The New Normal: A Secular Bear Market

I get a kick out of reading commentary from the perma-bears. No matter what the market does, how bullish the economic data or how strong corporate earnings results, these pundits are always looking for the next calamity that’s going to send the market back to its March lows or push the global economy into a double-dip recession.

These commentators typically have their days in the sun every few years when the market gets hit; as you might expect, last year’s sickening collapse was one of the best years ever for the permanently ursine. Of course, when the market starts rising the same cadre of bears will fight the tape and tell investors they’re ignoring the coming crash.

Many like to claim they “called” the market’s collapse, though a cursory examination reveals many have been making the same basic call for years. And they’re also guilty of an even more egregious sin: missing out on the huge run-up in global stock markets this year by refusing to adjust to cyclical changes in the market.

Let me cut off the flood of e-mails telling me I’m whistling past the graveyard in a bullish daze. I don’t find the bearish commentators amusing because I disagree with them. In truth, many of the more common bearish talking points are absolutely dead-on.

Chief among the concerns: The US consumer is overleveraged and won’t be the engine of global growth in future.

Source: Bloomberg, Personal Finance

US consumers have borrowed at unprecedented levels in recent years, encouraged by the Federal Reserve’s easy money policies that inflated a credit bubble. As you can see in “Borrowing Boom,” in the late 1950s total US household debt--such as mortgages, credit cards and auto loans--stood at less than 40 percent of gross domestic product (GDP).

That ratio rose to roughly 45 percent by the mid-’70s. But just as the savings rate dropped precipitously post-1982, debt levels steadily increased and were near 100 percent in 2007.

The pattern is clear: Americans cut their savings and borrowed money to fund consumption. This alone accounts for the consumer’s resilience and willingness to buy the country out of every contraction over the past 25 years.

But that trend has ended abruptly. The US savings rate jumped to as high as 6.2 percent in recent months, and the household debt-to-GDP ratio has begun to decline as Americans pay down their debt.

Because the excessive debt burdens of the past few years are unsustainable, this pattern of deleveraging is likely to continue for at least a few more years. The US consumer isn’t spent but will no longer drive economic growth.

Meanwhile, US federal deficits are at banana republic levels, which will ultimately mean higher interest rates as foreign investors demand a higher return to lend yet more money to the US government.

Deficits are likely to go higher in the near term; regardless of what you might think of proposed health care reform, the US stimulus package and various financial bailouts, it’s obvious that all have added to America’s government debt binge.

All of this is reflected in the value of the US dollar. The dollar will likely rally from time to time, but it’s tough to see the back of the dollar bear market broken anytime soon.

I could chew oodles of bandwidth detailing the challenges the US economy faces in coming years. Suffice it to say that I see the US stuck in a secular bear market for years to come.

But here’s where I differ from the perma-bears. Discussing long-term headwinds is an interesting intellectual exercise, but it’s not going to make you a dime, or even a euro-cent. As investors, our mission isn’t to dig up new indicators to justify a long-term bearish position.

The mission is to make money. This means looking for opportunities to make money even in less-than-perfect market conditions.

In all fairness, I’ve been careful to direct my comments at “perma-bears” rather than bears in general. I firmly believe that all investors should be aware of the long-term headwinds facing the economy. And there are plenty of outstanding bearish commentators who are willing to suspend their beliefs and take advantage of opportunities as they arrive. All investors should read these commentators and pay attention.

My point is simple: As popular as they are today, the perma-bears are every bit as ridiculous as the cheerleaders who rode the market all the way down after the collapse of the tech boom in 2000 and the more recent credit debacle.

Recognizing the long-term headwinds facing the US, investors can still make money in the current environment. Here are a couple of the basic strategies I’d recommend.

Flexibility/Willingness to Sell. Look back at charts of markets in prior secular bear phases such as the S&P 500 from 1968 to 1982 and after 1932 and Japan’s Nikkei 225 in the ’90s.

