Special Report:
A Sneak Peek at the
Next Bear Market in Stocks

For well over a year leading up to last spring, despite fresh bull market highs in both the Dow Jones Industrial Average (DJIA) and S&P 500 in 2006, and all-time highs in various secondary stock indices, Wall Street packed all the excitement of watching paint dry. Seemingly every thrust by the averages into marginal new highs was met not by decisive follow-through, but rather by stagnation or a lapse back into the prior trading range. In fact, blue-chip stocks spent all of 2005 locked in a tight 10% band.

Accordingly, the VIX, a measure of anticipated volatility in the S&P over an upcoming 30- day period, remained near historic lows, closing at 11.78 on Wednesday, May 10, 2006, a day the Dow topped within 0.7% of its all-time high before starting a nasty 5-week sell-off. Derived from S&P 500 options, the VIX – often called the “fear gauge” because of its tendency to spike amid sharp stock market dives – dipped below 10 intraday as recently as July 2005. That’s even less than the lowest reading registered in 1995, a year in which the biggest correction in the DJIA amounted to a mere 3.29%. Until 2005, the VIX hadn’t dropped to single digits since 1993. In between, the VIX soared to almost 50 during several major upheavals, including the Asian Crisis, which sparked a single-day 554-point Dow decline that activated trading curbs and temporarily shut down the NYSE in October 1997; the Russian debt default and subsequent collapse of the Long Term Capital Management hedge fund, leading to a violent correction into October 1998; the aftermath of the September 11, 2001 terrorist attacks, and in July 2002, following a greater than 25% fall in the Dow in 2 months as stocks plunged headlong toward a climactic October bear market low.

Yet any souls intrepid enough to play the VIX got no such kicks once futures on the popular fear gauge began trading over 2 years ago, let alone in the comparatively brief period since VIX options debuted on Friday, February 24, 2006. Instead, complacency – if not outright greed – appears to have supplanted fear as the prevailing emotion. After more than doubling as stocks sank to their June nadir, the VIX on August 16 returned to its lowest level since the Dow hit its 2006 high on May 10. Back then, a weak employment report convinced pundits that the Federal Reserve’s 2-year campaign of interest rate hikes was near an end. In mid-August, the release of unexpectedly mild inflation data reinforced hopes that the Fed, this time, was indeed finished tightening. Major stock indices shot up to their highest prices since May.

But just when the public thought it was safe to jump back in the market, there are signs that this picture of relative calm may be about to change drastically – at least if you pay heed to the repeated lessons delivered by decennial cycles.

The concept of recurring decennial market patterns is not new. An English economist named William Morton Halbert, in his 1878 publication, "An Exploration of Economic and Financial Science Based upon a Cycle of the Seasons in Each Decade," stated that, "Each decade in its parallel years presents many commercial phases almost alike, if not indeed identical, this, too, even though commerce has made such gigantic strides and progress during the last 50 years, and financial science has grown up as a great and vital system."

At the same time, in the United States, W. Stanley Jevons (one of the earliest cycle researchers) also observed that depressions occurred at regular intervals of about 10 years. It was his original work that prompted Edgar Lawrence Smith in the first half of the 20th century to cut a stock market chart in ten-year segments and place them one above the other to see if there was a recurrent pattern (The period 1911-1920 would be placed on top of 1901-1910, etc.). From this he developed the theory that a "decennial pattern" existed, with stock prices duplicating patterns seen in previous decades.

A recapitulation of the typical 10-year cycle could soon pose a thorny problem for domestic stockholders. That’s because, except for the 1920s and 1990s, U.S. stocks established concluding bull market tops in either the 6 th or 7 th year of every decade in the 20 th century, including all 4 occasions when the bull sprang to life from a 2 nd-year low. Over the past century, the 6 th year marked the end 6 different times (1906, 1916, 1946, 1956, 1966, 1976), the 7 th year twice (1937, 1987). The 60-year cycle remains our “best fit,” given the trading pattern since 2002. The shortest major advance off a 2 nd-year low (1962-66) ran for 3 years, 7 months and 14 days, projecting to an ultimate top for our market on may 24, 2006. So far this year, the highest reading in the S&P came intraday on May 8. The 1942-46 bull market peaked on May 29, 1946. Three other decennial-cycle anniversary highs (January 19, 1906, August 2, 1956 and February 9, 1966) have passed this year already. Bull markets off 2 nd-year bottoms tend to last longer than most, and then fall harder once they’re done. Waterfall declines following the market tops of 1946 and other years preceded by second-year bear market lows offer the likeliest indication of what’s in store at the conclusion of the present bull market (Table). The S&P plunged sharply to lose an average of 35% in the 4 such previous instances, before eventually staging major rallies that began at or near final bear market lows. Every market shown either crashed or bottomed in October of its topping year, setting up a lucrative scenario for put buying in event of a replay.

