Today I’d like to present a bit of an “epiphany” I’ve had recently. It’s regarding where we are in the investment cycle and when we might see a final washout, assuming there is one to come. I believe this is one of those “highly important” blogs that I post once in a while. Its a bit detailed (long), but the message I present today, IMO, is vital stuff! I’ll draw on some market history, and build in some “Elliott Wave Lite” analysis for context (like lite beer- not as good as the real stuff, but passable).

Bear markets typically end in capitulation.

To start: True bear markets (as opposed to corrections) typically end in extremes of fear and capitulation. It is my view that the current bear has not seen that capitulation and fear phase. Here’s why:

Quantitatively, we can measure sentiment indicators to spot a bear market’s “puke phase”. I covered most of these tools in my book Smart Money, Dumb Money. Some of the best indicators measuring sentiment extremes include the Put/Call ratio, the Smart Money/Dumb Money (sentimentrader.com) indicator, and the VIX. All are useful in spotting that wonderful moment of fear & loathing in the market. The VIX, in particular, is a favorite tool of mine to spot those glorious moments. It’s actually quite predictive. The VIX basically illustrates option premiums. More volatility, which typically happens in declining markets, means option writers want more premium. The chart below highlights moments of the VIX levels exceeding 35 as opportunistic. That said, a level of 45 (top black horizontal dashed line) is the more reliable level signifying the bottom of true bear markets.

See my red boxes on the VIX chart highlighting the moments of extreme fear during the major selloffs over the past quarter century. Sometimes, we will see quick tests of that 45 level. That’s typically when the market has seen a short or fast correction. Eg–

2015 (summer commodity selloff),
2018 (December selloff)
2020 (COVID bear market – crash in March, recovery by August .

Now, note the prolonged “true bears” of the 1999-2003 period, followed by the 2008-2011 period.

During significant corrections, or bear markets, we saw single or multiple tests of 45 on the VIX at bottoms. In other words: it ain’t over until the VIX sings.

Note: We have barely seen 35 exceeded in the 2022 bear market (green commentary on chart). Every “true bear” has tested 45. I believe that we are setting up for the final washout to 45+ on the VIX in the coming months. We have not likely seen the bottom of the current bear, if history is a guide. More on that below. And, by the way…history has been, in the case of the VIX, a darned good guide!

Part 1: Some backdrop

How ValueTrend “knew” that the summer and fall rallies were head-fakes

Truthfully: Nobody can actually “know” future market moves! However…ValueTrend uses studies, like the VIX noted above, to guide us. We utilize PROBABILITY analysis. I’ve often told investors, we cannot time the markets. But we ABSOLUTELY CAN quantitatively measure the approximate risk/reward tradeoffs using our proven 3- factor probability model. This is not market timing, or sure-thing fortune telling. This is about understanding the risk vs reward potentials. We use that probability model – which incorporates Trend rules, Risk/ “Bear-o-meter” rules, and Fundamental factors to make assessments.

We can also do qualitative “observational” analysis. For example:

Many investors speculated that the bottom had been seen during the two 2022 bear market rallies – first in July, then in October. Again…Bear markets end in fear, loathing, all hope lost, capitulation puke phases. Did you get that vibe before these two rallies? We didn’t. The media didn’t:

Bad news is good news

The optimistic attitude of hope by market participants seems to be changing. Its becoming more pessimistic, more despondent. The end of the bull is farther away than previously hoped. Such bad news. So sad. So depressing. Why stay invested, they ask?

That’s good news!!

We need some good, wholesome fear, loathing and despondency! Case in point: Open your favorite investment news site now, and read the headlines quoting the experts. Almost everyone is calling for a continuation of the bear market (now that we’ve been in one for an entire year). And that’s good news! History shows that a crowded trade, where everyone agrees, is soon to end.

We’re now into the traditional “Yearly outlook” writeups. Predictions for 2023 are coming out suggesting a weak or declining market in 2023…. such as this. And this one:

Another example: Most of the first half of last year saw market pundits suggest that:

inflation would be transitory,
recession would be unlikely or mild,
the afore mentioned trough & rallies were the bottom.

Now, we witness headlines like this one from Time Magazine:

Lesson: Most experts aren’t experts, except at getting paid a lot to waste your time. They are reactionaries with track records that leave much to be desired.

Part 2: The bullish setup

The headlines are gloomy. Experts are predicting flat, or lousy market returns- even negative returns for 2023.
The “transitory inflation” cult has lost its voice. Now, we are seeing acceptance of entrenched inflation. Something that I have been telling you for almost 3 years. Old news for me.
We’re also seeing Canadian and US governments, you know–the ones who were vehemently denying the likelihood of recession for the past 12 months (while I was suggesting it was almost impossible to avoid one..) are now saying “well, of course we are about to have a recession…”. Again: Old news for me.

Dr. Doom has entered peoples headspaces, and he’s just getting started messing with their minds. Fear is in the air, and its growing. That negative headspace is necessary for the bullish follow-up. Fear will continue to grow. “Get me out!”, says Johnny Dumb. Now he wants out, a year after the top (when he was bullish). Go, Johnny, go! We need him and other Dumb-money investors to panic and sell now that they’ve lost 20%. This creates the final washout. Run, Johnny Dumb, run! You too, Forest.

This panic will drive sentiment indicators like the VIX to uber-high levels – like 45, or more. And therein lies the opportunity.

If you are not excited now, you are not paying attention. The puke phase is coming! Rejoice, those of you who continue to hold cash and defensive’s! With your cash, and Johnny’s panic selling, soon your greatest opportunity to earn profits will arrive.

Part 3: The Playbook. Its all been seen before

OK, here comes the deep stuff. I need to go over some history for you to get a handle on when Johnny Dumb’s panic selling is over and done with. The fear & loathing phase will afford you, the more informed investor, a magnificent opportunity to buy equites cheap. But only when Johnny has finished upchucking his portfolio into the toilet.

To start: One of the greatest investment books I have ever read (and I’ve read plenty), is The Wave Principle of Human Social Behavior and the New Science of Socionomics: Prechter, Robert R: 9781946597021: Books – Amazon.ca

The book compares general societal mood swings with stock market movements. In a nutshell, mood and markets are correlated. Markets are a reflection of everything. We’re talking: the types of movies being produced, baseball attendance, tobacco usage, alcohol consumption, even war. Social mood, government policy, discontent & happiness are reflected in the stock market. These moods coincide with the traditional Elliott Wave phases on the market.

I’m not going to cover each wave and the socio-economic correlations described in the book right now. But I do recommend you read it – you will love the book if you are like me, a student of human behavior. Instead of covering each wave, I am going to cover the final wave of a bear market, which is “Wave C”. That, I believe, is what we are entering right now. Prechtor noted that Wave C is characterized by falling markets roughly coinciding with:

War(s)
Social unrest, fear, declining hope, discontent
New levels of unprecedented or abnormal government control – the crowd allowing such controls when looking for direction, and driven by fear & despondency.
Often inflation or recession (or both)
Finally, the bottom of Wave C–coinciding with or within the approximate timeline of a move away from the controls, fear, discontent, unrest, and war.
Note the washout lows within each period.

This pattern results in “EXTRODINARY OPPORTUNITY’, as Prechter puts it, for investors who wish to earn profits.

Lets take a look at Prechter’s observations applied to significant bear markets over the past 100 years. Here’s the Dow since 1900, bears & C-Wave washouts highlighted: