Excerpt from the Hussman Funds' Weekly Market Comment (12/10/12):
We continue to view the stock market as being in a “secular bear” – a period that includes a series of separate “cyclical” bull and bear markets, with the defining characteristic that successive bear market troughs move toward increasingly depressed levels of valuation. Secular bears begin from elevated valuations – generally Shiller P/E’s well above 18 (the ratio of the S&P 500 to the 10-year average of inflation-adjusted earnings), and typically end about 14-18 years later, at depressed valuations and after a number of separate market cycles. There are certainly many periods during a "secular" bear market when it makes perfect sense to take moderate and even aggressive "cyclical" risks, but it is worth noting that the average "cyclical" decline in a "secular" bear has wiped out about 80% of the prior bull market advance.
As a severe example of a secular bear period, the Shiller P/E reached 25 in 1929, and plunged to less than 5 by 1932, but despite significant gains off of the 1932 low, valuations eventually settled back to a Shiller multiple of just 7.5 by 1942. From the standpoint of prospective returns, we estimate that valuations were consistent with negative 10-year prospective returns on the S&P 500 at the 1929 peak, but with prospective returns near 20% annually at the 1942 low (see the chart in A False Sense of Security).
Now, if the S&P 500 had achieved significantly different returns over the period since 2000 than we actually projected on the basis of normalized valuations, one might be inclined to disregard our valuation concerns as somehow outdated or unreflective of new realities. But we’ve observed no such disparity. Moreover, there's no evidence that our valuation methods are locked in a bearish mode. Even our own estimates of prospective 10-year returns (which are based on a variety of normalized fundamentals well beyond Shiller multiples) indicated – I believe correctly – that stocks were modestly undervalued at the 2009 low, though I certainly don’t believe that 2009 represented a secular low.
One way to think about the effect of a secular bear market is to compare the absolute amount of volatility experienced by the market to the total distance it travels. In the chart below, the blue line represents the sum of absolute weekly percentage changes in the S&P 500 over the preceding 4-year period, divided by the absolute overall change in the S&P 500 over that period. A “spike” in that line indicates that the market experienced a great deal of week-to-week volatility over a 4-year period, without much net movement overall (Geek’s note – this calculation is related to the concept of “fractal dimension” - the spikes are singularities where the ratio is undefined because the 4-year change is close to zero).
An extended period of blue spikes is the hallmark of secular bear markets. These periods have reliably followed periods of elevated valuations as we have observed, with little respite, since the late-1990’s. A great deal of distance traveled, with little to show for it overall. Present valuations provide little reason to believe that this period is behind us. Things will change, and this period of distortion will be behind us. The transition is likely to be unpleasant for the market, but again, I expect that we’ll observe good opportunities to accept significant market exposure even in the coming market cycle.