In all three cases, the market’s trend was lower or, at best, sideways. If you were trying to buy and hold a broad collection of US stocks, you would have been crushed in those markets.

That said, contrary to popular belief, some of the most dramatic rallies in stock market history occur during secular bear market phases. In many cases, these moves can produce triple digit gains and last for a year or more. A classic case in point: the recent rally off the March lows and the rally after the vicious 1973-74 recession.

Investors willing to follow cyclical moves in the economy and markets can make money even in a down tape. And I’m not talking about aggressive trading. Investors need not catch exact tops and bottoms but must be willing to take gains from time to time and buy when economic and market conditions are improving.

As I’ve often noted here and in Personal Finance, I’ve been bullish on the US market since last spring. Every month, I analyze one of my favorite quick indicators of the state of the US economy: the Conference Board’s Leading Economic Index (LEI), an indicator that’s composed of 10 constituent economic indicators. Here’s a look at the year-over-year change in LEI going back to 1970.

Source: Bloomberg

When the LEI year-over-year change crosses from above zero to below, it’s a good indication the US economy is entering recession. This simple rule “called” the US recession that began in late 2007 and was a stern warning that it was time to reduce exposure.

Similarly, the LEI began to show signs of life in the spring and crossed back above zero in midsummer. Although this does nothing to change the longer-term headwinds I describe above, it’s clear the US economy is experiencing a cyclical rebound that’s helped to push the averages to new highs this month.

Selectivity. During the secular bear market of the ’70s, gold, oil and other commodities performed well. In addition, some foreign markets, such as Japan, produced solid returns even as the US market marched in place.

Amid a secular bear market in the US, investors need to focus their attention overseas, particularly to developing markets like China and India. These markets rebounded from the global financial crisis of late 2008 much more quickly than the US, a sign that some foreign markets are beginning to de-couple from the US cycle.

My colleague Yiannis Mostrous notes in this week’s issue of Emerging Markets Speculator:

As expected China’s gross domestic product (GDP) posted solid growth in the third quarter, touching 9 percent. In the wake of this news, stories abounded about how the Chinese would likely raise interest rates to prevent the economy from overheating.

Investors should disregard these kneejerk stories; the National Bureau of Statistics of China recently released a statement reassuring investors that its monetary policy will remain accommodative.

...

As I’ve stated in the past, Chinese monetary authorities will target GDP growth of 8 to 9 percent next year; given lackluster growth in developed economies, the stimulus should remain in place. Any withdrawal of stimulus will occur gradually as the private sector picks up the slack, especially in the infrastructure area.

Domestic consumption and investment remain the driving forces behind China’s GDP growth, as exports were very weak. If exports to developed economies pick up in a meaningful way, then expect GDP to grow 9 percent next year.

My investment recommendations have targeted names that benefit from domestic growth, so I was encouraged to learn that per capita disposable income rose by 10.5 percent in the cities and 9.2 percent in the countryside.

Investing directly in China and India is one part of this selectivity strategy. But certain specific sectors and stocks in the US also benefit from growth abroad.

For example, energy commodities and related stocks are a big beneficiary of global growth in oil demand. From 1998 to 2008, oil demand from countries in the Organization for Economic Co-Operation and Development (OECD)--a proxy for the developed world--saw total demand growth of about 750,000 barrels a day (bbl/d). In contrast, non-OECD demand jumped by more than 10 million bbl/d.

That means the developing world drives more than 90 percent of global oil demand growth. This simple fact makes a mockery of those analysts who continue to focus solely on US oil demand and inventories as a predictor of global oil prices. And, as I recently wrote in The Energy Letter, the world faces severe oil supply constraints that will also help push prices higher in coming years.

You might also be surprised to find that US technology stocks are an excellent play on foreign growth as well. Of the 10 official S&P 500 economic sectors, Information Technology ranks near the top of the list in terms of generating revenues outside North America. Close to 55 percent of the sector’s revenues are derived from outside the region, and that proportion has been rising steadily in recent years.