All of these examples, plus earlier ones dating back to the 19 th century, might be considered nothing more than mildly interesting coincidences if not for their characterization by foreign wars, rampant speculation, real estate bubbles, spiraling inflation, skyrocketing commodities prices, rising interest rates, increased globalization of finance, record trade deficits, reliance on foreign investment capital, deployment of American combat troops overseas, and the existence of heavily-armed urban street gangs that made some areas unsafe even during the daytime.

Fortunately, we no longer need contend with any of those conditions today, huh?

So in order to ascertain whether indeed, “The more things change, the more they stay the same,” let’s take a look back at some of the more notable cases of 2 nd-year lows, 6 th-year highs and 7 th-year panics, and compare them to the present.

1932-1937: At its June 1, 1932 Great Depression stock market low, the S&P was down 86%. The Dow Industrials would lose 89% in their descent from a September 1929 top to the July 1932 trough. The magnitude of these declines exceeds even the respective 83% and 78% drubbings suffered by the NASDAQ 100 and NASDAQ Composite indices between March 2000 and October 2002 after the unraveling of the tech-stock frenzy. In all cases, the averages required between 2 years, 6 months and about 2 years, 10 months to hit bottom. Interestingly, after the other great speculative mania to sweep a developed economy – Tokyo’s explosive stock and land boom of the 1980s – Japan’s Nikkei Dow collapsed for nearly 2 years and 8 months before launching a massive rally in August 1992, the 2 nd year of the decade. The Nikkei attained its highest subsequent point during a bear market rally in – you guessed it – 1996, but continued to slide until 2003, over 12 years after its final peak. In its fateful last leg up in the summer of 1929, the Dow Jones Utility Average outgained the Industrials 2-to-1, but then also tumbled for between 12 and 13 years. With the once red-hot NASDAQ still a lot closer to its low than to its high, that’s something to bear in mind going forward.

1942-46: As since 2002, the DJIA significantly lagged the S&P, and broader averages left both blue-chip benchmarks in the dust during this 4-year advance. Commodity prices started a sustained rise in late 1939, just as they did near the end of the last decade, on the eve of the outbreak of World War II. The secular bond market bull of 1920-1946 carried interest rates to a historic low on January 26, 1946. This year, as in 1946 (60-Year Cycle), bonds turned lower from a late-January high after more than 20 years of declining long-term interest rates. A January 18, 2006 bond market peak was preceded by a double bottom in long rates in June 2003 and June 2005. With a 22-year fall in long-term rates from the record levels of 1981 seemingly behind us, the 10-year Treasury bond yield continued to hit new 4-year highs into early summer.

1962-66: This was easily the most restrained of the bull markets starting from 2 nd-year lows, with the S&P climbing only 80%. So far, the S&P has gained as much as 73% since October 2002. A bust in the overheated technology sector set up the 1962 low as well. Stocks like Polaroid and Avnet Electronics sold for over 100 times earnings in 1961, while IBM traded at a multiple above 80 before losing more than half its value.

1982-87: Here too, bonds went into a tailspin early in the 6 th year. Corrections in the blue chips stayed small after 1984, with no decline as great as 9% for the duration of the bull market. The largest sell-off in the S&P this year or last has been limited to 8.1%.

6 th-Year Tops

1806: In the era of Lewis and Clark, U.S. exports of grain, cotton and other goods to warring European nations surge dramatically. But after Napoleon institutes the Continental System, blockading the British Isles in retaliation for a British blockade of France, the U.S. – under President Thomas Jefferson – would pass the Embargo Act of 1807, slashing American exports 80% in 1808 and leading to depression.

January 19, 1906: A metals mania gripped Wall Street. Stocks like U.S. Cast Iron Pipe and National Lead rocketed nearly 800% in the 1903-06 bull market. U.S. Steel more than quintupled after sagging to a low of 8-3/8 in May 1904 when it eliminated its dividend. Copper prices went ballistic, thanks to escalating demand from rapidly expanding electric utilities. Over half the issues in what was then an early 12-stock incarnation of the DJIA were metals-related, including American Smelting and Amalgamated Copper, and they propelled the average above a nominal level of 100 for the first time, to a final top of 103. In its current bull market from a November 2001 low, copper, aided by burgeoning industrialization demand from China’s fast-growing economy, has nearly septupled, surging as much as 153% above its former all-time high of 164.75 cents/lb. Year-to-date through August 15, 2006, steel (up 34.21%) ranks as the best-performing industry group, according to Dow Jones & Company, despite a vicious May-June correction. Over the past year, steel stocks gained over 52%, while the industrial metals sector – including steel, aluminum and nonferrous metals – tacked on 32%. Steel stocks are up a whopping 278% in the last 3 years.

