This past year, after reading Van Tharp’s Trade Your Way to Financial Freedom, I became intrigued by the idea of secular bull and bear markets. In a nutshell this means that the market moves in large waves of expansion and contraction. On average secular bull markets last 15 years while the average bear market lasts 18 years. The crash of 2000 marked the end of the secular bull market which began in 1982. We are now in secular bear market which could easily last well into 2018. Before you jump off that bridge, there are a couple of important points to understand about secular bear markets.
1. P/E Valuations decline in secular bear markets even though stock prices may increase.
2. Some of the largest sustained market rallies, those lasting 18 months or more have occurred in the middle of secular bear markets.
3. The biggest rallies tend to occur when P/E valuations have entered the single digits.
Robert Shiller, author of "Irrational Exuberance", maintains an extensive spreadsheet of historical price earnings (P/E) which clearly illustrates the point that during secular bear markets prices may rise while overall valuations decline. The two big secular bear markets of the twentieth century ran from 1929-1949 and 1966-1982. Shiller’s spreadsheet makes for an interesting read and may shed some light on the market’s current path.
June of 1932 marked both the price and valuation low of the Great Depression. P/E values were a measly 5.57 and the S&P stood at 4.77. Market prices trended up for the next years until the dawn of the next golden bull in 1949. Valuations however peak at a P/E of nearly 22 in 1937 and then gradually declined back to 9 over the next 12 years. Price peaked at 18 and meandered back and forth finally setting at 13.97.
September of 1974 marked the price and valuation low of the 1966-1982 secular bear market. The S&P price was 68.12 with a P/E of 8.68. The market’s followed the same pattern as in 1932 meaning prices increased with occasional rallies but this time the market couldn’t even get above a P/E of 12 during this period. It finally bottom with a P/E of 6.64 in the fall of 1982 and soon began our last secular bull market. Price increased from the 1974 low of 68.12 to 110.80 in 1982 with some peaks and valleys in between.
So what does history say about today? We suffered through a terrible decline and I truly hope the worst is behind us however the P/E numbers plus the trend history of 1932 and 1974 indicate turbulence ahead.
Today the S&P 500’s P/E, according to the Shiller spreadsheet, is 15.39 which means that we are roughly at historical averages. As I illustrated above secular bear markets tend to bottom when the P/E reaches single digits. Based on current earnings, for the S&P 500 to achieve just a P/E of 10 would mean the current price would have to drop to 485. Today the price is 805. To reach single digits the S&P 500 would have to go even lower.
Now for the good news. When secular bear markets bottom in both price and P/E it creates the conditions for large sustained rallies even though the overall price trend of the market is down.
I have borrowed the table below from Martin Zweig Winning on Wall Street to demonstrate the point. I have added the S&P 500 P/E from the Shiller spreadsheet to show correlation but not necessarily causation for large bull runs.
Greatest S&P 500 Advances – 1926 to 1996 | ||
Date of Low | P/E | Max. % Gain within 18 months of low |
6/1/32 | 5.57 | +154.5 |
2/27/33 | 7.83 | +120.6 |
3/31/38 | 12.38 | +62.2 |
4/28/42 | 8.54 | +60.2 |
6/13/49 | 9.07 | +50.0 |
9/14/53 | 11.34 | +65.2 |
10/22/57 | 14.15 | +49.2 |
5/26/70 | 13.98 | +51.2 |
10/3/74 | 8.74 | +66.1 |
8/12/82 | 6.64 | +68.6 |
12/13/84 | 9.60 | +53.3 |
10/11/90 | 14.82 | +52.1 |
The above table illustrates an amazing fact that the market’s biggest rallies can and do occur after things have gotten really bad and pessimism reins supreme. I was surprised to see that the top 4 rallies occurred during the Great Depression and in the middle of World War II. In recent times the market stage big rallies after the disastrous period from 73-74 and the gloomy recession of 1982. The market was up 50% after its perilous decline from 2000-2003.
So what does this mean for you today? First, historical precedence seems to indicate that we have a while before the market will truly bottom however that doesn’t mean that significant short term rallies can’t occur. Second, to capture both the short and ultimately the long term move you need to have a trading system to help you navigate these troubled waters. If you don’t have system to trade individual stocks in this market environment then it is best to sit in cash until the storm passes. Finally, those of you sitting in mutual funds do not open your statements for quite a while.
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