Monday, April 13, 2009

Why Stocks Won't Come Out of the SECULAR Bear Market Any Time Soon

Update: I had to change the headline, the original (Why the stock's...) sounded as if I had been listening to Marina Orlova (nyet! nyet! nyet!) and picked up a somewhere east of the Caucuses diction.
Original post:
We may have already emerged from the CYCLICAL bear market. One definition is a 20% up move that follows a 20% down move. I've never cared much for hairsplitting on the shorter moves. Secular moves are different. Regarding the secular bear market from 1966 to 1982 ('64-'82 depending on your pick of mid-sixties market tops) Warren Buffett comments:
December 31, 1964: DJIA 874.12
December 31, 1981: DJIA 875.00

“Now I’m known as a long-term investor and a patient guy, but that is not my idea of a big move.”
-Warren Buffett

Secular bear's [as opposed to observant ones? -ed] tend to be sideways, trading range affairs characterized by declining p/e ratios. From February's "Where in the Bear are We?":

Our two guiding principles right now, are:

Anything past settlement date is long term.
Anything long term is terminal.

Even when we come out of the cyclical bear we will still be in a secular bear market (i.e. the red bars)**. From Crestmont Research via The Big Picture:

Dow Chart with P/E, 105 Years
click for larger chart


Source: Crestmont Research

Although there is a pleasing symmetry between the 18 year sixties/seventies bear and the 18 year eighties/nineties bull, there is nothing magical about that length of time [except that four such periods roughly add up to the Biblical "Threescore and ten" -ed.]

The money to buy equity assets is either cash or leverage. The leverage is going or gone.

From EconLog:

David Warsh points to this lecture.

variation in leverage has a huge impact on the price of assets, contributing to economic bubbles and busts. This is because for many assets there is a class of buyer for whom the asset is more valuable than it is for the rest of the public (standard economic theory, in contrast, assumes that asset prices reflect some fundamental value). These buyers are willing to pay more, perhaps because they are more sophisticated and know better how to hedge their exposure to the assets, or they are more risk tolerant, or they simply like the assets more. If they can get their hands on more money through more highly leveraged borrowing (that is, getting a loan with less collateral), they will spend it on the assets and drive those prices up. If they lose wealth, or lose the ability to borrow, they will buy less, so the asset will fall into more pessimistic hands and be valued less.

This looks interesting. More comments follow.

As he points out, the focus of macro has traditionally been on the interest rate, not on the leverage ratio. It is not easy to get the leverage ratio to matter in a model where everyone has similar preferences and identical views of the probability distribution of outcomes....MORE

The valuations going forward will be lower because less buying power will be chasing the assets. Valuations will also be lower because corporate earnings power is being deleveraged.

From ClusterStock:

Earnings Recovery Could Take 20 Years

Over the long haul, stocks track earnings (the 10% market return over the past century was composed of 2% real earnings growth, 3% inflation, 4% dividends, and 1% multiple expansion). It therefore makes sense to get a sense of how fast earnings are likely to recover once this depression ends.

John Mauldin discussed this issue in his newsletter last week. John still believes the recent rally is a suckers' rally and that we'll likely be working our way out of this hole for years. One reason for that pessimism is the conviction that earnings won't just snap back to pre-crash highs the way they have in recent recessions.

Why not?

In short, because the peak earnings of 2007 were inflated by leverage (debt), and that leverage is now been stripped from the system. Last time we went through an extended period of deleveraging, after the 1920s, it took 18 years for earnings to regain their old highs. If this recovery mirrors the 1930s recovery, S&P 500 earnings won't regain their highs until 2025 or so.

John also thinks that the current rally in the stock market will fail as soon as the stimulus bleeds off and the Bush tax cuts phase out next year:

[L]et's look at a very interesting chart sent to me by one of my readers, Chad Starliper of Rather and Kittrell in Knoxville, Tennessee. It shows all the cumulative drops in earnings from major peaks, along with the recovery paths. What is interesting is the divergence between the pre- and post-WWII periods. Our experience since 1945 is one of rather quick recoveries, averaging about 3-4 years until earnings rise above the old highs....MORE