I am still on alert for a larger pullback in the market. The larger picture suggests the SPX will li...
Why even after a 70% gain this is still a secular bear market
02/19/2010 9:30 am EST
Even though stocks, measured by the Standard & Poor’s 500 Stock Index, were up 70% from their March 9, 2009 low to their recent high on January 19, 2010.
Yep. Yes indeed. Absolutely.
If by bear market you’re talking about what’s called a secular bear market.
Strong market rallies—even three to four year cyclical bull markets—can take place inside a longer bear market trend. And despite the bull rally the long-term trend can remain pointing very strongly downward.
I think that’s exactly where we are now: in the midst of a strong cyclical bull rally that’s taking place in a long-term bear market down trend that began in March 2000 and could have another five to 10 years to run.
I raise this question and answer it this way not to scare you out of the market. Remember that even if this is just a cyclical bull market rally inside a larger downtrend such a rally can go on for as long as three or four years. (Although a cyclical bull is by no means guaranteed to go on for that long.) I don’t want you to jump ship just yet.
But I think understanding that we’re in a cyclical bull market rally inside a longer-term secular bear market is the best way to explain why this stock market feels the way it does, why so many investors still doubt this rally even after a 70% gain, and why it has been so hard to go along for the ride.
That feeling like it’s all going to end badly? Perfectly normal and likely as not to be correct in the longer-term if this is still a secular bear market
Okay, so what this “secular” and “cyclical” stuff? How can the current market be both a bear and a bull market?
The easiest way to explain that is to take a look at the last great secular market trend, the secular bull market that began in 1982 and ended with a huge thud in March 2000.
On March 26, 1980 the S&P 500 index hit a low of 98.68. Stocks spent the next two years and more going first up to 138.31 by November 24, 1980—a 42% gain—and then back down to 102.84 on August 10, 1982. That almost matched the 1980 low. Almost. But instead it was a successful test of that March 1980 low—the August 1982 low wasn’t as low as the 1980 low.
And it marked the beginning of a new secular bull market that would take the index from 102.84 in August 1982 to a high of 1527.35 on March 23, 2000. That’s a gain of 1309%.
That doesn’t mean that great secular bull market was never interrupted by something that felt very much like a bear market. (You know big teeth, sharp claws, etc.)
For example, from July 20, 1998 to October 7, 1998, the S&P 500 index fell 18%. And from July 13 1990 to October 11, 1990 the index fell 18%.
Those drops lasted just a few months and stocks quickly recovered the ground they’d lost. The bull market trend continued.
But the bull was punctuated by longer and more vicious bear markets. The most famous of which was the crash of October 1987.
The stock market peaked that year at 336.77 on August 1987. It then wobbled for a month, hitting 314.89 on September 16. Righted itself to climb back to 321.69 on September 30. And then plunged off a cliff in October. The worst day, October 19, took the S&P 500 down to 224.84 in a terrifying 20% drop in just one day. Stocks meandered lower into December when the S&P 500 hit 223.92 on the fourth for a 34% drop from the August high.
The stock market then steadily picked up ground off that low. But it still took the S&P 500 index until July of 1989 to match its August 1987 high.
Two years to crash and then recover. But even that didn’t end the secular bull. That great climbing market had more than another decade to run.
That’s because secular bull and bear markets are built on really strong underlying fundamental trends.
In fact I’d argue that it’s the evidence of that strong underlying fundamental trend that’s the easiest way to identify a secular bull or a secular bear.
For example, the secular bull market that began in 1982 was built on a twenty-year decline in U.S. (and indeed global) interest rates.
In 1980, the set up for the secular bull, a 10-year Treasury paid a yield of 11.43%, according to the Federal Reserve. In 1981 that yield climbed to 13.92%. By 1982 the yield was down to 13.01%.
Year after year, for one decade and into the next, interest rates fell. By 1992 a 10-year Treasury paid 7.01%. In 1998 the yield was just 5.26%.
That’s a drop of 8.66 percentage points in 17 years. Just for comparison a 10-year Treasury paid a yield of 3.66% on February 16. In those 17 years from 1981 to 1998 the yield on 10-year Treasury saw a drop equal to about three times today’s total yield.
What happens when interest rates fall by this large a margin?
All things being equal, economic growth picks up. Capital to start new business and to expand existing businesses is cheaper. Earnings climb—not just because of faster economic growth but because companies use cheap debt to leverage their balance sheets rather than diluting earnings by issuing more stock to raise capital. Stock prices go up because earnings go up—and because falling interest rates make bonds and other interest-paying investments less attractive in comparison to equities. Wages (well, wages after inflation anyway) rise along with the economy. That plus cheap money encourages consumers to leverage their own balance sheets. Home equity and credit card use climbs. Productivity increases as companies use cheap capital to add machines and tools that make workers more productive.