November 21, 1916: America got rich supplying the Allies. Commodity producers, including copper stocks, were again big winners. Bethlehem Steel shares soared from 29, when World War I broke out at the end of July 1914, to 700. Premier sugar stocks went up 600% or more. Sugar prices early in 2006 climbed to their highest levels since 1981.

May 29, 1946: As in 1985 and 2005, no serious correction took place in 1945. But a quick 10% sell-off in the blue chips in early 1946 set the stage for a final run up. Transportation stocks lagged the general market to establish their bear market low in June 1942 (the DJIA and S&P bottomed in April), only to far outdistance the blue chips in the ensuing bull market. But they were especially hard hit when the market reversed course dramatically in late 1946. The Dow Jones Transportation Average this decade failed to bottom until March 2003, 5 months behind most indices, but still has virtually doubled the S&P’s entire gain since 2002.

August 2, 1956: Surprise! Industrial metals stocks – where have we heard that before? – led a bull market that topped in a 6 th year. Aluminums were particularly strong. Transportation and oil stocks also fared well.

February 9, 1966: The U.S. first sent combat troops to Vietnam the year before. Although inflation and interest rates were poised to move seriously higher, 1966 stands as the only 6 th year in which commodity prices peaked almost simultaneously with a major stock market top. When the market entered free-fall mode during summer, the hottest stocks from the last bull campaign, as usual, burned investors the worst. In 1966, those included airlines, electronics and color TV stocks.

September 21, 1976: In 1976, the Dow clawed its way back over 1000 for the first time since 1973, but couldn’t manage to hang on for long. I know this sounds like a broken record, but steel stocks were strong, with both Bethlehem and U.S. Steel reaching 15-year highs. In the brave new world of OPEC and stratospheric (for the time) oil prices, energy stocks went wild. The steels reversed sharply lower in the face of cheap imports during 1977, but the overall bear market was abnormally mild – and didn’t affect smaller stocks at all – even though blue chips didn’t bottom until early 1978.

Seventh-Year Panics

If you can keep your head while all about you are losing theirs, maybe it’s not the 7 th year. With the possible exception of 1929, years ending in “7” have traditionally served up the biggest stock market disasters.

1837: A real estate boom, fueled by an aggressive expansion of credit, ended in disaster. Leveraged speculators eagerly snapped up (mostly Western) land sold by the government, and found bankers all too willing to accommodate them. Public land sales zoomed from 4.7 million acres in 1834 to 20 million acres in 1836. Receipts were deposited in state banks, fueling aggressive expansion of credit and currency and an explosion in canal building.

By the time stocks topped in 1835, New York Stock Exchange volume averaged 8500 shares a day, up 50-fold in 7 years. Today, we’re again witnessing great optimism about the future of the exchange. When the NYSE finally went public on March 8, 2006, jubilant investors quickly bid up its shares by 25%.

In the 1830s, American prosperity and inflation resulted in record trade deficits, yet inflows of speculative capital from sales of securities in Europe were so great that the U.S. actually imported 4 times as much gold as it exported between 1834 and 1837. The money from overseas financed domestic railroad and canal building. Similarly, in 2005, the U.S. trade deficit rose 17.5% to an all-time high, but foreigners spent record sums (over $1 trillion) buying our stocks and bonds. By July 21, 1836, the drain in British reserves prompted a clampdown. The Bank of England initially hiked its rediscount rate to 4.5%, before ratcheting it up to a full 5% a few weeks later. The upsurge in British rates combined with U.S. inflation to draw funds away from securities. This year, in March 2006, the Bank of Japan announced the end to its 5-year era of super-easy monetary policy just days after the European Central Bank raised rates a quarter-point and left the markets expecting further increases when it revised its growth and inflation forecasts higher.

By the time President Van Buren took office in March 1837, currency shortages plagued the nation, with New Orleans banks in especially deep trouble. When some banks admitted their inability to honor drafts, the panic spread to Wall Street. Financial problems in London compounded the crisis. Between March 1 and April 10, 1837, stock in former highflier Morris Canal plunged 54%, from 96 to 44. By May 10, with runs a daily occurrence, all New York banks suspended operations. By early fall of 1837, 90% of eastern factories closed. Despite a temporary reprieve in 1838, the depression worsened over the next several years. Morris Canal went bust. Banks, which had accepted overvalued land as collateral for loans used to buy yet more real estate, took it on the chin. United States Bank shares, which hadn’t traded below 100 for 20 years, collapsed from 122 in 1837 to 4 in November 1841.