Source: Bloomberg

This graphic shows the performance of the 10 US technology firms in the S&P 500 with the highest proportion of revenues from outside the US. The list includes such names as Texas Instruments (TXN) and Intel (INTC). As you can see, tech stocks with heavy foreign exposure have handily outperformed since the March lows.

Comments

[swissfrank]

You say "... some foreign markets are beginning to de-couple from the US cycle."

That really is the question. Will it be different next time or will everything come down together? I might now be persuaded that gold bullion will do well so long as the US and UK show no political will to tackle their respective debt mountains (in other words, quite a while) but I'm less convinced that my BRIC ETFs have really decoupled or will offer shelter from the storm.

2009 Nov 11 06:35 AM

[enigmaman]

I agree about all falling in concert, what if? you know the weakest link theory, yield curve spread (10--2yr) appears to be at previous two top formations before they rolled over and took the markets to the wood shed, read Pimco founder article about recent rally, made excellent sense and appeared like many other to state these are the times to invest but end with " not at this particular time" now caution is warranted, it would be interesting to see if there is a correlation between LEI and other technicals that can be used to confirm the authors thesis "When the LEI year-over-year change crosses from above zero to below, it’s a good indication the US economy is entering recession." Is there a group of indicators that have been used in concert to reliably predict economic cycles

2009 Nov 11 06:53 AM

[bbro]

Excellent article...but i must deal with the one bugaboo that many
SA readers quote to satisfy their various agendas. I am not going to get into the whole debt to gdp issue just the one cited here but the
concept is the same. Household debt to GDP has gone from 1986 to today from around 50% to today at 95% I pick 1986 ( since it is the last time)
we had a 7 to 8% savings rate. Debt Service payments are Probably as of the 3rd quarter 12.8%...debt service in 1986 was 12%.....not as big a bugaboo as you think....Ok you say if we get
inflation we are in deep doodoo. But if we get inflation doesn't that
devalue debt???? One consequence begats another consequence....

2009 Nov 11 07:57 AM

[MikeD71]

"how bullish the economic data or how strong corporate earnings results".

-If these were ACCURATE, there would be less bearish sentiment. But they aren't. Cost-cutting, as in eliminating jobs...probably permanently, and a flood of Monopoly money, IMO, are nothing to cheer.

"This means looking for opportunities to make money even in less-than-perfect market conditions."

-No doubt about it. Being bearish doesn't mean you shouldn't be looking for opportunities.

"As expected China’s gross domestic product (GDP) posted solid growth in the third quarter, touching 9 percent"

-Yes, but China is a greater illusion than our markets. They are on borrowed time. (Just like us)

2009 Nov 11 08:06 AM

[a fat panda]

OK I'll bite. Your Household Debt to GDP is misleading when put into historical context. There is no historical context with the amount of money that the government is spending.

For example, if the government were to print 140 billion dollars,and distribute it to the citizens as "stimulus", and they pay down debt the your debt picture will improve when in fact all that was done was move private debt onto the public balance sheet.

My neighbor is a great example of stimulus. He has gone from working with private companies to almost exclusively servicing government contracts. When I talk to him, he says that he is personally 'hunkering-down'. The cash that goes to him goes to paydown debt. Again, the debt picture isn't changing - we are just moving private debt onto the public balance sheet as though it will never be paid back.

2009 Nov 11 08:20 AM

[Dave Wrixon]

On Nov 11 08:06 AM MikeD71 wrote:

> -Yes, but China is a greater illusion than our markets. They are
> on borrowed time. (Just like us)

No they are not. They need to be wary not to repeat your mistakes in 20-30 years time, but for now they are working comfortably within their means, and could even sustain substantial devaluation of US debt, but it really doesn't give them much incentive to lend your more right now, especially as discretionary imports have all but dried up.

