“Bubbles cast long shadows after they burst “

The Gold Bubble popped at $850 in 1980, the Japanese Nikkei Bubble popped at 39,000 in 1990 and the U.S. NASDAQ-led bubble popped at 5,000 in 2000. There have been many bubbles popped in market history, typically quantified by accelerating rates of change and heightened levels of awareness as they reach their peak, only to come crashing back to reality after the pin and balloon consummate their inevitable relationship.

Chart 1 shows an overlay of the gold and Japanese cycles moved forward in time to match the more recent NASDAQ Composite Cycle, lined up from the bubble peaks. The blowing up and bursting of a bubble leads to an initial crash rebound (“ICR”) that seems to put in a ceiling that repels subsequent rallies for more than a decade, or two.


click to enlarge

Gold bugs recall the 1983 rebound to $500, got really excited when it touched it again in 1987 briefly, and have felt cheated by Mr. Market ever since. Japanese investors wince when I explain that their 1993 rebound from 14,000 to 21,000 reminded me very much of the prior decade in the gold market; and as a long-time gold market participant, I would politely explain that they may find the second decade of waiting a tad frustrating. 15 years from their peak, they are still struggling with the 12,000 level, while 25 years later the gold bug community still pines for $850.

In the current context for NASDAQ, the 2003 rebound toward the 2,200 level has increasingly begun to look like the same sort of ceiling level Tokyo established in 1993/94 around the 21,000 level. Enthusiasm was high, with investors and traders wistfully looking back to the bubble peak at 39,000 as if Mr. Market personally owed them another shot at it. Just like the gold bugs did a decade earlier. And today, every little rally in the market seems to bring on a chorus of “Buy tech stocks”, with one or two favored leaders being instantly translated into the inference of a generic rush back to the same well that was poisoned five years earlier.

As an observer of bubbles, it is my opinion that the stalling by the NASDAQ Composite Index is effectively confirming what I call the “Busted Bubbles Model” and the 2,200 +/- 10% is likely to be a ceiling for that index for a decade or two ahead.


One of the most astounding bubble models was the post-1990-crash shift from Japan to “Pacific Ex-Japan” markets in 1992/93. After Japan crashed, the chart above shows the MSCI P-ex-J Index more than doubling in 1991/93. What is astounding is to look back from 2005, when China and their neighbors have literally undergone an industrial revolution in one generation, with growth of mind-boggling proportions. In the past few years, “China” has become the one-word answer to virtually any economic question. Now consider that this index in June 2005 is still below the peak it made in Dec 1993, twelve years ago. For American equity markets in general, I believe we have passed a comparable bubble peak. For the S&P and other major indices, it’s not impossible the 2,000 highs may be seen again, but the notion of 10% to 15% plus growth rates for any sustained period ahead is a dangerous flight of fancy in my view. The 1990s were an extraordinary anomaly, and I fear a generation that discovered the stock market in that decade faces some hard lessons in reality in the years ahead.

Secular & Cyclical Trends

Chart 2 shows the S&P 500 and predecessor indices back to 1900. It is commonly stated that in the long term, common stocks always go up. Yes… if you are patient enough to sit out the odd generational hiccup.


The textbooks argue that stocks return roughly 10 percent per annum over the long term, but they often forget to mention that about half of that was derived from dividend payouts. Peddlers of investment products paint the illusion of a smoothly rising long-term trend, while the actual history reveals that big bull markets such as that experienced from 1982 to 2000, or 1949 to 1965 are the rare anomaly rather than the norm. Major turning points in “secular” trend, looking back with 20/20 hindsight occurred in 2000, 1982, 1966, 1949, 1932, and 1921. I define “secular trend” as a multi-cycle trend that departs visibly from what the prior generation experienced.