Although Merrill Lynch calculates that the housing market accounted for 55% of economic growth in 2005, new Federal Reserve chairman Ben Bernanke doesn’t regard the alleged real estate bubble as a threat. In his first semiannual monetary policy testimony before congress on February 15, 2006, Bernanke opined that housing activity will moderate, but remains consistent with solid overall economic growth. Meanwhile, the National Association of Realtors (NAR) reported that the median price of single-family homes fell more than 4%, from $219,700 in July 2005 to $210,500 in January, and the Commerce Department announced a record backlog of unsold new homes. The NAR predicts that sales of new and existing homes will decline in 2006 for the first time in 5 years. Home construction shares have failed to participate in the latest upturn in stocks, losing 41% in the last year, with Hovnavian Enterprises down 58% and leading luxury homebuilder Toll Brothers off more than 51%.

The financial storm of 1837-42 led to more lenient bankruptcy provisions and passage of a federal bankruptcy law wiping out $450 million worth of debts. So it’s perhaps worth noting that congress moved to tighten bankruptcy laws in April 2005. The more stringent regulations could require homeowners filing bankruptcy to sell their homes in certain cases.

1857: In 1848, booming grain exports fueled by poor harvests and revolutions in Europe combined with the Californian Gold Rush to make America a rich country. The good times rolled well into the 1850s. From 1847 to 1853, U.S. gold production skyrocketed over 7,000%. Without planes and automobiles, you needed trains to get to California. Domestic railroad building grew to rival that of all other countries combined. Powerful demand from the railroad and agricultural equipment industries caused pig iron prices to soar. Iron and railroad creation required increased coal production, further stimulating the need for railroads and mining equipment. Britain and France forgot all about the problems of a decade or more earlier and poured money into America’s rail boom. Foreign investment reached a high in 1853. The familiar ingredients of commodity price inflation, exploding energy demand, strength in industrial metals, a robust bull market in transportation stocks and excess foreign investment were in place.

Europe’s deficit spending to finance its wars sparked a sharp rise in interest rates and diverted investment funds into European bonds. Capital transfers to the U.S. slid 80% from 1853 to 1856. In 1857, grain prices and exports plunged amid record harvests and falling demand in Europe as the end of the Crimean War reopened world markets to Russia. Some railroads defaulted. As the situation worsened, Irish street gangs – their ranks swelled by heavy emigration to the U.S. in the 1840s – rioted in New York in July. The August 24 failure of the New York branch of the Ohio Life Insurance & Trust Co., which specialized in placing foreign funds in U.S. land and railroad investments, battered the market, causing the prices of most stocks to fall between 3% and 7% the next day. Mounting failures claimed legendary speculator Jacob Little on August 27 – not because he bet wrong, but because his debtors couldn’t deliver money and securities they owed him. Lest you think that such counterparty risk is a thing of the past, modern investment icon Warren Buffet, in a 2003 letter to shareholders, referred to the massive and mostly arcane derivatives markets as potential “financial weapons of mass destruction.”

The September 12 sinking of the steamer SS Central America in a hurricane off Cape Hatteras while carrying 30,000 lbs. of gold bound for eastern banks stirred up a fresh wave of panic and bank runs. Treasury Secretary Howell Cobb temporarily sought to restore confidence by using gold to repurchase state bonds, but a spate of redemptions depleted gold supplies and forced him to stop on October 13, 1857. The news ignited a tremendous panic, quickly causing New York banks to suspend gold payments and leading banks nationwide to follow suit. The shocks reverberated all the way to the major European bourses, where a third of all foreign securities traded were American. The Bank of England’s money rate jumped an unprecedented 3% in less than a month by October 8. The crisis hit Paris even harder and spread to exchanges in Central Europe in what is generally considered the first international financial panic. Railroad stocks in the U.S. plunged over 25% in October alone. By the time the carnage abated, Erie Railroad had plummeted to 11 from an 1857 high of 62, Michigan Central dropped from 96 to 40, and Reading Railroad fell from 81 to 30.

