In yesterday's Secular Bear Market Myths Part 1 we debunked the myth that a secular bear market requires poor earnings growth. In part two, we illustrate the typical price pattern of a thirteen to sixteen year secular bear market and use that pattern to provide a near term and long term Market Outlook. The market may be nearing a critical juncture. If you want to know what to expect, read on ….
A Secular Pattern
Inflation Adjusted (Real) S&P 500 Index 1953-1991
After adjusting for inflation, both the high inflation driven secular bear markets and the deflation driven secular bear markets take on a more similar form. This is especially true when a secular bear market is defined as the period between the peak and trough of the average P/E ratio. Using the numbers on the above chart we see that from the 1966 peak in the P/E ratio  (see chart of Shiller’s CAPE in first report) to the 1982 low  was sixteen years. Both the nominal and real price peak was in late 1968, thirteen years from the 1982 low. This is indicative of the typical secular bear market; a period of sixteen to thirteen years.
There are seven years between the two peaks  and  along with two major declines . After the second major decline, there is a relief rally [R], then a multi-month trading range as a period of distribution, followed by a multi-year decline to complete the bear market .
S&P Composite 1917-1951 with Present S&P 500
S&P Composite 1917-1951 with Present S&P 500
We can see a similar pattern of behavior in the deflationary bear market of the 1930’s. Yes, the market overlay in orange is our present S&P 500. We will get to that next.
Like the inflation adjusted 1970’s (and 1900-1921) the major highs and lows follow a pattern. The entire period from 1929 to 1942 encompasses thirteen years. The two major tops  and  are seven years apart. There are two major declines , a relief rally [R] followed by a prolonged sideways period, and finally a decline to complete the bear market .
The 2000 - 2016? Bear Market
Overlaid in orange on the above chart is the current S&P 500 with the P/E ratio peak in 2000 lined up with the P/E ratio peak in 1929. Not surprisingly, the peak  and troughs  all line up within a couple of months of their 1930’s counterparts. It appears the rally from the March ’09 low was the relief rally [R]. If our current S&P 500 follows the same path as these previous bear markets, we should expect a prolonged sideways period and decline to final low of the bear market sometime in-between 2013 and 2016. As illustrated in the historical chart of the S&P Composite, when this secular bear market is complete the trailing Shiller CAPE ratios should be under ten. The higher the earnings from now until that time, the less the market will need to decline to complete this period and move into the next secular bull market. Conversely, the lower the earnings, the more the market averages would need to decline to meet their sub 10 trough in the index P/E ratio.
Inflation Adjusted (Real) S&P 500 1959-1983 with Current Inflation Adjusted S&P 500
As nicely as the current bear market has fit within the profile of the past, the chart above and the chart below should serve as signs of caution not to expect too tight a correlation between past markets and the present. The patterns of past market behavior are a good guide; they help us understand the environment we are in and keep our expectations in check. But the turning points that look so perfect on the monthly charts have still been accurate only within a +/- of several months. In hind sight that does not seem like much, in real time two or three months can feel like an eternity.
Also, each secular period is unique, and the market will respond to that uniqueness in a manner different than what our past market roadmaps might lead us to expect. For example, when we line up the current market with the 1966 P/E ratio peak (above), although the major turning points line up, there is a unique rally peak in 1968 (see above chart). That difference can be explained by the difference between inflation and deflation based bear markets. But, for now, the current environment is not completely identical to either the pure inflation or deflation periods.
Obviously, current inflation is not the least bit similar to the 1970’s and despite deflationary pressures; this is not the Great Depression. We do believe that this cycle will have more in common with deflationary cycles than inflation. If we look back again at the P/E chart on (reposted below) we can see that secular bear markets have cycled between a falling interest rate and falling P/E environment, and a rising interest rate falling P/E environment. The current economic background is more similar to the deflationary period. In previous Market Updates we have illustrated how, since 1998, the intermarket correlations have been indicative of a market that fears deflation more than inflation, which fits very well with this cycle.
P/E Ratio (CAPE) for US Equities and Long Term Interest Rates: source RJ Shiller
NASDAQ Composite Aligned with Nikkei 225 1984-2010
Japan is another example of a deflationary bear market. We have shown the above chart before, with the overlay of the NASDAQ Composite matching the year 2000 peak of the NASDAQ and the 1990 (December 1989) peak of the Nikkei 225. The major turning points fit very well with the pattern, but the volatility between the turning points is very different. For example, where our S&P Composite model suggest a modest decline followed by a sideways period (after [R]), the Nikkei 225 collapsed without pause. It is very unlikely that the NASDAQ Composite will decline at same rate with which the Nikkei 225 declined at this stage of their bear market. It is more likely that the sharpness of the Nikkei’s decline from 2000 [R] to 2003  will be a feature unique to their bear market. We should also note that it is apparent from our model that Japan’s bear market should have been complete in 2003 . The Nikkei’s rally from the 2003 low to 2007 high was an astounding 140%! But, the decline that followed, and the current persistent deflation shows they have not yet pulled themselves out of their economic bear market. Is this because of incorrect monetary or fiscal policy decisions? Have we made similar policy mistakes? We don’t know and won’t know until after the fact.
Thus, while we have a good road map to follow, we must still diligently monitor our indicators and market conditions. It is more important to follow what the market is doing, than what it should do relative to any predictive model.
Short Term Outlook
The above pages were originally written in June, 2010. The addendum below is a short term outlook as of September 19, 2010.
Since July, we have been using the above price pattern of the NASDAQ 100 as it topped in the year 2000 as our guide to the to the current price expectations. Interestingly, the NASDAQ 100 in 2000 even had a mini-Flash Crash as the same time (relative to its top) we experienced this year. So far, this model has worked surprisingly well, but we must emphasize that current behavior will deviate from this historical pattern at some point in the near future. When it does, whether the current market is stronger or weaker will be sending us a message. It should also be noted that each rally in the NASDAQ 100 in 2000, and the current DJIA, broke just above a previous high before failing. For now, the model suggests a market top in early October, which is similar to our other timing models that indicate the late September and very early October time period, is a high probability for a market high. Our expectations are for the market to decline to a test of the August or July low. We will be monitoring other behavior to determine if this is the move that will take the market out of its trading range. In past secular bear markets the prolonged trading range that followed the Relief Rally [R] lasted between ten and eleven months. The current trading range is only half that old.
In the months or years ahead, some areas of the market will likely fall to below their March ’09 low. Some will hold their value, while even others will begin their own new bull market long before the major indices. Our job, our mission, is to identify the major turning points in a timely fashion and identify those stocks and sectors that will perform the best and those that will perform the worst in the months ahead.
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