Viewing the past century in a different context, one might conclude that wide trading ranges made up of several shorter-term cycles have been the norm, between brief bursts of enthusiasm. Secular trend appears to shift about every 16 to 20 years, while below that there is an apparent cycle of roughly four years that has increasingly tended to reflect the U.S. political Presidential Cycle. To keep it basic, one might suggest a secular trend may well consist of four, perhaps five, Presidential Cycles.

I am purposefully approximate in these labels, in part because I see too many younger math-wiz-types attempting to take this sort of broader overview down to the minutiae as if Tokyo’s behavior on the 14th Thursday after the low in 1992 had anything to do with NASDAQ’s corresponding 14th week off its low.

I don’t propose this sort of analogue as a trading tool, but as a broader road map to help shape major trend expectations. For example, if I told you that history suggests that the NASDAQ took 20 years fluctuating between 1,100 and 2,200, might that prompt a rethink of “holding tech stocks for the ‘long term’ in your portfolio? A study of market history leads me to that conclusion, as a technical market analyst, I will leave it to the economists and ‘funny-mentalists’ to write the script explaining it later…

Markets tend to be leading indicators that provide economists with their script six to twelve months later. When the talking heads of CNBC start explaining that a 0.1% number is above or below ‘expectations’ and “THAT” is why the market is doing something, they are basically acting as microbiologists in drag… talking about the biological makeup of a leaf, on a tree, that happens to be in a forest. Their business is to try and attach historical significance to every moment of the day, while any serious student of history realizes that it typically is the next generation or later that can best put the present into an historical context. But they have a lot of ads to sell, and apparently a willing audience who seem to believe that “THE” answer to it all is out there somewhere, and they hang on every word from the visiting “experts.” (The classical definition of an “expert” is someone who can draw a perfectly straight line from an unwarranted assumption, to a foregone conclusion…)


Chart 3 shows the S&P and predecessor indices from 1900 to 1955. From 1900 to 1924, and then post-crash, from 1933 to 1949 it reveals two long, broad ranges of several cycles. The 1929 peak was not surpassed until 1954… 25 years later. Might that imply NASDAQ may have a chance of seeing 5,000 again, perhaps in 2025?


Where the 1921-29 bubble and 1929-32 bust set extraordinary extremes, the period of 1965-83 also marked a generational or secular trend shift from what had been experienced in the great rise from 1949 to 1965. The more widely watched DJ Industrials first probed the 1,000 level in Jan 1966, and finally left it behind in January 1983, 17 years later, with five bear market cycles in between. The more broadly representative S&P Index bottomed in August 1982 at 102, a level it first touched in July 1968, fourteen years earlier.

For the baby-boomer of today contemplating investing for retirement in 10 to 20 years, the secular trend risk is immense. The 1966-82 period was masqued by inflation with the stock market going in a sideways range for 17 years. But the purchasing power of money declined substantially over that inflationary period. (Best characterized by the then popular line: “How is it that my same old nickel cigar now costs me $5.00?)

The 1929-49 era was turbulent and deflationary, including the depression era and World War Two. In both instances, systemic risk factors enabled ever-greater intervention by political forces bent largely on ensuring that “an accident” doesn’t happen on their watch, to interfere with their re-election prospects…

‘Policy’ these days exposes how significant the first three letters are in that all important ingredient… CONfidence. Policy makers, including the FED, now seem to spend more time on the political “spin” than the actual policy.

Not unlike drug dealers passing out free drugs in schoolyards to create dependency, and later, total control of the new young adults that survived and traded up to ever stronger drugs; the modern American political process has transformed its populace into a giving up the notions of independence and liberty that created “the land of opportunity” into a quasi-welfare state that has taken on an alarming, almost neo-fascist tone in the post 9-11 era. Layers of “entitlement” programs that originated as social “safety nets” have devolved into God-given rights that can’t be tampered with. As the bulge of baby boomers approach the age of retirement and soaring medical expenses over the next two decades, there can be little doubt that systemic stress and dashed expectations will result in ever-greater divisiveness and disenchantment with the modern political process.

