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A False Sense of Security: Hussman Weekly Market Commentary
Posted by: John Hussman (IP Logged)
Date: March 26, 2012 03:57PM
"The world economy has stepped back from the brink and we have causes to be a little bit more optimistic. But optimism should not give us a sense of comfort and certainly should not lull us into a false sense of security." IMF Managing Director Christine Lagarde, March 17, 2012
As we examine the present evidence relating to both the financial markets and the global economy, the aspect that strikes us most is the extent to which Wall Street continues to emphasize superficially positive data in preference for deeper analysis, to extrapolate short-term distortions as if they were long-term trends, and to misconstrue freshly printed wallpaper and thin supporting ice as if they were solid walls and floors.
Two propositions we heard last week were characteristic of this false sense of security. One was a remark by an analyst that stocks were in a "secular bull market" here. The other was a Wall Street "factoid" being passed around, suggesting that the "equity risk premium" on stocks has never been higher.
Let's address these in turn. When people talk about bull and bear markets, they often use the terms "cyclical" and "secular." One cyclical bull and one cyclical bear market comprise the normal garden-variety market cycle of about 5 years in duration (though with quite a bit of variation around that norm, see "notes on secular and cyclical markets" in Hanging Around, Hoping to Get Lucky ). Taking very broad averages, a cyclical bull market lasts about 3.75 years, averaging a trough-to-peak gain of about 150%, and a cyclical bear market lasts about 1.25 years, averaging a decline of just over 30% from peak-to-trough. If you do the compounding, you'll observe that the typical bear market wipes out more than half of the preceding bull market gain.
However, those averages mask an additional source of variation, which depends on "secular" conditions. If you examine market history as far back as the late-1800's, you'll find that market valuations have moved in broad advancing and declining phases, with each phase lasting about 17-18 years in duration (that still should be treated only as a tendency, and there's no reason I know for treating it as a magic number). As an example, stocks moved from extremely low valuations in 1947 to quite rich valuations by 1965, producing a long "secular" bull market where each successive cyclical bull market topped out at higher and higher valuation multiples. In contrast, from 1965 to 1982, valuation multiples went through a long contraction, where each successive cyclical bear market bottomed out at lower and lower valuation multiples.
The effect of these longer valuation "waves" is this: during long secular bull phases, the cyclical bull markets tend to be longer and more rewarding, and the cyclical bear markets tend to be shorter and less damaging. In secular bulls, the market is running with the wind at its back. The secular bull market period from 1982 through 2000 was a good example of this tendency.
In contrast, during long secular bear phases, the cyclical bull markets tend to be shorter and less rewarding, while the cyclical bear markets tend to be longer and more violent. In secular bears, the market is swimming against the tide. The secular bear period that began in 2000 has been a good example of this tendency.
As Nautilus Capital observes, the average cyclical bull market in a secular bear market period has produced an average gain of only about 85%, lasting less than 3 years on average. In contrast, the average cyclical bear in a secular bear has been unusually violent, averaging a 39% loss over a span of about a year and a half. Compound the two, and that's enough damage to drag the cumulative full-cycle return down to just 13%, on average.
Needless to say, the assertion that stocks are in a "secular" bull market is really an assertion that investors can let down their guard, in the sense that downturns are likely to be muted and advances will be extended. But from our standpoint, if you're going to pick a secular team, it would be best to have reliable data to back up the choice.
So what distinguishes a secular bull from a secular bear? Valuations. Not just any valuation measure however - it's important to demonstrate that the valuation measure you choose actually has a strong and demonstrable long-term relationship with subsequent market returns (which is where Wall Street's disingenuous use of toy models like simple price-to-forward earnings multiples and the "Fed Model" makes us nearly apoplectic).
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