2009 Nov 11 08:27 AM

[SEMTrader]

Well said & a nice change of pace. We've been trying to explain to clients that the fundamentals are Bearish over the long-term---there is absolutely no way over the next 10-15 years the US economy can grow anywhere near the pace it grew the last 20 years. In addition, indicators (such as Aggregate Work Week) that normally should have turned in a FULL economic recovery have not. Unless that improves, this bounce in the economy will be short lived, which will cause a great deal of pain to buy & hold investors.

Despite our long-term fundamental "bearishness", we are technically bullish. We missed most of the downside & began legging back in by late March & were all in by May. By investing in things such as Asia Pacific & Latin America we have caught back up to the "benchmark" S&P 500.

There needs to be more of a balance between perma-bears & the buy & hold perma-bulls. Those perma-bulls have done so much damage to the average investor by making them believe you must buy & hold in order to succeed.

2009 Nov 11 08:39 AM

[MikeD71]

We'll see how it plays out, but China is way overextended and producing at levels that are nowhere near justified. There, or anywhere else. They had better get their people spending. And we better figure this problem as well. The US consumer will never again account for 70% GDP.


On Nov 11 08:27 AM Dave Wrixon wrote:

>

2009 Nov 11 09:10 AM

[CGP]

Didn't realize the debt to GDP ratio was so high. I think there is an interesting play on demographics here. The drastic climb in the ratio coincides with the effects of the Reagan administration and the baby boomers reaching maturity in the job market. 20+ years later we're now seeing another shift as a new generation of decision makers is coming into power, with the last active influences of the pre-boomer generation fading and the leading edge of the boomers facing their retirement years. There is a knowledge\experience\e... gap here as I'm sure many of us don't fully understand or recognize the changes in the speed and rhythm of the cycle (but not necessarily the nature). Note the massive difference made by the democratization of information now compared to other periods in time (i.e. the Great Depression, 70's).

2009 Nov 11 10:18 AM

[Conventional Wisdumb]

I have a very simple question for all pundits: What were your clients results from Aug 07 till now?

The annualized, geometric return, not the average return. No gimmicks. Beginning and ending money.

The only way you could win in this market is to be a market timer - a long term buy and holder is still buying and crying.

2009 Nov 11 10:32 AM

[Gary A]

I don't know if this model can continue. I don't see drunken Americans purchasing 6 dollar gas. I see them staying home and buying used video games.

And about decoupling, it hasn't happened yet.


On Nov 11 10:07 AM bobbybutte wrote:

> China and the US will be joined at the hip and will dominate the
> world over the next 20 plus years
>
> They need us to consume and will buy our debt and like drunken sailors
> will not stop drinking until the bottle is empty
>
> The Chinese will try and decouple but Asian peopel will not buy all
> the worthless goods China produces and the Us peopel will never go
> without what they feel they deserve

2009 Nov 11 11:48 AM

[bbro]

Consumer debt service payments to GDP in 1986 was 8.8% today
it is 9.8%......

2009 Nov 11 11:49 AM

[Gary A]

Got a link for that? And is that good or bad in your opinion? Wages were rising then, but they aren't now.


On Nov 11 11:49 AM bbro wrote:

> Consumer debt service payments to GDP in 1986 was 8.8% today
> it is 9.8%......

2009 Nov 11 01:37 PM

[bbro]

i worked those numbers myself....debt service payments to disposable income was 12% in 1986 ..the upcoming third quarter
numbers is likely to have 13 to 12.8 %.....I am not minimizing the
debt problem but a lot of people need to chill....and realize we can work ourselves out this over time....

2009 Nov 11 02:17 PM

[inthemoney]

China is a bubble at this point. Everybody who visited recently says it is smoke and mirrors - a lot of new nice and empty buildings.
Let's check back on your investment advice in 6 months.

2009 Nov 11 02:33 PM

[Elliott Gue]

I am not saying that the problem is insurmountable just that it's an important obstacle that's likely to contribute to slower US GDP growth going forward.

