of 100 as of January 1980. The dark red line is the actual M3 indexed growth. The light red line simply multiplies this M3 index by 3 to expand its vertical scale and make it much easier to visually discern the changes in slope of the monetary inflation rate.

Remember Alan Greenspan's now notorious "irrational exuberance" speech in Washington, DC in December 1996?

It will astound future historians to no end that Greenspan, a famous and brilliant student of economic history, told the world that the markets were dangerously overvalued in 1996, and then proceeded to not only do nothing about it, but throw the credit taps wide open in response to various global "crises" and in effect create what was probably one of the greatest and most destructive equity bubbles in history!

Almost three centuries earlier, John Law's hideous inflationary experiment of unbridled monetary growth led to the terribly destructive French equity bubble in the 1720s (aka Mississippi Scheme), from which France never really fully recovered.  The creation of the unconstitutional private Federal Reserve by stealth and subterfuge in 1913 led to the obnoxious monetary growth in the 1920s that ultimately led to the legendary 1929 Crash in the States. Almost without fail, every destructive bubble in history is created by excessive money and credit growth perpetrated by unelected and unaccountable bankers and bureaucrats.

The Fed's almost unprecedented monetary excesses of the 1990s were almost certainly one of the primary causes of our current brutal bear market bust. Like most poor decisions in life, fiat monetary inflation has inescapable consequences that are exceedingly unpleasant. We have only witnessed a fraction of this bitter fruit so far, when the markets begin to slide. The bear market in equities has a long way yet to run. Eventually a portion of that mass exodus of money fleeing the equity bear market will probably migrate towards consumer goods, causing inflation that is impossible for the government statisticians to hide, and into commodities, sparking a legendary commodities rally in the coming decade.

The S&P 500's current excruciating slow-motion crash, marked by the second white arrow above, is occurring because a supercycle bubble in equities was allowed to grow and fester by unaccountable bureaucrats who control the supply of US dollars. I sure hope history remembers these central-banking hooligans who wrought all this widespread devastation in a very harsh light. In future textbooks, next to the chapter on the 18th century's notorious mega-inflationist John Law, there will be a chapter on today's notorious mega-inflationist Alan Greenspan.

The ongoing slow-motion S&P 500 crash becomes even more apparent when zooming in on the graph from 1995 onward.

The symmetry between the bubble run-up in the S&P 500 and the resulting slow-motion crash is absolutely amazing! So far the near mirror-image has held up remarkably well on the downside.

Pretty much every market technician on the planet is marveling and sweating over the gargantuan multi-year "head and shoulders" formation the S&P 500 finally completed this week. The head and shoulders are marked above. As a lifelong chocolate-chip cookie fanatic, this colossal blue head and shoulders in our graph looks to me like the silhouette of Sesame Street's legendary Cookie Monster. What this has to do with the S&P 500, I have no idea, but the big blue Cookie Monster rocks and is certainly almost as cool as "The Matrix" movie!

The white support line above marks the "neckline," the base off of which the twin shoulders and bubble head formed. Once the neckline is broken, as it was decisively on July 10th as marked with the red "X" above, the future technical probability is vastly weighted towards more serious downside action. The head and shoulders chart pattern is one of the most reliable technical indicators in existence.

What is a reasonable target for this accelerating S&P 500 bear market now that the neckline has fallen under the roaring bear onslaught?

If the S&P 500 was to fall back down to its normal 7.4% return line proxy as commenced in January 1980, it would have to plunge to the 550 range in today's terms, a long way down from here!

As of the end of June, however, the S&P 500 was still trading at a breathtaking 28.6x earnings. With 13.5x earnings being normal historical average territory, and double that (27x) officially bubble territory, the S&P 500 is still a bubble at current valuations! This fact is exceedingly frightening and ought to make even the most red-blooded stock bull shiver in terror. If US corporations continue to prove utterly unable to earn anywhere near enough profits to justify their stratospheric valuations, current corporate earnings push the S&P 500's fair value down to around 470 or so today. That's a long, long way down from here!

But, sadly, the normal historical unwinding process after a magnificent equity bubble is for a devastating equity bust of comparable magnitude to follow. The bust is necessary to bleed off the gross bubble excesses and lay the solid foundations for the next boom. I know it's no fun, but history is absolutely unambiguous in teaching investors the hard lesson that general market valuations, as measured by P/E ratios, plunge to half fair value (7x) at the pits of despair when a bust bear-market bottoms. If the S&P 500 was to become universally loathed as panic and capitulation reigned supreme, the index could conceivably fall to a difficult to believe level around 250 before it reaches its ultimate bottom. That's a long, long, long way down from here!

