This is part one of a two part report derived from our weekly Market Outlook as published on June 04, 2010. In this report we discuss two secular market myths and then detail the price pattern historically consistent with past secular bear markets, and how we expect the equity market to perform in the months and years ahead.
There are two myths about secular bear markets that persist even after ten years of living through one. The first is that secular bear markets are periods of generally poor or even declining earnings, and thus most secular bull markets are the result of stronger earnings. Second is that most secular bear markets are typically thirteen to sixteen year periods of trendless sideways price action.
How can it be that higher earnings don’t always advance the equity market?
A secular bear market has little to do with earnings. During the 1900 to 1921 bear market, a period of no net gain in equities, and where stocks oscillated between declines of 30% to 50%, earnings grew by 63%. In the secular bear market from 1966 to 1982 earnings grew by more than 250% while the major equity indices posted no net gain for more than a decade, all the while being cursed with multiple corrections of 20% to 50%.
The difference between the top of a secular bull market and the bottom of a secular bear market is investor mood. At the end of a secular bull market, equities are the investors’ investment of choice. Equities will send their children to college, build their retirement, and afford them a better lifestyle. On the other hand, secular bear markets are prolonged periods of time where investor sentiment toward equities deteriorates. By the end of a secular bear market, only a fool would own equities for the long run. Equities are for gamblers, their ability to profit a crapshoot. By the end of the secular bear market, investor mood has reversed 180 degrees from the peak of the secular bull. It is this cycle of deteriorating mood and the resulting declining demand for equities that leads to the long slow decline in the broad market price to earnings ratio (P/E) and prevents a long term rising trend in equity prices.
In the year 2000 we witnessed the shift in mood as investors traded in expectations of wealth through internet stocks for wealth through real estate. That was the beginning of the shift away from equities as THE investment of choice. Like equities, the secular uptrend in real estate ended with investors believing it would be their ticket to guaranteed prosperity. While equities are still an important part of investor total assets, after two severe market declines in less than ten years, and market averages struggling to regain past highs, we have already witnessed the beginning of a trend of investment flows into the guaranteed return of US Government Bonds. As we will detail later in this report, with at least three to six years left to the current secular trend, investor mood toward equities should continue to erode for some time to come.
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P/E Ratio (CAPE) for US Equities and Long Term Interest Rates: source RJ Schiller
With the above chart of RJ Shiller’s Cyclically Adjusted P/E Ratio (CAPE) and Long-Term interest rates it is easy to identify the peaks and troughs of investor mood over the past one hundred and twenty plus years. Just as secular bear markets are defined by declining P/E ratios, secular bull markets are driven by expanding earnings multiples, typically over a multi-decade period. Even if we knew nothing of corporate earnings trends, we can identify secular bull and bear markets using only the P/E information in the above chart. Secular bull and bear trends are not about corporate earnings; secular trends are driven by investor mood and long term market expectations. The Cyclically Adjusted P/E ratio is an ideal long term measure of investor mood. When the mood is positive, investors drive the P/E ratio to a secular high. When the mood is negative, waning interest in equities erodes the P/E ratio to a secular low.
The Second Myth
Regarding the second myth; when we hear discussions of secular bear markets, those comments are most often accompanied by a reference to the 1970’s market illustrated in the first chart below. It should be of interest that the second chart below, which is of the 1900-1921 bear market, is very similar to the 1970’s bear; a long sideways grind in nominal equity prices with no net gain over the long term but, sharp declines every few years.
We believe it is important for investors to understand that what makes these two periods in time so similar is what makes them so different from our current environment. The 1970’s and early 1900’s (pre-1921) were periods that included high inflation and rising interest rates. It is the high inflation and rising interest rate environment that makes these two secular bear market periods look alike, tame and boring on a nominal basis. However, when the inflation rate climbs between 6.9% and 13.3% each and every year, as it did from 1973 to 1981, the nominal return doesn’t reflect true index or investor performance.
S&P Composite 1900 - 1931
S&P 500 1953-1990
Inflation Adjusted (Real) S&P 500 Index 1953-1991
The chart above illustrates the real monthly return of the S&P 500 after adjusting for inflation. Rather than a flat market with a low in 1974, the real return declined by nearly 70%, and the value of the index was lower in 1982 than in 1974. If you haven’t seen an inflation adjusted index, take a moment to compare the above chart with the nominal return chart illustrated on the previous page. When we think of how difficult it must have been to watch everything go up in price except your investments, we can understand how sentiment deteriorated to the point where so few investors wanted to participate in the equity market.
In tomorrow’s part two of this report we will discuss in detail how the numbered price pattern in the chart above is the historical pattern of a secular bear market, and show where the U.S. equity market is now and what is yet to come.
Disclosure: No positions