Comparable, perhaps even greater systemic risks exist today given that the 1949-65 boom was fueled by consuming the savings carefully guarded in the prior era; while the 1982-2000 consumed any lingering savings and was leveraged by escalating debt. By itself, nobody can define how much debt is too much, but there are two looming problems with total credit market debt now at an unprecedented ratio of 3 times total GDP. Somebody somewhere ‘owns’ that debt and thinks it’s an asset that will be repaid some day. Non-resident, non-nationals who are not as controllable as natural citizens own more and more of that debt and may choose to go elsewhere. (To suggest they can not go anywhere else is the height of arrogance, but does typify the mindset of current U.S. foreign policy schemers. In due course, that will compound a dollar crisis far beyond anything we have seen since the breakup of the Bretton Woods Agreements in 1968/71.)

Much of the “security” behind U.S. debt is geared to ever-escalating real estate valuations, with consumers borrowing equity out of their inflated home “values.” Not unlike a farmer consuming his seed corn, U.S. consumers are literally eating their house one brick at a time… and any spike in interest rates could pop what may be the last great bubble extant in today’s world of lavish overconsumption.


2005 and 2006 are the Post Election and Mid-Term years of the U.S. Presidential Election Cycle, with 6 of 8 quarters proffering unattractive investment prospects relative to the rolling out of the gravy train in the subsequent third and fourth year when re-election again becomes the driver. Quite apart from week-to-week ups and downs, the results of the last 14 election cycles suggest that longer-term investors should be guarding purchasing power with an eye to picking potentially low-hanging fruit in mid- to late 2006.


From the 1998 lows to date, Small Cap investing has won an expanding audience, to the extent that one now hears suggestions that Small Cap stocks ALWAYS outperform large cap stocks. The bottom line on Chart 6 is a ratio of the S&P 600 Small Caps to the S&P 100 Index of Large Caps. The declining red line in 1989/90, and 1994/99 demonstrates that fallacy. (“Never” and “Always” are two words that no responsible analyst of markets should ever use in a market context.)

Markets are nothing more than psychological travels between un-measurable human emotional extremes of greed and fear on a mass level. First coined, as a book title in the 1840’s by Charles Mackay, “Extraordinary Popular Delusions and the Madness of Crowds” sums it up, and is perhaps the most valuable investment history book I know of, as a study of the gullibility of man in financial markets, driven by greed, invariably ending up in despair.

The troubling aspect of this chart is that the 100 Big OEX stocks represent more than 50% of the total U.S. market capitalization, while that spectacular steady uptrend in small caps has increased the share of those 600 stocks from 3% to 4% of total market cap. In the 1966-82 secular period, small caps tended to swing widely, in both directions. I fear the next few years may rattle the cages of all those recently converted “Small Cap Specialists” that I seem to meet these days.


Most small investors could care less whether the market cap of a company they are considering is $500 million or $50 billion. They would not invest 6 times as much in Cisco as Costco just because the former is 6 times larger in market valuation, or 20 times more in Intel than Intuit. But with the extraordinary growth of managed funds that are “indexed” or “benchmarked” to major indices, that is how more than 60% of the total market cap of the U.S. equity market is now managed. (S&P claims over $4.0 trillion; MSCI claims over $3 trillion; Frank Russell claims more than $2.5 trillion, and Wilshire Associates claim in excess of $2 trillion. That adds up to $11+ trillion of market cap that is bench-marked or passively indexed.)

With the massive concentration of large pension and mutual funds, it always comes as a jolt to recognize the added challenges they face, and how it impacts the total market.

From personal experience, I have many times run into the following situation when talking to prospective investors about a fund with a market cap of approximately $500 million. You make a presentation, and the prospect concludes: “Great story, but it’s too small for me. I can’t own more than 5% of anything, so my largest position in your deal would be $25 million (5% of $500mil). I’m a $3 billion fund, and can’t afford to ‘waste my time’ with a lot of small positions that are less than 1% of my portfolio.”

