It's been tough out there for stock investors. But when making this statement, I'm not necessarily focusing on the last few months. Instead, I'm thinking about the last thirteen years.
Suppose I woke up on the morning of April 8, 1999 and decided to invest in an S&P 500 Index (SPY) fund. A mere 3,320 trading days later, the value of my investment on a price basis is DOWN by -1.1%. Along the way, this same investment had been up as much as +19% as recently as five years ago and down as much as -50% just over three years ago. This has hardly been a rewarding experience from a risk-adjusted return perspective.
The turbulent experience for stock investors over the last decade and more begs an obvious question. That is, when will we finally reach a bottom in this seeming endless cycle and begin a new sustained bull market?
Several key developments are likely before we will be able to finally declare the end of the current secular bear market. And one key factor has accompanied the end of each of the past secular bear phases over the last century.
A true wash out of stock valuations will signal that we have finally reached a stock market bottom and that the beginning of a new secular bull market can finally get underway. And at present, we likely still remain a couple of years removed from this concluding destination.
Many analysts often remark that stocks are inexpensive from a historical valuation perspective with the 12-month trailing P/E on the S&P 500 at 14.9x earnings. I would strongly contend, however, that such a conclusion is misguided when delving deeper into the details of the market.
Certainly, stocks appear inexpensive when viewed exclusively over the last thirty years when the average 12-month trailing P/E on the S&P 500 has been a healthy 21.9x. But this recent time period was defined by two critical factors that were supportive of higher than normal valuations but soon may no longer be so.
The first is price stability characterized by a consistently low and positive inflation rates. This is beneficial for valuations as such an environment promotes greater earnings predictability and the ability to earn a positive real return on investment. But one of the primary characteristics of the current crisis is a desperate effort by global central banks to ward off a chronic deflation problem with tools that could lead to spiraling inflation. And pricing uncertainty undermines operational predictability and causes investors to be less willing to pay for each dollar of earnings, hence lower valuations.
The second was the rapid escalation of leverage. Due to increasingly relaxed regulations over the last few decades, private sector institutions were able to dramatically dial up leverage ratios with the resulting additional funds pouring into capital markets. And when this increased leverage ultimately resulted in the demise of several systemically important financial institutions several years ago, the source of this leverage shifted to the public sector in a frantic attempt to prop up already inflated asset prices. Given that excessive leverage at the household, financial institution and sovereign level remains at the rotting core of the ongoing crisis, a major deleveraging cycle is necessary to finally put the current situation behind us.
Viewed from this perspective, stocks remain considerably overvalued. Using history as a guide, the average trailing 12-month P/E ratio on the S&P 500 from 1900 through the present is 15.7x. And at present, the P/E ratio on the S&P 500 is 14.8x, which implies the stock market is just below fair value from an overall long-term view. But we are currently in a secular bear market. And the average trailing 12-month P/E ratio on the S&P 500 during secular bear markets since 1900 has been 12.9x.
The more important focus, however, is the final depths that valuations reached before a secular stock market bottom was ultimately achieved. Near the end of the 1901-1920 inflation-then-deflation secular bear market, the S&P 500 P/E ratio dipped as low as 4.9x earnings. At the end of the deflation-then-inflation driven secular bear market from 1929 to 1949, this same P/E ratio plunged to 6.2x earnings. And at the conclusion of the stagflation driven secular bear market from 1968 to 1982, the stock market P/E ratio dropped as low as 7.3x earnings. Applying a long-term trend line to the valuations bottoms associated with the last three secular bear markets to the likely deflation-then-inflation scenario today implies that we would need to see the current 12-month trailing P/E ratio decline to 8.4x earnings before we reach a final bottom in the current cycle.
It is also notable that these long-term secular bear market bottoms in valuation have occurred with a fairly consistent periodicity of 379 months and 395 months between the last three valuation bottoms. At present, we are 360 months from the last secular bear market valuation bottom in 1982. If this periodicity were to hold once again, this implies a final wash out in valuations would occur anywhere between late 2013 and early 2015.
Of course, the bottom line question tied to any valuation wash out is its implications for the stock market price level. If the final cleansing in valuations were to come to pass during the time period outlined above, this would imply stocks falling to a range of 750 to 850 on the S&P 500 before setting a final bottom. Interestingly from a technical perspective, such an outcome would also result in a major head-and-shoulders bottom pattern for stocks, with a final correction in this range effectively matching the shoulder set during the late 2002 / early 2003 bottom.
The expectation for another major correction in stocks before the secular bear market concludes highlights the importance of remaining hedged in a broader portfolio strategy. Maintaining an allocation to stocks is still worthwhile, but positions are best viewed with a tactical perspective and limited holding period time horizons. And depending on prevailing conditions, this can imply portfolio stock weightings falling close to zero at times. Given the potential risks and instabilities at present, my only two remaining stock positions are McDonald's (MCD) and Tootsie Roll (TR), both of which are conditioned to hold up relatively well given a sharp market pullback.
Instead, portfolio allocations remain focused beyond the stock market in the current environment. Agency MBS (MBB) is a worthwhile holding not only for its price consistency and attractive income characteristics but also given the fact that this area of the market is likely to be the focus of any upcoming Fed chatter about additional stimulus. Other positions also offer the potential for steadily positive price performance regardless of what the stock market is doing at any moment in time. These include U.S. TIPS (TIP), Build American Bonds (BAB) and Municipal Bonds (MUB). To directly position against a fall in stock prices, Long-Term U.S. Treasuries (TLT) continue to offer the most attractive risk-adjusted way to establish a short position against the stock market. And both Gold (GLD) and Silver (SLV) continue to offer appeal as protection both against potential inflation as well as crisis.
Both the global economy and its stock markets will eventually undergo the final cleansing required to bring the secular bear market to an end. And a major contraction in stock valuations will be a key signal that this process is underway. Once this occurs, the time will finally come once again to reengage the stock market in a far more meaningful way. In the meantime, maintaining portfolio diversification and applying hedging strategies provides an ideal way to generate consistent upside while managing risk 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.