"It's been very hard
but it's getting easier now
Hard times are over, over for awhile"
--Hard Times Are Over, John Lennon & Yoko Ono, Double Fantasy, 1980
The hard times for the stock market have been over for a while now. It has been over four years now since stocks reached their final bottom in the aftermath of the financial crisis in March 2009. But now that markets have traveled all of the way back to return to their all-time highs, it is reasonable to wonder whether hard times may soon return once again to financial markets.
The stock market has been engaged in a triple fantasy over the last 15 years. Along the way, we have seen three major peaks, all falling within the 1550 to 1600 range on the S&P 500 Index.
The first fantasy was the dot-com bubble of the late 1990s. While the commercialization of the Internet was a game-changing event for the global economy, it simply was not to be for many of the stocks that got caught up in the frenzy at the time but were never able to even begin generating the profits that their once lofty stock prices suggested. After peaking in March 2000, stocks would go on to lose -50% of their value over the next two and half years, heralding the start of the current secular bear market in the process. As for the tech heavy NASDAQ that briefly crossed the 5000 threshold in March 2000, it would proceed to lose -78% of its value over this same two and a half year time period and still remains -36% below its peak level through today. The experience of the NASDAQ serves as an important reminder to investors that sometimes when stocks fall it can take decades for them to come back. The same can be said of Japan's Nikkei 225 Index, which peaked at 38916 on the very last trading day of the 1980s on December 29, 1989 and still remains mired -65% below these peaks over two decades later today.
The second fantasy was the housing bubble of the mid 2000s. The global economy was moribund in the aftermath of the busted dot-com bubble and in need of cleansing following nearly two decades of largely uninterrupted growth and the associated excesses that were accumulated along the way during the 1980s and 1990s. But instead of allowing a healthy recessionary process to take place, fiscal and monetary policy makers instead turned their attention to the housing market as a way to stimulate growth. And quite the spark they generated, as housing prices that typically increased at a rate of +5% or less per year were sent skyrocketing at a double-digit rate, increasing by over +50% over the course of just four years. As we all know, this episode ended most badly, as home prices collapsed by over -40% from their early 2006 peaks in falling to levels last seen in early 1998 before finally bottoming. The experience of the housing market serves as another important reminder that just because something has not occurred in the past, such as a decline in house prices on a nationwide basis according to the Fed Chairman Ben Bernanke himself back in July 2005, it does not mean that such an event cannot happen in the future. And once the housing market burst into a debt fueled blaze, it brought the market crashing down with it, as stocks plunged by -56% in dropping below its previous lows in the aftermath of the dot-com bubble in the process.
The third fantasy in which we are now engaged is the asset bubble over the last several years. Once again, instead of allowing the global economy to enter into a long overdue corrective and cleansing process after stabilizing the financial system in the aftermath of the crisis, policy makers including global central banks in particular insisted on trying to push the petal to the floor by seeking to inflate asset prices in order to stimulate growth. For example, after successfully rescuing the global financial system from total collapse from late 2008 to early 2010 through its quantitative easing (QE) program, the U.S. Federal Reserve could not leave well enough alone by allowing the economy to work off some of its lingering excesses. Instead, it quickly launched into another round of massive stimulus with QE2 in a desperate attempt to stimulate growth. Then Operation Twist. Then Operation Twist 2. Then QE3. All of this brings us to where we are today. The stock market has once again returned to its all-time highs. But the pace of economic growth remains sluggish at best and underlying risks to the financial system remain as profound as ever. But will this latest experience indeed mark a triple fantasy for financial markets?
On the positive side, the stock market finds itself in a more favorable state from a valuation standpoint as it makes its latest arrival at its all-time highs. When stocks first arrived at the 1550 to 1600 level on the S&P 500 back at the turn of the millennium, they were trading at ridiculously high multiples with the price-to-earnings ratio in excess of 30 times trailing 12-month earnings. Such valuations at the time were simply unsustainable. On their second arrival at these same peak levels over seven years later, stocks were trading at still fairly lofty but far more reasonable multiples at around 20 times trailing 12-month earnings. And on their current approach today, stocks are still rich but slightly more reasonable at just below 18 times earnings. This fact alone is a sign of progress, as the underlying stocks that make up the S&P 500 are bringing a higher level of earnings with each successive arrival at its all time peak.
