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Stock Cycles

Progress of the secular bear market: position as of March 31, 2009

Years into Secular Bear market
The value for R is 1570 as of April 2010. For S&P500 of about 1190 this gives P/R of 0.76.

Progress Update on the Current Secular Bear Market

The market has risen strongly my last update on November 20, 2008. Retrospectively, buying on that day was good strategy. The reason I gave for buying at the time was as follows:

Based on the 752 close on 20 November 2008 (see blue cross in figure) we are essentially already at the bottom. Based on the latter assessment, I pulled the trigger and deployed most of my cash into the S&P500 on 20 November 2008.

I did not actually buy at the bottom, it would have been even better to wait and buy in March, 2009. Of course there is no way to know to forecast a market bottom (or top) in real time; such turning points are only identified retrospectively. Only now that a consensus has formed that a double dip recession capable to sending the market down below the March 2009 is not going to happen has the March 2009 bottom been reasonably confirmed.

So what I was saying was that the price was low enough that the market was attractively priced. For stocks, an attractive price is one that is below the vast majority of prices in the near future, allowing the future sale of the stock at a profit. Whether or not a stock is attractively priced is then something that can only be determined in retrospect. I can now say that that the S&P500 on November 20, 2008 was truly attractively priced because I bought it then and enjoyed substantial gains since then.

What we would like is a method to assess whether or not the S&P500 is attractively priced at the time when we would like to buy it, not a year and a half later. That is, we would like a way to "value the market". Nine years ago I addressed this question and concluded that price to resources (P/R) gave the best assessment of value. Since that time I have plotted P/R valuations for this secular bear market along with those from four previous secular bear markets. The graph above shows that the current secular bear market is unfolding much as three of the four other ones have. The exception is the 1881-96 secular bear market, which never showed low values of P/R like the other three have. With the 2008 stock market collapse, the current secular bear market has joined the other three secular bear markets; P/R has fallen below the minimum value seen in the 1881-96 secular bear market. This bear market can no longer be considered as relevant for historical comparison. So in the subsequent discussion I will exclude the 1881-96 secular bear market in my comparison.

Figure 1. Five-year returns starting in secular bear markets as a function of valuation
P/R Relative to Start P/R

Figure 1 presents actual real returns over five year holding periods that began during the three 20th century secular bear markets as a function of valuation. A total return index for the S&P500 was constructed and adjusted for inflation to give real return. For each month in a secular bear market a value of P/R was determined. This value was divided by the value of P/R at the beginning of the secular bear market to put values for different secular bear markets on the same scale. The value of the total return index five years after that month was used to calculate the annualized return over that five years. This value was plotted against relative P/R in Figure 1.

Figure 1 shows if you buy the S&P500 when relative P/R is above 0.55 or so, the expected return over the next five years would about zero. The market is priced "high" at these levels. Figure 1 also shows that if you buy when relative P/R is below 0.4, significant positive gains are expected. The market is priced "low" at these levels. The value of P/R at the beginning of the current secular bear market was 1.47, which gives corresponding P/R values of >0.8 for high-priced and <0.59 for low-priced. R had a value of about 1550 in fall 2008. Multiplying these P/R values by 1550 gives an S&P500 index value above 1250 as high-priced and below 900 as low-priced in fall 2008.

Until the collapse in fall 2008, the market was high-priced. It then fell briefly below 900, rose and then began a sharp collapse which ended on November 20. On this day the S&P500 closed at 752, which is a P/R of about 0.48 or 0.33 relative to the start P/R of 1.47. Figure 2 shows an expected an annualized real return of around 10% for this valuation. A ten percent real return over five years translates to nearly 70%, assuming a very low 1% inflation rate. My 54% return in less than two years shows I am well on my way to achieving this expected return.

R has not changed significantly since fall 2008. This means the same value for high (>1250) and low-priced (<900) still apply today. With an S&P500 of nearly 1200, the market is a lot closer to high than low. This would suggest that it is too late to buy today. But the analysis presented so far is based on averages. As Figure 1 shows there is a lot of scatter in the data. Table 1 presents the same return data in a different way. Here subsets of previous secular bear markets were selected that had values of relative P/R close to that of today and to those of the November 2008 to March 2009 period.

Table 1. Minimum expected returns today and at the recent lows as a function of probability
Probability Now Nov 08 - Mar 09
3 yrs 5 yrs 10 yrs 3 yrs 5 yrs 10 yrs
90% -10.3% -4.0% 1.8% 0.50% 2.7% 5.0%
75% -7.8% -1.7% 2.5% 2.6% 3.9% 6.3%
50% -2.8% 1.0% 4.0% 5.6% 7.4% 8.5%
25% 0.5% 4.0% 6.0% 7.4% 9.3% 10.6%
10% 10.8% 8.6% 7.9% 13.0% 11.4% 11.9%

Table 1 shows that when I bought, I had a 90% chance of seeing a 0.5% or better real return over the next three years. Over longer periods this 90%-probable return is higher. This means that it was very unlikely that my investment would be underwater three years later, although over shorter periods this could happen (I fact it did happen in March 2009). And even if the worst happened and I got a poor return over the next three years, over ten years my return would almost certainly be OK. Table 1 also shows that buying at today's higher valuations entails more risk. There is a good probability of losses over the next three years, which will likely be rectified over more time.

This analysis presents a pretty grim picture for investments made today or in the future if the market continues to rise. This grim picture is more a limitation of this analysis than a prediction. Since we are likely at the beginning of a multiyear economic expansion, the market will very likely rise over the next several years. In this case stocks today are surely a better prospect than they were at similar levels in 2008. But the analysis presented above treats a 1200 level in the S&P500 in fall 2008 exactly the same as one today. Since the latter occurred just before a recession and the latter occurred after a recession they are clearly different.

This is why I have focused so much on the structure of a secular bear market, looking at where the market at a given point in the secular bear market. Indeed I used such a structure as my argument for why I bought in November 2008. On that day, the market reached a level equal to the projected bottom for the second ordinary bear market in a secular bear market, which implied that a strong return would be seen from that bottom. And indeed this is exactly what happened.

But this sort of timing-based analysis is risky because it can prevent one from selling. As I pointed out back then, my structural model for this secular bear market called for a top in 2008, not 2007 and at a level above the level of 2007. Thus, I did not sell my positions in 2007 and the money already in stocks in 2007 has produced a loss from that point, which partially offsets the gain from that well-timed investment in November 2008.

Also, the effectiveness of this approach diminishes as you penetrate deeper into the secular bear market. Using the methods presented here, one can get a pretty good idea when stocks become attractively valued during a secular bear market and so one can "call" the bottoms as I did for the bottoms in 2002 and 2009. These methods have no use for determining when to sell. The method to do this is based on the timing of the shorter cycles within the secular bear market. All the historical secular bear markets start out aligned: the beginning of the secular bear market is also the beginning of an ordinary bear market. And since these things have a standard range of lengths, when the first ordinary bear market happens tends to occur at around the same distance, more or less, into the secular bear market. As the bear market progresses these deviations accumulate and eventually the shorter cycles are completely unaligned and no predictions can be made.

I believed there was a reasonable good chance of calling the first bull market top in this secular bear market, which I believed would happen in 2008. It didn't happen that way and there is no point in trying to make any further calls for a top. My strategy this time is simple. I expect we will have at least a few years of expansion after 2010, during which time the market should advance as it did in the last expansion. The S&P500 today is about where it was in early 2005. In the three years afterward the market briefly reached the 2000 highs. I see no reason why this cannot happen again and when it does I plan to sell at that level, even if it looks certain that the market will proceed higher.


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