The almost relentless advance in stock prices off the lows registered during the spring of 2009 continues to frustrate the bears and though the resulting underweight position in equities has proved beneficial to investment performance over a horizon of four to five years, it is beyond dispute that watching from the sidelines in recent quarters can only be described as an error of judgement.
It comes as no surprise that the major stock market averages have bounced from the somewhat extreme levels of two years ago, but the magnitude of the recovery has been totally unexpected and has caused even the most ardent pessimists to question whether the secular bear that commenced during the spring of 2000 is over. Perhaps a satisfactory answer to this pertinent issue can be gleaned from the annals of history.
The term ‘secular’ derives from the Latin word ‘saeculum’ meaning ‘long periods of time,’ and scholars of financial history will be aware that over the past two centuries, the stock market has alternated for extended periods between bull and bear market regimes in which real returns have been exceptional and uninspiring respectively. The historical record shows that the major market averages have spent roughly half of the past two hundred years in a secular bull market in which the median real return has been 12 ½ per cent, and the remainder in a secular bear in which the median real return has been below zero.
Secular bear markets are precipitated by movements away from price stability towards inflationary or deflationary regimes and are characterised by greater economic volatility with downturns in business activity both more frequent and severe than those experienced in a more stable macro environment. The greater frequency and severity of economic recession means that cyclical declines in stock prices of 20 per cent or more typically occur every three to four years as compared with every eight to nine years during secular bull markets. Furthermore, the increased volatility of corporate cash flows precipitates a long-term downtrend in valuation multiples, as the dollar amount investors are willing to pay for a unit of trend earnings declines.
Real stock market returns approximate zero during secular bear markets, as the drop in valuation multiples and the accompanying decline in real prices erases the return on reinvested dividends. Indeed, the multiple investors were willing to pay for a unit of trend earnings dropped from more than 20 times in 1901 to just seven times in 1921, and the resulting decline in real prices erased more than half a century of capital gains; the secular bear from 1929 to 1949 saw multiples drop from 31 to seven times and real prices bottomed at levels first registered in 1924. The decline in multiples during the 1966 to 1982 bear was similar to 1901/21 and prices were no higher at the bottom in real terms than at the market’s peak in the autumn of 1929.
How does the current incarnation compare to its predecessors? The decline from the previous secular peak in the spring of 2000 to the market’s low two years ago was of a similar magnitude to previous bears, but it must be noted that the valuation excesses at the beginning of the current episode were far greater than anything seen before.
The multiple investors attached to trend earnings dropped from more than 40 times at the height of the technology bubble to just 12 times as the financial system threatened to implode two years later. However, the low valuation was several multiple points higher than prior secular troughs and the number of year’s capital gains lost came to 14, substantially less than previous episodes. Furthermore, the duration of the current long-term bear has been relatively short by historical standards, while the number of cyclical blows to the market’s performance has been relatively few. Thus, the historical evidence would suggest that the secular bear is not over.
Perhaps this time is different and a new secular bull began in earnest during the spring of 2009. However, the speed with which valuation multiples moved to more than 20 times trend earnings after the most recent market debacle suggests that investors can still look forward to nothing better than mediocre long-term returns. In this regard, it is worth noting that following the end of previous secular bears, it has taken years and not months for valuations to reach today’s nosebleed levels – eight years from 1921 to 1929, 17 years from 1949 to 1966, and 13 years from 1982 – and importantly, in each case, the secular bull was closer to its end than its beginning.
The bulls may well argue that the surprising surge in corporate profits despite a lacklustre economy, suggests that earnings warrant a higher multiple. Indeed, the facts reveal that real earnings bottomed during the third quarter of 2009 at levels first reached three decades ago, and in just 18 months have recovered to within touching distance of a record high.
This is undoubtedly an impressive development, but for investors to purchase the stock market at current valuations, they must believe that trend earnings have experienced an upward shift such that near-record profit margins can be sustained indefinitely. Such thinking assumes implicitly that the same Federal Reserve that presided over the ‘Great Recession’ can return the economy to a state that mimics the best of the ‘Great Moderation.’ Dangerous thinking indeed!
Careful analysis suggests that the secular bear market is not yet complete, though momentum – the primary driver of short-term performance – clearly sides with the bulls for now and may see prices move higher. However, mean reversion – the key determinant of long-term returns – is a powerful foe that inevitably overwhelms short-term considerations. Those who play in an overvalued market should be aware that they may well be seen as the ‘Greater Fool.’