The Fed publishes a household debt service ratio calculated as the ratio of debt service payments to disposable income. The current ratio is 13.11 percent down from a high nearly 13.90 percent on 09/30/07. In the early 1980's it stood around 10.5 percent. And again in 1992/93 after the early 90's recession, it was back in that 10.50 to 11 neighborhood. The aberrant period on this measure is really post-2000 and my guess is we'll head back to that 10.50 neighborhood in coming years as consumers pay down debt and save more.

Fairly small shifts in this debt service ratio imply significant sums and take time to play out.

On Nov 11 02:17 PM bbro wrote:

> i worked those numbers myself....debt service payments to disposable
> income was 12% in 1986 ..the upcoming third quarter
> numbers is likely to have 13 to 12.8 %.....I am not minimizing the
>
> debt problem but a lot of people need to chill....and realize we
> can work ourselves out this over time....

2009 Nov 11 02:34 PM

[bbro]

Who says its the peak???


On Nov 11 03:09 PM BUFFETT&SINK wrote:

> Why Warren Buffett pays $34 billion for BNI instead max. $20 billion
> when market DJIA was at 6500?
> Why BRK depends on Goldman Sachs bankers?
> Why Buffett is buying stuff at the peak of the market instead of
> waiting to buy cheaper in a very short time ?
> Does he think DJIA at 10000 is "cheap" ?
> He buys BNI at the top to calm the matket panic and "make you buy
> too".
> Why BRK is not selling all their stuff, when W. Buffett knows very
> clear that DJIA will be 5000 soon and will bottom only at 2000 that
> will hit him too?
> Find out in WARREN BUFFET? link
> alturl.com/dzgp

2009 Nov 11 03:17 PM

[David Van Knapp]

I'm not managing anybody's money but my own, but I'll answer your question anyway. My results from August 7 until now closely mirror the S&P 500's, which is to say they're damn good. Actually, my results have been that way since April, when I recognized that a mid-recession rally was under way.

Often when "timing" is mentioned, a straw man is set up to contrast with it: buy-and-hold. The fact of the matter is, the Sensible Stock Investor need not be strictly a market timer nor a buy-and holder. There are gradations along the scale, subtleties and nuances. It's not a binary choice.

So in the market since 2000 (which has had both strong up and down periods), it was possible for a stock investor to be invested at some times, partially invested at other times, and completely out of the market at still other times. It was possible to follow two completely different strategies: One for capital gains (which usually leads to more trading) and another based on the receipt of ever-increasing dividends (which usually means little trading). There have been an infinite number of ways to invest and make money, and an infinite number of ways to lose money.

Furthermore, just because one's long-term view may that we are in a secular bear market does not mean that one cannot be flexible and take advantage of periodic opportunities when the stock market is going up, as it has been since March. If that's "timing," so be it, I don't care about semantic arguments. The point is not to get wedded to one point of view--don't get emotional, get practical. I think that was the point of the article.


On Nov 11 10:32 AM Conventional Wisdumb wrote:

> I have a very simple question for all pundits: What were your clients
> results from Aug 07 till now?
>
> The annualized, geometric return, not the average return. No gimmicks.
> Beginning and ending money.
>
> The only way you could win in this market is to be a market timer
> - a long term buy and holder is still buying and crying.

2009 Nov 11 04:58 PM

[DL1947]

Very interesting article ; but my conclusion is buy the real dips ( S&P at 700-775 not at 950-1025 ) then you should do well and be patient , if it takes a year to get back down there , wait it out . Although a serious double dip is not the most likely scenario for 2010 , it's still a reasonable probability , so I will be careful . Buying now to get the last 10-15% is just too dangerous .

2009 Nov 11 05:04 PM

[LaChic]

What makes you think this “perma-bears” are not invested in the market?, just because they are bear does not mean they don't trade, actually, i think these people are more in tune with what is happening now, and by the way, i see a couple of W's in that chart.

I rather be bear than bullish with this market, it keeps me thinking and on my toes.

2009 Nov 11 07:08 PM