There have been several articles as of late discussing that the next great secular bull market has arrived. Historically, secular bear markets have averaged about 14 years, and considering that we began writing about the current secular bear market cycle in early 2000, that would put the current cycle about 2 years away from its historic average.
However, the reality is that this cycle is currently unlike anything that we have potentially witnessed in the past. With massive central bank interventions, artificially suppressed interest rates, sub-par economic growth, high unemployment and elevated stock market prices, it is likely that the current secular bear market may be longer than the historical average. In either event, we are likely closer to the end than the beginning, and the next major stock market correction will likely be the last for this cycle.
There are several fundamental reasons from valuations to the current level of interest rates that support this viewpoint. The first chart shows the inflation adjusted, or "real," ratio of the stock market (NYSEARCA:SPY) to the economy as measured by real GDP. With the economic recovery, such as it is, currently in its fourth year, the market to GDP ratio is beginning to push levels that are normally consistent with cyclical bull market peaks rather than where secular bear markets have ended.
Furthermore, secular bull markets do not begin when prices are already stretched well above their long-term growth trend. I often use the "rubber ball" analogy to express the movement of prices relative to their trends. Like throwing a rubber ball into the air -- the momentum of the throw can make it seem like it is temporarily defying the laws of gravity. However, the effect of momentum will fade as the pull from gravity increases on the ball until it reaches its maximum height. The ball will then quickly revert back to earth. The same goes for the financial markets.
The chart below shows, very importantly, that secular bull markets do not begin when prices are already trading well above their long-term growth trend. Very much like past secular bear markets -- prices can remain above their long-term growth trend for quite some time until they eventually "mean revert."
These reversions take prices to a position that is an equal distance below the long-term growth trend. As the chart shows -- if you had moved out of the market in early 2000 and gone into bonds, you would still be well ahead of those that had stayed in the stock market.
Not surprisingly, when prices are elevated well beyond their long-term trends, valuations are at levels that are normally associated with secular bull market peaks rather than the troughs where secular bull markets are usually born.
The chart below uses the Shiller Cyclically Adjusted P/E (price to earnings) ratio, which has been inflation adjusted. The immediate argument to this analysis is that some analyst on television stated the "valuations are cheap based on 'forward earnings expectations,' which are below the long-term average." There are two huge flaws in that statement:
1) The long-term median P/E as shown below is based on trailing reported earnings. Not forward operating earnings, which are full of accounting issues. This is an "apples to oranges" comparison.
2) More importantly, forward earnings are always overly optimistic by as much as 33% historically. Therefore, the valuation argument is generally wrong at the outset.
This brings us to the "stocks are cheap based on interest rates" argument. Despite the fact that prices and valuations are stretched well above their historic norms, this does not deter the media from finding some other flawed argument to try and lure "suckers"… um… I mean… investors into the Wall Street casino.
The chart below is the "Fed Model," which is the basis for the "stocks are cheap because earnings yield is higher than bond yields."
Following this model would have kept you out of stocks primarily when you should have been in, and vice versa. This is due to the intervention by the Fed to suppress interest rates to support economic growth. These suppressions have driven interest rates consistently lower over time, and have been the primary factor in the creation of one bubble after the next. Subsequently, when the Fed raises interest rates, it causes a dislocation in the markets.
The fallacy of the model is quite simple. There is no such thing as earnings yield. The earnings yield is simply the inverse of the P/E ratio, whereby corporate earnings are divided by the price of the market. However, as an investor in a stock, you do not receive the earnings yield in the form of a cash payment. However, you do receive the interest yield from bonds.
This is a very, very flawed analysis, and one that should be forever stricken from your investment valuation models.
Nothing Organic About It
No matter how you slice the data -- the simple fact is that we are still years away from the end of the current secular bear market. The mistake that analysts, economists and the media continue to make is that the current ebbs and flows of the economy are part of a natural, and organic, economic cycle. If this was the case, then there would be no need for continued injections of liquidity into the system in an ongoing attempt to artificially suppress interest rates, boost housing or inflate asset markets.
Nothing shows this more clearly than the amount of excess bank reserves, which is the direct byproduct of QE programs, which exploded higher last week by $46.4 billion.