Despite this progress on the earnings front during the secular bear market that began in 2000, this hardly suggests that we are now ready to put this long-term phase behind us and launch into a new secular bull market. For stocks not only remain well above the long-term historical trailing 12-month P/E Ratio of 15.5 times earnings, they also currently reside well above the long-term average multiple for secular bear markets at 12.9 times earnings. Moreover, stocks have typically traded at the very low end of the secular bear market range when they are finally ready to exit a secular bear market and enter into the next secular bull phase. But in the current cycle, stocks have only briefly grazed the long-term average multiple at just below 13 times earnings. While one could argue that the higher multiple today is justified by record low U.S. Treasury yields, another could just as easily argue that these same record low interest rates are part of the greater epidemic that have not only polluted the quality of these earnings but is also keeping the global economy paralyzed with fear and uncertainty, for if global central banks fail in their mission to stimulate growth through aggressive money printing, the subsequent fallout effects in global financial markets could suddenly make these multiples appear egregiously expensive.
Past secular bear markets also provide a number of instructive points as to what we should reasonably expect with the current episode. The last three secular bear markets occurred from 1901 to 1920, from 1929 to 1949 and from 1968 to 1982. Thus, the length of each of these past secular bear markets was 20 years, 21 years and 15 years, respectively. Given that we are only starting into year 13 of our current secular bear market, it would be most optimistic to think that the current secular bear market is now over. And it is even more optimistic to believe that the secular bear market this time around only lasted just over 8 years and that we are in fact in the fourth year of a new secular bull market.
The complexion of the global environment and posture of policy makers is another factor that undermines the conclusion that today's secular bear market is a thing of the past. In order to finally escape the clutches of past secular bear markets, the economy and the financial system was forced to take its medicine and undergo a massive and complete cleansing process before moving forward.
The end of the secular bear market in 1920 was marked by a Depression as the economy adjusted itself emerging from World War I. But instead of leaning away from the problem by trying to artificially prop up the economy, policy makers instead opted to turn into the problem and take it head on by lowering taxes and slashing government spending on the fiscal policy side and taking a hands off policy approach on the monetary policy side. In short, they forced the economy to take its medicine and cleanse itself. And this approach stands in stark contrast to what we are seeing today.
The end of the secular bear market in 1949 came as a result of the end of World War II. But although the world's infrastructure effectively needed to be rebuilt after the war, the financial system still needed to undergo a challenging transformation from a wartime to peacetime economy. And this process was allowed to play out without policy makers seeking to artificially sustain output at wartime levels that were no longer aligned with the global environment that had changed around it.
As for the end of the secular bear market in 1982, this came about as a result of policy makers aggressively leaning into the inflation problem at the time and forcibly cleansing the financial system instead of catering to it. Up until 1979, monetary policy makers at the Fed insisted on keeping monetary policy accommodative despite steadily increasing inflation under the notion that focusing on unemployment was far more important and that pricing pressures would simply correct themselves once employment finally picked up. In short, policy makers were leaning away from the problem just as they are today instead of dealing with it head on. But upon the arrival of Paul Volcker as Chairman of the Fed in August 1979, all of this changed. The Fed went on to raise interest rates dramatically to completely stomp out the inflation problem. While this action placed tremendous pressure on a variety of industries and sent the economy falling back into recession, the result was an economy that was cleansed of its inflation problem and ready to resume sustainable growth and steady job creation. Thus, the inclination to turn into the problem and force the economy to take the necessary corrective process head on actually helped bring an earlier than normal end to the last secular bear market and propelled the economy into what turned out to be the longest period of sustained expansion in history.
