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The subject for this year's investment letter is long term bull and bear market cycles in equities.  I will argue that these long term cycles repeat themselves and have similar characteristics in terms of their length and their excesses of optimism and pessimism.  These excesses translate into exceedingly high and low market prices at their peaks and troughs. 

 

I believe that after 18 years of increasing stock prices (1982 – 2000) we are currently experiencing a long term bear market in equities (2000  -  ?).  Long term bear markets are fairly rare historical events which normally last around 15 years.  When they end, investors can find tremendous real values if they have survived the long bear process with their money intact.

 

Some might say that this piece is negative.  I would respond by saying that until 2007 the case for optimism for stocks would likely have been more convincing to the large majority of investors.  But the economic and financial situation that we are in today may have convinced some of you to be more open to the negative case.  For those who say that long term valuation measures (discussed below) have no meaning in the new world of finance.  I would respond by saying that such talk may have belonged to the era of ever increasing equity prices and that era may be ending.

 

Finally let me say that although this piece describes some fairly negative short term stock market phenomena, the long term outlook is great.  If an investor conserves his money through these current bad times he will have the opportunity to buy stocks with great value in the not too distant future.  A rare opportunity indeed!

 

 

Part 1 – Stock Price Valuation

 

S&P 500 Historical Actual Prices

 

Below is a chart of the actual price movements in the S&P 500, the accepted broad measure of the U.S. stock market, from 1871 until today.

 

Robert Shiller Irrational Exuberance online data

http://www.econ.yale.edu/~shiller/data.htm

Log scale

 

There are no straight lines here, but rather lots of advances and declines.  The overall trend is up.  In fact the market’s price has risen by about 6% per year since 1932.

 

I've indicated the bull market tops (i.e. times to sell) with red arrows - 1906, 1929, 1968, 2000 and I’ve indicated bear market bottoms (-> i.e. times to buy) with green arrows - 1877, 1921, 1932, 1943, 1982. (1) 

 

When you look at this chart you may say that prices didn’t go very much lower during some of the bear markets that I've identified. Rather they look more like sideways trends.  And I would agree.

 

A partial reason for this sideways bear market look and the overall upward sloping trend of the chart is inflation.  Inflation makes stock prices rise, just as it does the cost of our groceries.

 

 

S&P 500 Historical Real Prices

 

We can strip out this inflation effect on the chart by subtracting changes in the consumer price index (CPI).  When we do this we have the real price of the S&P 500. 

Robert Shiller Irrational Exuberance online data

http://www.econ.yale.edu/~shiller/data.htm

Log scale

 

In this chart we can see that the gains are more subdued and the losses are more evident. 

 

I will argue that the movements from relative highs on the chart (red arrows) to lows (green arrows) represent the movement from overvaluation to undervaluation of equities.  But over/under valuation compared to what and based on what?

 

 

Book Value vs. Market Value

 

When we buy a share of stock we buy a share of the assets in a company.  The book value of those assets is measured by the contents of the balance sheet as reported in its financial statement.  We also purchase a share of the company’s actual yearly earnings, cash flow and dividends paid to shareholders.

 

The book value of a company must be contrasted with its market value.  When we buy a company’s share on a stock market we actually pay a price equal to the market value of that company (as quoted on exchanges).  At any given time the market value of the equity on a company’s balance sheet can be above or below its book value.  The company’s earnings and dividends can also be more or less rich / valuable

relative to its stock price.  Therefore buyers may, at times, pay too much for real assets, dividends and earnings while at other times pay very little for them (on sale, let’s say).  It’s down to the relationship between the market price and underlying real values.

 

Bull and Bear Market Extreme Valuations

 

Let’s look at the bull and bear markets shown in the above charts and measures of underlying values at tops and bottoms.  Since I don’t believe that the current bear market is over I have listed 2000 – 2009 (the low after the recent crash) and 2000 – 2011 (present) in order to help put our current bear in context with the others. 

 

Note: 

- All the above data have been taken from Robert Shiller’s Irrational Exuberance online

data base http://www.econ.yale.edu/~shiller/data.htm and manipulated by me except

for the Q ratio, http://www.advisorperspectives.com/dshort/updates/Q-Ratio-and-Market-Valuation.php

- I have shown the Cyclically Adjusted P/E which was developed by Robert Shiller. 