These liquidity pushes directly correlate with market ramp ups -- not improving economics or fundamentals.
Of course, this is also why each time these programs come to an end, the financial markets face steep corrections and economic growth plunges.
Into The Danger Zone
It is with this background that we continue to harp upon the dangers that are currently building in the markets. While no two market cycles are ever the same -- they generally behave similarly over time. I have posted the following chart several times lately showing the high degree of correlation between the market bubble prior to 2007 and currently.
I expect that the chart will begin to decouple somewhat in the months ahead, as there is not a relative crisis immediately available. However, come May, when the debt ceiling issue resurfaces, or there is a resurgence of the eurozone crisis, or some other exogenous event crops up -- stock prices are likely to correct very sharply.
Using a weekly analysis to slow down the day to day volatility of the market -- the market currently cannot achieve a higher level of its overbought status. It is "pegged out," "maxed," or whatever other term you want to use to describe the extreme nature of the overbought condition that currently exists.
The next chart overlays this overbought/oversold long-term weekly indicator with a weekly chart of the S&P 500.
See the potential problem here?
The next chart shows the STA Risk Ratio indicator, which is a composite index of the rate of change in the S&P 500, bullish versus bearish sentiment, the volatility index, and a ratio of new highs to new lows. Currently, that index is approaching levels normally only seen at very significant market tops.
I could show you chart after chart after chart. They all say the same thing -- the market is extremely overbought, and is currently pushing the limits of the current upside advance.
What I Am NOT Saying
The bulk of the mainstream media's, and analysts', blathering is more akin to a parade of idiots rather than something you should actually spend your time paying attention to. Pay attention to the data.
While I have spilled an exorbitant amount of ink this week on all the reasons why the market is getting extremely overbought and into very dangerous territory -- I am not saying that you should sell everything and hide in cash.
This may sound very counter-intuitive, but the markets are being driven by the expansion of the Fed's balance sheet. Therefore, due to this artificial influence, the market can move higher, for longer, than you can possibly fathom. It will end eventually, and it will end badly.
However, in the meantime, this is how to approach the current market:
1) Do not add to equity exposure at this time, no matter how emotionally conflicted you become. Emotions lead to bad investment decisions -- always.
2) Sell some, not all, of positions that are speculative in nature and have a lot of volatility. When the correction comes, these will be hit the hardest.
3) Increasing stock markets suppress bond prices. Therefore, rotate some money into bonds, which will benefit from a stock market correction. "Buy where the money ain't goin'."
4) Hoard cash -- you can't be a buyer when things get "cheap" when you don't have any cash to buy with.
5) Rotate from very aggressive equity exposure to more defensive positions that have an income stream. (i.e., utilities, staples, and healthcare). However, these positions WILL lose money when the market corrects -- just not as much.
6) Beware of high-dividend plays, particularly REITs and MLPs. The majority of these positions are GROSSLY overbought and overvalued, and a correction of magnitude will lead to larger losses than you can currently comprehend.
7) Fundamental valuations HAVE NO bearing on a stock market correction. No matter how fundamentally strong you think your investments are, they will generally correct as much, or more, than the market. Fundamental value is only effective for eliminating bankruptcy risk. In a market environment driven primarily by programmed trading, it is only PRICE ANALYSIS that matters.
8) Did I mention hoarding cash?
9) Pay attention to the trend. The trend is currently positive, and we want to be mindful of that. It will require a VERY substantial price correction at this point before a SELL signal is issued. This is why profit taking, and keeping new savings in cash, is the best way to stay invested but reduce overall portfolio risk.
10) Just because you take profits, or sell a position today, does not mean that you can't buy it back after it corrects. That is just a good portfolio management practice. There is no successful investor -- ever in history -- that only "bought and held."
There will be corrections that are buying opportunities, and there will be corrections that aren't. Unfortunately, you will never know which is which until it is too late. This is why employing rudimentary rebalancing processes, or even basic risk management tools, in your investment portfolio will work to protect your investment principal over time. Are you going to get out at the tops and in at the bottoms? No. Are you going to be the next great market timer? No. Will you keep from setting yourself back years from reaching your retirement goals? Definitely.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.