Of course, as the bulls have been relentlessly bashing into investors' heads for the past nine quarters or so, maybe US corporations will finally figure out how to earn healthy profits again and earnings will rise enough to lead to a slightly undervalued S&P 500 P/E above the psychologically-crucial 500 level. Who knows?

Any way you slice it though, the fundamental and technical case for the S&P 500 is certainly for another serious downleg approaching, probably not carrying us to the ultimate bottom, but definitely obliterating another significant percentage of already bleeding investors' scarce capital. Once the mighty index trades below its neckline of around 950 or so for a few weeks, the selling pressure will probably intensify immensely as fear increases and investors and traders decide discretion is the better part of valor for now.

There is also one additional factor that few folks seem to be discussing that is really troubling, kind of a wildcard that should cause great concern. Check out the light red M3 index line above, the one that is scaled up by three times to make it easier to digest in the context of this graph. When the S&P 500 reached its bubble apex, the Cookie Monster's big head (sorry), M3 was still growing, even accelerating to the upside. Please recall that unbridled monetary and credit expansion are the very seeds of wrath from which mighty equity bubbles are spawned.

Throughout the whole early slow-motion S&P 500 crash until this year, M3 was still growing and rising fairly dramatically in the Great Fed Panic of 2001. Even though broad M3 money was growing, the critical S&P 500 index was falling rather rapidly, bouncing off its neckline after the 9/11 attacks in one last valiant attempt to rally, which defined its right shoulder. But, amazingly enough in light of the Fed's appalling record of mismanaging the fiat US dollar, the broad US money supply has finally leveled and perhaps even begun to tentatively decline in 2002!

Now if you are an equity perma-bull, and you are suffering through a once-in-three generation supercycle bust, and the markets have been mauled by the most brutal bear in memory, and you find out that money supply growth is finally flattening and maybe even falling for the first time in over seven years, only one word comes to mind… uh-oh!

Bear markets typically evolve in three phases. First, the market declines 20% or so but everyone believes it is just a "correction" in a primary bullish trend and no one is concerned. Second, as the decline continues, investors on the periphery of the markets (ie, not mainstream long mutual fund holders) gradually grow fearful and selling pressure intensifies. Each successive major rally fails and new interim lows are carved out. Finally, in the horrific capitulation phase, mainstream investors have reached the outer limit of their pain tolerance and patience and clamber to sell at any price and vow to never, ever even think about owning those infernal stocks again.

My guess is that we are well into the second phase now, but I imagine that a flattening or even shrinking broad money supply, which we haven't seen at any time during this bear market bust so far, could make things a whole lot worse in the coming year. All investors and speculators with long or short exposure to the S&P 500 or any of the elite US stocks which comprise it should carefully watch the US money supplies in the coming months for clues as to what is approaching next.

With the S&P 500's enormously-overvalued P/E ratio and immensely bearish technical breakdown, I can't help but think that the professionals are selling out like crazy leaving the folks the Wall Street crowd call "suckers," the mainstream working American middle-class with their precious retirement and college savings in the markets, left holding the bag, which is emptying fast. It is truly a tragic sight to behold, but this is the way these supercycle busts always work in history too yet virtually no one seems to heed their hard lessons.

Just as the slow-motion S&P 500 crash is like the magnificent slow-motion action scenes in the movie "The Matrix," so is the general stock market like the concept of the Matrix itself.

The Matrix was an imaginary virtual reality computer construct. People trapped within the Matrix perceived one "reality" with their senses but that reality was false. Only by transcending the Matrix could our heroes Neo, Trinity, and Morpheus really understand what was happening and try to save the world.

While us private investors can't save the world, we can zealously try to transcend the real-world Matrix of popular opinion on the markets. Rather than living in the confusing world of Wall Street lies and perpetual promises of "the bottom is in" or the profit recovery will roar forth "next quarter," investors can seek to understand the markets as they really are.

The markets could not care less about you or me, they just exist. Only by understanding the markets in their actual strategic historical context, with mighty cyclical overvaluations giving way to gaping cyclical undervaluations over decades, can investors successfully beat the market year after year. The few investors outside the Matrix are the contrarians, who fervently strive to understand greed, fear, valuation, and history and do not buy into all the hype and obnoxious lies that mainstream investors eagerly lap up like famished kittens.

Like the movie Matrix, only a relatively small number of contrarian investors truly seek to understand the markets while the rest of the investors are trapped inside, by their own choice, and have no hope of escape, blinded by their own delusions.

Adam Hamilton, CPA
Zeal LLC.com

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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 delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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