I don’t have hard data, but that basically implies that the major money managers (perhaps 500 or so?) are precluded from investing in the vast majority of issues that trade. On the one hand, that creates opportunity for smaller investors, but on the other, it may explain why the Small Caps have become almost distorted in their behavior. The risk is that period when the wind shifts, the bear takes over and sentiment turns negative. The Small Caps don’t have any safety net such as pension fund inflows underneath them.

The Russell 1000 represents the 1,000 largest market caps in U.S. markets. Of those 1,000, the average market cap is $83 billion, and the median market cap is only $4.55 billion. Of the next 2,000 stocks down the market cap scale, measured by the Russell 2000 Index, the average market cap is: $1.1 billion, and the median is: $519 million.

Contrast those with the Top 200 stocks by market cap average $114 billion, with a median of $23.8 billion.

Collectively there are roughly 8,000 stocks listed on NYSE, NASDAQ and AMEX. The universe for the major players who control something like 70% of the total market cap is restricted to about the first 500 names, and the rest are ignored because they’re “too small.” There’s a lot of opportunity for the disciplined, smaller player in this structure, but unfortunately mob psychology tends to govern the vast majority, and those trends are determined by the major indices dominated by the major players.

That the S&P Small Cap Index largely “ignored” the 2000/02 bear market was impressive, and has attracted legions of new “small cap specialists,” I fear that the history of markets as I see it suggests an awful reality check for these relative ‘newbies’ may be looming once a cyclical downturn gets going.

The risk that Charts 6 and 7 highlights to my mind are that of an overextended trend that may be losing momentum, and having outperformed the large caps on the upside, may soon begin to outperform on the downside as the cyclical winds shift.

My Conclusions:

#1: The nature of trends experienced in the 1990s may not be seen again for a generation. The bursting of the bubble in 2000/2002 has likely shifted the secular trend from up to ‘sideways.’ (If we’re lucky enough to muddle through as the political powers will struggle to achieve by hook or by crook. Keep in mind that fraud is only a crime in the private sector.)

It is possible a systemic accident could occur that could more closely approximate the 1929/32 era, but recognize that government forces and their market sensitivity is such that they will do anything to avoid it. I like to remind people that fraud is only a crime in the private sector. I assume that Washington would (and probably should) do anything they can to halt such a crash.

We may never know the full extent of their involvement directly and indirectly in arresting the 1987 market accident, or the LTCM crash in 1998, but their fingerprints were all over the place. That upsets purists, but to a realist, I accept the premise that their job is to keep the wheels from falling off on their watch, even if the vehicle itself is doomed.

#2: I believe the bulk of the Initial Crash Rebound (“ICR”) is behind us, and the next move of a 10% to 15%+ magnitude is much more likely down than up from current levels. The Presidential Election Cycle would point to the second half of 2006 for the next likely cyclical bottom within the new secular trend in the S&P. To make a bottom, prices have to fall, valuations have to get “cheap” and sentiment has to turn negative. Bottoms are painful periods in the market, but that is when the low-hanging fruit everyone would like to buy is abundant… for those who have sidelines cash and the gumption to act when the going gets tough.

A lot of it comes back to managing your own psychological approach to markets. Significant declines create opportunity, but very few have the patience to wait for it. Many of those that do will end up practicing the doomed sport of javelin catching… trying to tell the market where to stop is a futile and costly exercise. Trying to “pick the bottom” during a decline is hazardous. “Hero” status is most typically awarded to the deceased. Hero calls on the market are typically fatal as well. Accumulate in stages, and liquidate in stages because nobody knows exactly where the top or bottom will actually occur in terms of time or price.