See (2) below for an explanation.

- Two bear market lows are listed after 1929.  See (3) below for the reason.

 

The exhibit shows the length of each bull and bear cycle as well as End Cycle Values for three valuation measures, which can identify under or over valuation in the stock market:

- Q Ratio

- Dividend yield

- Cyclically adjusted P/E ratio

 

 

Q Ratio

 

The first valuation measure is the Q ratio.  The Q ratio is a company’s market value (determined by financial markets) divided by its book value (published in financial statements).  The Q ratio for the broad market can be calculated using data published by the Federal Reserve called the Flow of Funds Accounts. (4)

 

 

Notice the following Q ratio data points. 1) at the end of bull markets the Q Ratio averaged around 1.1 with the exception of 2000 when this measure reached 1.8, by far its highest level in history.  At these times investors were paying relatively too high a market price for companies’ underlying real asset values.  2) at the end of every bear market (until our current market) the Q Ratio has reached a low of 0.3 - 0.4.  At those times investors were paying the lowest market prices for underlying assets (on sale).

 

Here’s a graph of the Q ratio since 1900.

 

Doug Short, The Q Ratio and Market Valuation

http://www.advisorperspectives.com/dshort/updates/Q-Ratio-and-Market-Valuation.php

See (5) for other info on q ratio

 

You can see the overvalued ratios around the bull market peaks of 1906, 1929, 1968 and 2000 on the upper half of the chart and the undervalued ratios around the bear market lows of 1921, 1932, 1943/1949 and 1982.

 

Notice that the market low in 2009 only reached 0.66, which is right around the Q’s historical average of 0.71.  The market did not even approach the extremely low levels seen at the end of prior long term bear markets.  In December 2011 we are at 0.82, which is closer to previous bull market highs than prior bear market lows.

 

I think that the current bear market will repeat those great cycles of the past and that it will display their same characteristics.  I don’t think that the current bear market has yet reached the final lows for the Q ratio.  Therefore, I WOULD EXPECT THAT THE Q RATIO WILL FALL BELOW 0.5 BEFORE THIS BEAR MARKET WILL HAVE ENDED, which will require a fairly dramatic fall in market prices.

 

Dividend Yield

 

The next measure of value is dividends, the all important real cash flow that companies pay their shareholders.

 

When we buy shares in a company, we are buying its dividends which generate cash flow for us.  We can pay too much or very little for those dividends depending on where we are in the market cycle.  If we buy shares when the market price is high and the dividend yield is low it may be that investors are too enthusiastic and are paying too much.  When we buy shares when the dividend yield is high and investors are despondent, we can buy great values.

 

 

 

Notice that at every bull market high dividends have yielded around 2% - 3% except for the 2000 high when the market was yielding 1.2%

 

On the other hand at bear market lows stock have yielded from 7% - 13%.  Great values!  

 

At the 2009 low, stocks were yielding around 3% and are currently yielding 2.1%, a dividend rate that is lower than all the bull market highs except for 2000.

 

Here’s a chart of the historical dividend yield.

 

Robert Shiller Irrational Exuberance online data

http://www.econ.yale.edu/~shiller/data.htm

 

Granted the overall trend of yields has been lower over time and companies have used other tools to create returns for shareholders, like share buybacks.  I have noted that the total return including reinvested dividends during the 1982 – 2000 bull market was as high or higher than prior bull markets.  And it may be that we have not seen the price falls that we have seen in prior bear markets due to the same phenomenon. 

We are however witnessing and increasing appetite for dividend paying stocks and it may grow as investors realize that long term equity returns have historically been generated via dividend reinvestments.  I WOULD EXPECT THAT THE DIVIDEND YIELD ON THE S%P 500 WILL REACH 5% BEFORE THIS BEAR MARKET HAS ENDED.

 

 

Cyclically Adjusted Price / Earnings Ratio (2)

 

Stocks can be a great investment because company earnings increase over time.  Inflation plays a part but productivity increases do as well.  Earnings and dividends create value and increasing earnings (not available with bonds) propel the overall

upward trend of the stock market.