A lot more went into the foundation of the great bull market of 1982 to 2000—the expansion of global markets, for example, added to the world’s rate of economic growth, but you can see the results in the rate of U.S. GDP growth for the period.
In 1980 the U.S. was in recession and the economy shrank by 0.3% in real terms. (That is after taking out the effect of inflation.) Growth gradually picked up so that for the last five years of the decade the real U.S. GDP grew by an average of 3.7% each year. After a brief slowdown in 1990 and 1991 (and an even briefer recession), real GDP grew by an even faster 3.8% a year on average for the rest of the decade.
Any real wonder then that the corrections and the 1987 crash weren’t enough to derail this great long secular bull market? Or that stocks gained 1309% during that 18 year period?
The great secular bull market came to an end as it (and the economy) ran out of interest-rate fuel. Yields on 10-year Treasuries actually kicked up in 1999 and 2000, going from 5.26% in 1998 to 5.65% in 1999 and 6.03% in 2000 before the Federal Reserve started to lower them again in response to the stock market collapse that began in March 2000. The Greenspan Fed cut rates and kept them low.
You know how that ultimately turned out.
Contrast where we are now in 2010 on these fundamental trends with where we were in 1982.
Interest rates on the 10-year Treasury hit 3.26% in 2009 and are headed up, not down, with time. Inflation, which was coming down in the 1980s threatens to rise in the years ahead. Companies and individuals rather than adding debt to leverage corporate and family balance sheets are deleveraging by cutting debt. Economic growth is likely to be below trend for the typical recovery from a recession and then to continue at a lower rate of growth because damage to the financial system will lead to reduced liquidity and higher interest rates, and because consumers and companies are building up cash to pay down debt loads. The buildup in global manufacturing capacity that cheap money encouraged has led to an excess of capacity in many industries and that will depress profits. (See my post on why this will be a profitless recovery http://jubakpicks.com/2010/01/19/get-your-portfolio-ready-for-the-profitless-global-economic-recovery/ )Rising interest rates will make stocks gradually less attractive to investors than yield-paying instruments. National balance sheets, damaged in “fixing” the crisis will require either budget cuts or higher taxes that will cut into growth. (For more on the global balance sheet see my post http://jubakpicks.com/2010/02/09/honey-we-bankrupted-the-kids/ )
You get the picture. On the fundamentals of the U.S. economy and the economies of many of the world’s developed nations investors in those stock markets are looking at the conditions for a prolonged secular bear market.
Pretty depressing. If this secular bear market lasts as long as the last secular bull market, we’re only a little more than half way through it.
Two wild cards to that forecast, one negative and one positive.
First, the bad news. This secular bear market hits just as global aging is accelerating. Countries with older populations grow more slowly on trend anyway, but there’s really no telling how much growth will be reduced by a rapid reduction in the working population and a rapid rise in the post-65-year old population. At the least, caring for an aging population will eat into the world’s reservoir of savings and could well make capital, already set to rise in price, even more expensive.
Second, the good news. The global economy is much different than it was in 1980. Then the world’s developed economies were pretty much the only economic game in town. And the kind of trends that I’ve outlined in my secular bear scenario would have guaranteed a global slowdown in economic growth and in stock market performance.
But this isn’t 1980 and the economies of the developing world are of a size to have an impact on global growth. I doubt that China, India, Brazil, and the rest of the gang can totally make up for the slowdown that I think is in the cards for the world’s developed economies, but those economies will make a difference.
The developing world won’t grow as fast if the developed world slumps, of course, but these economies now have significant domestic markets that can provide an engine of growth even if the developed world is dragging its feet. (For the limits to that engine, at least in China, see my post http://jubakpicks.com/2010/02/02/can-the-chinese-consumer-save-the-global-economy/ )
I don’t think the secular bear market fundamentals that I laid out above come as a surprise to most investors. We know how badly the global financial crisis damaged the world economy and especially the economy of developed countries. We know how badly the credit binge damaged corporate and consumer balance sheets. We have a pretty good idea that we’re in a deep, deep hole even if we can’t yet determine the exact dimensions of the hole.
It’s that knowledge of the long-term fundamentals that make so many of us so leery of the current cyclical bull market. We can see the light at the end of the tunnel and we’re pretty sure it’s a train about to run us over. If you can hear the train approaching, it’s hard to relax and enjoy today’s party.
If this is where we find ourselves as investors now—in a cyclical bull inside a secular bear—what do we do about it? I’ll tackle that teeny, tiny problem in a post next Tuesday, February 23.
Full disclosure: I don’t own shares of any company mentioned in this post.
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