Everywhere I go I’m asked, “Will there be inflation or deflation? Are we in a bull or bear market? Is the bond bulk market over and will interest rates rise?”
The flippant answer to all those questions is “Yes.” And that can be the correct answer as well, but it depends on what your time frame is and what tools you use to measure the markets and inflation. One of the newer members of the Mauldin Economics team is Jawad Mian, who writes a powerful global macro letter from his base in Dubai. He has been making the case for the “end of the deflation trade” (or more properly the return of a reflationary period) and the knock-on effects that would cause. Longtime readers know that I am in the secular deflation camp and ask me why there’s such a seeming difference my views and Jawad’s.
The answer is that Jawad and I are more or less on the same page over the longer term; the difference lies in the time frame of our perspective writings. I tend to think and forecast about longer periods of time, whereas Jawad’s main audience is portfolio managers and traders who are focused on the next 6 to 18 months. I tend to think in secular cycles, while Jawad is focused on the cyclical horizon. When you read the section below that Jawad writes, you will find a fairly upbeat analysis.
And that difference opens up a very important discussion for this week’s letter. I will start off by explaining why I think we are still in a long-term secular bear market in U.S. stocks, even while I can clearly see that we are also in a powerful cyclical bull market. It is important to know both, because there are quite different investment approaches that are appropriate for different combinations of secular and cyclical cycles.
Then we turn to Jawad, who will discuss why we could see a reflationary macro regime emerge in much of the developed world and where the resulting opportunities might lie. I will finish up with why I think that this reflationary period will be temporary, with a potential for a serious round of deflation further out in the future, even though I readily acknowledge that “temporary” could mean a few years. But the looming reality over the longer term is that the coming war over a return of deflation will be fought by central banks everywhere. It will truly be World War D.
Why start with equity markets when we are talking about deflation and inflation? Because we need to see the connections!
Secular bear markets
I first wrote about a coming secular bear market in 1999. I was early, of course. The market went up (a lot!) for the next year. Over the next few years I began to do some work looking at secular bear markets not in terms of price but in terms of valuations. My now very good friend Ed Easterling of Crestmont Research was doing similar analysis, and we compared notes. Then we published a series of reports in this letter, which I later adapted in two chapters (co-authored by Ed) of my book Bull’s Eye Investing in 2003.
I believe secular bull and bear markets should be seen in terms of valuation, and cyclical bull and bear markets in terms of price. A secular bull market should be approached with a more aggressive, relative return style of trading, while a secular bear should have an absolute return focus with appropriate risk controls. That difference in trading style is necessary because of how valuations will trend in the two different types of markets.
Let’s look at the updated charts that Ed sent me over the weekend from his fabulous, data-rich website. In general, secular cycles are long-term trends in valuation. These cycles include numerous interim surges and falls in price that reflect shorter-term psychology and economics. The long-term secular cycles can be seen in this first graph, with secular bears represented in red and secular bulls shaded green. The driver of these cycles is the relative valuation of the stock market as reflected in the price/earnings ratio (P/E). When P/E trends higher, it multiplies earnings growth and generates periods of above-average returns. When P/E trends lower, it offsets some or all of earnings growth and delivers periods of below-average returns. P/E is the blue line underlying the secular cycles on the chart.
The P/E segments for all of the red-bar secular bears can be overlaid on a chart with time in years across the bottom and the level of P/E on the side (see chart below). First, secular bears tend to start in the red zone of high P/Es and decline to the green zone of low P/Es. This downshift into a secular bear is caused by a trend in the inflation rate from low, stable inflation to levels of either high inflation or deflation.
Second, this chart includes red and green arrow-lines that highlight the shorter-term cyclical bears and bulls during the current secular bear. The chart demonstrates that longer-term secular periods have cyclical bears and bulls within them, offering very profitable trading opportunities.
Third, the current level of the market P/E indicates that the stock market is fairly high. It is now well above the peaks of past secular bears and nowhere near the levels needed for a secular bull market start.
Even after more than 15 years in a secular bear market, the current secular trend has a ways to go to reach lower valuation levels. How can that be true after such a long period? In part, it’s because this secular bear started at such high levels. The current secular bear has experienced the same amount of P/E decline that many of the past secular bears experienced over longer and shorter periods, but the current secular bear started at twice the historical highs.
Bears start where bulls end and vice versa. As the secular bull market version of the previous chart shows, the late 1990s bubble took that secular bull market to unprecedented heights. A return from a period of either high inflation or deflation to low, stable levels of inflation will result in a rising trend in P/E during secular bull markets .
The “difference” between Jawad’s and my view on the inflation/deflation question is so important because turns within cycles have a major impact on pricing and valuations.
Yet even though we are in a secular bear that has come a long way with quite a ways to go, this secular bear looks and acts like previous secular bears. For example, here’s the daily graph for the previous secular bear in the 1960s and ’70s.
The cycles are very evident. Note the dramatic magnitude of their swings. Here’s the same format of chart for the current secular bear. Notice there are very similar patterns and magnitude … and new highs in the middle of the secular period.
continue reading: http://www.mauldineconomics.com/frontlinethoughts/world-war-d-deflation