 

When we buy earnings we pay a market price for a share of those earnings.  There is no fixed market price (P) for a share of earnings (E) in a company.  Therefore the P/E ratio is an important measure of value.  Sometimes investors are enthusiastic and pay a lot for earnings and sometimes they are just despondent and are not willing to pay much at all.  So the P/E ratio fluctuates from high levels at the top of bull markets

when people are most enthusiastic, to extremely low levels when people have no interest in stocks.

 

Here are the P/E ratios for bull and bear market extremes.

 

 

The P/E ratio has ranged from 20 – 44 at bull market peaks.  Notice that the P/E of 44 in 2000 greatly exceeded the previous peak of 33 in 1929.  In fact it was 1/3 higher.  Investors were very enthusiastic indeed to buy shares of stock in 2000!

 

At the bottom of prior bear markets the P/E ratio ranged from 5 – 9.  At the crash low in 2009 the P/E reached 13 and it rose to 23 in mid 2011.  A P/E ratio of 23 is similar to those at the highs of the 1968 bull market!

 

The following is a chart of the Price / Earnings ratio of the stock market through time.

Robert Shiller Irrational Exuberance online data

http://www.econ.yale.edu/~shiller/data.htm

 

There is still far too much enthusiasm to buy shares of stock.  I believe that when we reach the bottom of this bear market investors will be completely despondent and will have no interest in the stock market.  Stocks will then be on sale at extremely low P/E multiples. 

I WOULD EXPECT THAT THE S%P 500 CA P/E RATIO WILL FALL BELOW 10 BEFORE THIS BEAR MARKET HAS ENDED.

 

 

PART 2 – Bear Market Cycles

 

In this section I would like to look at how market prices moved towards their conclusions during prior bear markets. 

 

Let’s start with charts of actual and real price comparisons of the bear markets we’ve seen.   Each of the charts below show price movements (starting from 1.0) over 15 years measured in months with month zero being the high point of the prior bull market.

 

The actual prices are always shown in black and the real (inflation adjusted) prices are shown in color. 

 

1906 – 1921                     

 

 

1929 - 1942

 

 

1968- 1982                                             

 

 

 

 

2000- 2011

 

The 1906 and 1968 bear markets took place during periods of inflation.  You can see this because the actual price moves further and further above the real price through time.  The 1929 bear market happened during a period of deflation.  In that case the actual

price at times moved below the real price.  The 2000 bear market is taking place during a period of low inflation.

 

Remember the real price of the market determines real values.  For example, during the 1968 – 1982 bear market the actual price of the market rose after 1973 (approx. month 70).  On the other hand the real market price continued lower for another 9 years.  This is because the actual market price increases did not keep pace with the overall rate of inflation as well as increases in the book value of company assets and their inflated earnings and dividends.

 

Now let’s look at the movements in real prices only. 

 

1906 – 1921                                                     

 

1929 – 1942

 

1968- 1982             

 

 

2000- 2011

 

Again, all of the above charts show a period of 15 years.  As you can see bear markets don’t reach their lows in a straight line.  They go through periods of greater and lesser enthusiasm cycling lower and higher through time.

 

I have traced out three waves lower in each of the four cases.  There has been a first wave down and then a recovery, often to near the prior all time high.  Then a second fall, a recovery and a final 3^rd wave lower. 

 

These waves down slowly transform the extreme enthusiasm for stocks at the top of the bull market to the final despondency at the bottom.  It takes time to transform these emotions.  On the first wave down people may say, “It’s just a blip in a continuing bull market”.  On the second wave down people may say, “That’s twice now.  This is nerve wracking but maybe I should stay invested in stocks for the long term.”  By the time of the third wave down after a decade and a half of losses people might say, “I don’t want to own a share of stock for the rest of my life.” 

 

Let’s consider the current bear market.  We may remember the first fall as the bursting of the tech bubble from 2000 – 2003.  Then there was a tremendous bull market from 2003 – 2008 and then the crash of 2008 – 2009.  We are now in the midst of a recovery from the 2009 low.   I WOULD EXPECT THAT BEFORE THIS BEAR MARKET IS OVER THERE WILL BE A THIRD WAVE LOWER IN THE STOCK MARKET WHICH WILL REACH OR EXCEED THE LOWS OF 2009.