1907: The stock market, which topped in January 1906, actually held up pretty well for the rest of that year. However, the Bank of England started raising rates in December 1906, and the DJIA soon began to slide, losing 8.3% in one day on March 14, 1907, still the 7 th-greatest single-day percentage decline. When Judge Kenesaw Landis, later appointed commissioner of baseball in the aftermath of the 1919 Black Sox scandal, fined Indiana Standard $29 million for illegal rebates in early August, he sent Wall Street’s bulls to an early shower. The Dow got battered another 32% until the November 15 final low. Along the way, New York City endured perhaps its worst banking panic in 50 years. Trust companies, which competed against the more heavily regulated banking industry, had also enjoyed faster growth than the banks. On Friday, October 18, 1907, Charles Barney, president of Knickerbocker Trust, the 3 rd largest trust in New York, was reported to have been involved in a failed corner of United Copper shares, in which the mining company stock fell from 84 to 10 in a day. The following Monday, National Bank of Commerce announced it would stop clearing checks for Knickerbocker. The ensuing run on Tuesday, October 22 put the trust out of business. Runs commenced on other big trusts, threatening banks too because of trusts’ sudden need to liquidate stock-collateralized call loans, which imperiled the assets of banks involved in call money lending. Call money rates briefly soared as high as 125%. A consortium of bankers organized by J.P. Morgan saved the day by extending enough credit to the beleaguered institutions. The close call to the nation’s financial system spurred the government to create the Federal Reserve in 1913 to act as a lender of last resort. The 37.7% Dow decline for all of 1907 still ranks as the 2 nd worst in any calendar year. As in most crashes, the bigger of a success a stock was in the preceding bull market, the harder it fell. Copper giant Anaconda got strangled from 76 all the way down to 25. Amalgamated copper fell from 122 to 42, and U.S. Steel dropped from 50 to 22.

1917: Stock prices sank over 7% on February 1, after Germany warned that it would begin attacking neutral merchant ships in a blockade of the Allies. World War I caused raging inflation, and the U.S. government passed an excess profits tax (as some lawmakers now wish to impose on the oil industry), imposed price controls on steel and seized control of domestic railroads in December 1917. The Bolsheviks took charge in Russia. Shares of former bull market star Bethlehem Steel melted down over 70%. The Dow lost 40% in the bear market, more than it did in the crash of 1987 or in the entire 2000-2002 decline.

1937: Severe credit tightening by the Fed undermined industrial production, which fell faster than during the Great Depression in 1929-33. In an autumn crash, the S&P plunged over 9% on October 18. The Dow got hammered for a 34% loss in a span of less than 3 weeks. By the end of March 1938, the S&P was down nearly 55% in little over a year. Steel stocks were again big winners late in the bull market, only to lose 60% to 80% or even more in some cases in the ensuing bear.

1957: Not a true panic, but although the bear market lasted over a year, virtually all the selling was concentrated in a relatively brief July-October window in 1957 after the Dow triple topped. Numerous formerly highflying metals stocks got whacked for losses of around 50% or higher.

1987: New Federal Reserve Chairman Alan Greenspan replaced legendary Paul Volcker in August 1987 and wasted no time hiking the discount rate on September 4. Now Greenspan is the legend, and Ben Bernanke replaced him this year and began hiking rates. Flashing shades of 1937, the DJIA lost 34% in 2 weeks starting in early October 1987. A whopping monthly trade deficit report and a second raise in the prime rate jumpstarted the rout. On Monday, October 19, 1987, the Dow got slammed for a surreal 22.6% single-day loss, by far its largest ever. The industrial giants of the Dow 30 were among the few stocks anyone could reliably sell, as market makers in over-the-counter issues simply stopped picking up their phones. The next day, things got so bad the authorities came within a hair of shutting down the market before the Dow reversed to close over 6% higher. With liquidity restored, however, the NASDAQ got socked for a record one-day loss as anxious sellers were finally able to unload their positions.

Now that you’ve seen how recurring decennial cycles impact the market and promise to mark the current period as a calm before the storm, can you afford not to prepare? All of the key warning signs that presaged past 6 th-year tops and 7 th-year panics – especially after bull markets originating in the 2 nd year of a decade – are present to an almost absurd degree.

Visit http://www.GannGlobal.com to find out how the Research Engine helping traders like you stay on the right side of market moves.

About the Author:

James Flanagan is the president and founder of Gann Global Financial. In 1978, while majoring in economics at Claremont McKenna College, he acquired his first book written by W.D. Gann, “How to Make Profits Trading in Commodities.” This set in motion his passion to validate the claims of this early pioneer of market psychology and technical analysis. In April 1990, he launched his first newsletter Past Present Futures, which has been in continuous publication since that time. James Flanagan oversees all of the research and research development at gannglobal.com.

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