#3: Cash is trash? Where do I go when I’m out? is a common question. My standard response is T-Bills, because they are the oil that turns the government wheels. A two-year note could suddenly become a 10-year note in a crisis, but the 91-Day T-Bills are as close to sacred as anything gets in financial markets. In any hypothetical worst-case scenario, the 91-Day Bill would be the last instrument a government would mess with.
But T-Bills “don’t pay anything.” The point of owning Bills is to preserve purchasing power. Perhaps it only paid you 2% for two years, but when you choose to reenter the markets after a serious decline, you have $1 to spend, while most of your competition is probably down to fifty or sixty cent dollars. The competitor who lost 50% has to double his money to get back to even, where your T-Bill was and still is. With that thought in mind, what is your T-Bill worth at that stage? Still inclined to complain about low yield? I would not complain too loudly… It is a capital preservation tool, not an income instrument.

#4: Small Cap Risks? The technical indicators for “calling an end” to the superior performance of Small Caps vs. Large Caps is not all in as yet, but that day is rapidly approaching, in my view. Those who remain on the dance floor until the music actually stops may be in for a hard lesson about illiquidity in markets. There’s a lot of money in small-cap indexed funds. When those funds swing from net inflows to net outflows (redemptions), the persistent support those flows have provided in recent years will reverse and become persistent pressures.

#5: Gold, Silver and Commodities: The “other” secular trend shift that has occurred in recent years – from down to up. Gold and gold shares had a great bull run from 2000 to 2003, with the highly leveraged HUI Gold Bugs Index logging a 632% gain from the Nov ’00 low to the Dec ’03 peak, while gold resolved a large basing pattern that dated from late 1997. I believe that cycle turned the secular downtrend that had governed since the madness of the 1980 peak, and the Initial Crash rebound (“ICR”) to the $500 level in 1983, and again in 1987.

There were a great many excesses in gold shares in 2003, and the subsequent double top in late 2004 supporting my belief that a counter-trend bear cycle has been underway in the gold shares for more than a year, while the bullion price may yet need a shake out to the $375 area to set the stage for the next up-cycle, and a challenge of the $500 barrier to really confirm the secular trend shift that should govern sequentially higher cycles for a decade or more ahead.

Gold bugs wince when I suggest a pullback to the $375 area to cool off the stubbornly high bullish sentiment reading extant for the past three years, while complaining that the HUI Index has “already crumbled from 265 to 170… a 33% decline. But they forget to note that at 200, that Index is still trading at 5.5 times the low it left behind in Nov 2000. There’s not a lot of “low-hanging fruit” when you’re five stories up the tree…

But more on the topic of gold in my regular writings, and a later time.


Ian McAvity, CMT, has been writing his Deliberations on World Markets Newsletter since 1972 for a global readership. The service is primarily based on chart and inter-market relationships analysis; a market historian’s perspective.

Ian draws on over 40 years experience in the world of finance since 1961, as a banker, stockbroker, and an independent financial advisor and entrepreneur since 1975. In the 1980s and 1990s, he served as a director of many junior gold mining and exploration companies.

In 1983, he was a founding director of Central Fund of Canada, the AMEX-listed (CEF) closed-end bullion fund that now holds approximately 20 tonnes of physical gold and 1000 tonnes of physical silver held in Canadian chartered bank vaults. In 2003, he was a founding trustee of Central Gold-Trust, a TSX-listed gold bullion trust holding approximately four tonnes of physical gold.

His contributions to the field of technical analysis include pioneering work in 1974, identifying lead/lag relationships between gold mining shares and gold; defining the U.S. Presidential Election Cycles in markets long before it came to be widely recognized, and a 1976 article for Barron’s, identifying a cyclical lag relationship between Canadian and U.S. markets. With the advent of floating exchange rates in 1968-1971, he was a pioneer in publishing Forex charts as a forecasting tool. His unique graphical presentation of historical financial data to “tell the story in pictures” has won wide acclaim over the years.

He has been profiled frequently by most major North American financial media, (Wall Street Journal, Barron’s, Canada’s Financial Post, etc.) since the early 1970s, and has often been a periodic special guest commentator on major financial television programs in North America, since the 1980s.

[Ed. Note: For more information and to subscribe to his excellent service, visit www.chartguy.com]