As for the current secular bear market today, policy makers are unfortunately still running away from the problem. Fiscal policy is in shambles as global sovereigns continue to accumulate ever more debt in the desperate hopes of generating enough future growth to someday repay these obligations. And monetary policy makers have embarked on an unprecedentedly aggressive money printing campaign in hopes of papering over a problem that is only compounded with each successive policy response. In short, policy makers continue to resist the need to finally turn into the problem and take it head on by allowing the global financial system to undergo the uncomfortable cleansing process once and for all. In the end, this inclination to try and avoid the problem will only serve to prolong the secular bear market.
"I'm just sitting here watching the wheels go round and round,
I really love to watch them roll,
No longer riding on the merry-go-round
I just had to let it go"
--Watching The Wheels, John Lennon & Yoko Ono, Double Fantasy, 1980
So what can we reasonably expect if the latest peak in the stock market is indeed a triple fantasy? Notably, the stock market as measured by the S&P 500 has followed a similar pattern during its third fantasy relative to the first two. While the move from the previous bottom to the upside has bounced between the paths of the prior two fantasies along the way, it has converged to the same destination today. Of course, all fantasies have different endings, and this was certainly true of the first two episodes. The stock market descended into a slow and steady grind lower following the 2000 market peak, as it took nearly three years for the unwind to completely play out. Of course, the decline following the 2007 peak was far more severe, as the market moved from peak to trough in roughly half the time relative to the first. Thus, it remains uncertain how the current fantasy will play itself out.
It remains very possible that stocks may continue to rise and break out to new highs in its current dream state. After all, this is the outcome that policy makers desperately want in the current fantasy. Whether it will actually result in sustained economic growth is still subject to great debate, but they will likely continue to provide ample support to try and achieve this outcome. For this reason alone, it remains prudent to maintain long positions in the stock market and stand at the ready to reinvest on any sustained moves to the upside.
But with this being said, a variety of signals suggest that the rally will be hard pressed to continue from here and that the latest fantasy may soon come to an end. Not only are the problems in the European banking system increasingly boiling over, but it also appears that we may be finally arriving at the juncture where excessively aggressive monetary policy interventions are starting to result in destabilizing effects on the global financial system as evidenced by recent volatility in the Japanese government bond market. And mass liquidations such as what has occurred in the commodities space including gold (GLD) and silver (SLV) typically do not occur in isolation and can often provide an early warning signal of building disconnects within the financial system. And, by the way, in a factor that once held much higher importance to investors, the global economy continues to slow with many regions already in recession and the U.S. seemingly following the path of deceleration to the downside.
On a final note, if the market were to break lower from here, it is likely that the move lower would follow the more gradual and grinding path following the post 2000 peak than the sharp crash following the post 2007 peak, as the endlessly aggressive support from policy makers would likely serve to stem but also prolong the bleeding to the downside under such a scenario.
As a result, while I love to watch the stock market move to the upside, I am no longer riding the merry-go-round at the moment until we see greater clarity on how recent events overhanging the market play out. While I remain long high quality stocks trading at attractive valuations and providing attractive current income including ExxonMobil (XOM) and McDonald's (MCD), I recently used the opportunity to either lock in gains or step aside on a variety of other stock positions. For if stocks are able to overcome their current challenges and continue to the upside, the opportunity will always be available to reinvest back in. And if the market does indeed break to the downside, it should provide more attractive reentry points from today. Recent moves by International Business Machines (IBM) and General Electric (GE) are already foreshadowing these very points in either direction. In the meantime, I remain long stock market hedges including long-term U.S. Treasuries (TLT) and Build America Bonds (BAB). I also remain long the precious metals complex including the Central GoldTrust (GTU), the Central Fund of Canada (CEF) and the Sprott Physical Silver Trust (PSLV), which is now trading at a discount to its net asset value for the first time in its history.
We are currently in year 13 of the current secular bear market, and policy makers remain insistent on leaning away from the problem. And given that past secular bear markets have lasted 15 to 20 years on average and only came to an end once the necessary corrective processes were permitted to occur, it is highly unlikely that the hard times are over and a new happy reality has emerged in the current episode. Instead, we remain stuck in a triple fantasy. And until policy makers either opt to or are forced to face head on the problems we continue to deal with today, the probability remains high that the secular bear market will not only persist but enter into new destabilizing phases along the way.
This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.