>Are You Ready for Another Lost Decade?

In April 2003 we published an article which posed the question, “Whither the secular Trend of Equities?” This piece laid out the case that the year 2000 was a secular or “long-term” peak for the U.S. stock market. Th e article also forecast that equity prices would experience a wide multi-year trading range as sentiment unwound from the unrealistic assumptions that pushed price earnings ratios and dividend yields to record extremes. Many investors and members
of the fi nancial press are only now recognizing that stock prices have lost ground over the last 10 years, labeling this period as the “Lost Decade.” Not only have equities been unable to make any net progress in that time, but they have actually lost value in purchasing power terms. Given the sharp 2009 rally, one of the strongest on record, it makes sense to re-open the question of whether investors should revert to a buy hold approach or continue to apply the tactical asset
allocation strategy that has worked so well in the last 10 years. Before we address that question, let us fi rst defi ne what we mean by a secular trend.

What is a Secular Trend?
A long-term secular trend is formed when a series of business cycles are linked together establishing extended periods of stock market out- or under-performance. Th ese long-term secular price trends last up to 20 years and sometimes more. Investors need to correctly identify the direction of the prevailing secular trend if they are to successfully protect and grow wealth. Th at is because the tide of a secular bull market lift s all boats as investors are quickly bailed out of their mistakes. Anyone who adopts the buy/hold approach might be a temporary hero but the secular bear proves that the emperor has no clothes. Risky strategies may work in a secular bull market, but only defensive cautious ones will enable you to preserve real purchasing power during a secular bear.

Characteristics of Previous Secular Bear Markets and Where We Are Today
Secular bear markets are characterized by several factors. Th e most important is a complete reversal in psychology from the euphoria and over confi dence of the previous secular bull, to one of total disgust with equities by the time the bear has run its course. Unfortunately this is not an overnight process, but requires prices to experience a huge drop over an extended period. Th e large decline is obviously discouraging as investors see their wealth being slowly eroded. However, it is the extended duration of the drop in real purchasing power that slowly eats away at the confidence of even the most optimistic investors. Experience has shown that in order to correct the structural distortions built up in the previous secular bull, it was normal for the economy to undergo between four and six recessions before the bear is finally laid to rest.

We’ll examine the psychological aspects fi rst by considering valuation, not as a fundamental measure, but as one of sentiment. Arguably the most popular long-term measure of stock market valuation is the price investors are willing to pay for corporate earnings. Why at one time are fearful investors only willing to pay $6.64 for $1 of earnings, (i.e. 1982 Secular Bottom) while at another time investors are eager to pay $44.20 for that same $1 of earnings (i.e. 2000 Secular Peak)? Th e answer lies in the extremes of confi dence or lack thereof only seen at major secular turning points.

Take a moment to look at the Shiller P/E series at the bottom of Chart 3*. Th e key turning points are summarized in Table 1. Notice that at the beginning of secular bear markets the average P/E ratio is 31.5; in contrast the average at the end of these periods is 6.95. Th e current (October 2009) Shiller P/E reading is 18.77. We may have traveled a long way from the 2000 historic overvaluation peak (P/E 44) but clearly there is a long way to go to reach truly undervalued levels once again.

Does Inflation Have an Effect on the Secular Trend?
Th e long-term trend of commodity prices appears to have an enormous eff ect on the direction of the secular trend of stock prices adjusted for the CPI. Th is relationship is shown quite clearly in Chart 6. Th e series in the upper panel represents stock prices defl ated by the CPI since 1871 and industrial commodity prices prior to that date. The secular bear markets since 1850 have been fl agged with the dashed red arrows. It is fairly evident that all of them have been associated with a background of rising commodity prices. Th e relationship is not an exact tick by tick correlation but the chart clearly demonstrates that a sustained trend of rising commodity prices sooner or later results in the demise of equities. Th ere was one exception to this relationship and that developed in the 1929-32 bear market where commodities and equities both fell due to the collapsing economy. Aft er that, sharply rising commodities resulted in a trading range for equities until 1949. By the same token, the solid green arrows show that a sustained trend of falling or stable commodity prices is positive for equities as all six secular bulls developed under such an environment. Th is point is also underscored by the opening decade of the last century. It has been labeled a secular bear, but real equity prices were initially quite stable as they were able to shrug off the gentle rise in commodities. Only when commodity prices accelerated to the upside a few years later did stock prices adjusted for infl ation sell off sharply.

To read the full report: ANOTHER LOST DECADE