Sunday, March 20, 2016

Napier, Anatomy of the Bear

Described as “a cult classic in the investment community,” Russell Napier’s Anatomy of the Bear: Lessons from Wall Street’s Four Great Bottoms, first published in 2005, is now in its fourth edition, with a new foreword and preface (Harriman House, 2016).

Napier remains a bear. He believes that the run-up in the markets we have seen since 2009 is merely a bear market rally. The “inexorable pressure” from rising consumption in China and increasing retirement in the U.S. “augurs deflation and thus can unleash the force that will push equities to valuation levels associated with the bear market bottoms of 1921, 1932, 1949 and 1982.” (p. 13)

August 1921, July 1932, June 1949, and August 1982: four summer bottoms. What do they have in common? And what can we learn from them to steer ourselves through the next “big one,” whenever it may occur?

To study the nature of bear market bottoms, and how investors reacted to them, Napier analyzed “some 70,000 articles from the Wall Street Journal written in the two months either side of the four great bear market bottoms.” From his research he unearths “approaches that have worked in assessing when the bear is about to become the bull. What also emerges is an understanding of how similar the great four bear-market bottoms were, in turn leading us to a set of signals to guide investment strategy.” (p. 27)

As a measure of value Napier adopts Tobin’s q ratio, “the stock-market valuation of a company relative to the replacement value of its assets.” The four market bottoms in this book “are the only occasions when equities were at more than a 70% discount to replacement value.” (p. 29) The years 1921, 1932, 1949, and 1982, Napier claims, “also mark momentous change in American society. There was the birth of the consumer society (1921), the birth of big government (1932), the birth of the military-industrial complex (1949) and the rebirth of free markets (1982).” (p. 31)

Napier’s analysis often flies in the face of common wisdom. For instance, the popular myth that the stock market leads the economy by six to nine months is incorrect, at least for the four market bottoms analyzed in this book. “At these extreme times it seems the bottoms for the economy and the equity market were much closer together and the economy might have led the stock market.” This is an important finding since it “suggests the risk to investors at these extreme times may not be as great as often assumed. An investor need not buy equities on his forecast that the economy will start to improve in six-to-nine months. At the great bear market bottoms there is likely to be growing evidence the economy is already on the mend.” (pp. 253-54)

Whatever one’s view of what the next longer-term move in the market is likely to be—up or down—Napier’s history and analysis of major bear market bottoms is worth reading now, and tucking away for darker times.

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