 

There will be a big difference between the upcoming final low and the 2003 and 2009 lows that came before it.  When we get to the final low in the coming years there will be no rapid recovery.  Stock markets will stay down.  People will be really despondent, uninterested in stock market investing.  Probably with more time at very low levels (2014 – 2015), with dividends holding up and maybe some more inflation we will see a Q Ratio of less than 5, a dividend yield of over 5% and a CA P/E ratio of less than 10.

 

In short there will again be great real values in the stock market and no one will be interested. (7)  The exact opposite of 2000 when there were no real values in the stock market and everyone was enthusiastic to buy!

 

The important thing now may be to have some money left when it is time to buy.

 

 

Part 3 – Investing in 2012 and beyond

 

If we apply the expected bear market low parameters to current stock market prices we can get a sense of what the final low prices will be.

 

By calculating a result based on dividends and CA P/E using Robert Shiller’s data you can come to a rough estimate of around 600 on the S&P 500.  This outcome would be affected by time and inflation.  But in order to be reasonably conservative I’ll say that THE S&P 500 WILL RETURN TO AND TEST ITS MARCH 2009 LOWS OF AROUND 670 BEFORE THIS BEAR MARKET IS OVER.  And given that the other bear market final lows were reached within 15 years, I believe that we will see the ultimate low sometime between now and 2015.

 

Heat Map

 

The exhibit above I have overlaid the four Real bear market charts shown above.  It shows red when prices are falling and green when they are rising. The chart should give us a sense of timing the bear markets in our study. 

 

For each of the four bear markets we’ve seen in this study I’ve marked downtrends with red boxes and uptrends with green boxes.  Every bear market starts at month 0 at 1.0 and the chart shows 180 months (15 years) of price evolution.

 

You can see the full red color at the start of the bear markets (month 0 – 15).  Then as some markets turn up the red becomes less pronounced until all the markets are in an uptrend (green) in months 35 and stay positive until around month 90.

 

In month 90 the chart goes full red (until 103) as all bear markets were falling during the same period.  This was the timing of the crash of 2008 – 2009. 

 

We then see different shades of green due to the subsequent recoveries.

 

Finally in month 126 we see all red.  This is the timing of the 3^rd leg down of the bear markets in our study.  The 2000 to present bear market (in blue color) is hovering precariously above those large red boxes. 

 

Please also notice that the first two market falls (deep red areas / 0 – 15 & 90 - 103) are narrow (starting and ending quickly) while the final legs of the bear downtrends are long and wide (time destroys enthusiasm),

 

Based on this comparative bear market timing chart, we will likely see (dramatically?) lower stock prices in 2012.

 

 

50 and 200 Month Moving Averages

 

 

Above is another chart of the Actual S&P 500 since the 1870.  This chart also includes the price’s 50 month moving average (50 MMA) in orange and 200 month moving average (200 MMA) in brown.

 

Traders traditionally follow 50 day and 200 day moving averages.  When the 50 day MA falls below the 200 day MA market technicians call it a “death cross” (not a good omen).  And generally longer term technical signals are considered to send stronger messages.  So when the 50 week MA crosses the 200 week MA we may say it is a stronger negative signal than a daily cross.  Well in 2012 we may experience a monthly

MA death cross, which is a signal not seen since 1934 when the 50 month MA fell below the 200 month MA.

 

Here are a couple of things to notice on this chart.  First, see how the 50 MMA acted as price support (the actual price often touched but did not fall below the 50 MMA) throughout the bull market periods of 1949 – 1968 and 1982 – 2000.

 

Second, you can see the 50 MMA tends to fall below the 200 MMA towards the end of bear markets.  One exception is following 1929 when the 50 MMA immediately fell below the 200 MMA and stayed there for 12 years.  In fact the 50 MMA rose up and touched the 200 MMA in 1939 but was unable to rise above it until 1946.  The other exception is 1978 when the 50 MMA touched the 200 MMA, never fell below it and

continued higher as the new bull market began in 1982.

 

As of today we can see the 50 MMA headed for a collision with the 200 MMA and the 50 MMA will likely break below the 200 MMA some time in late 2012.  This will happen unless a new long term bull market starts next year (probably in the unlikely context of a rapid rise in inflation).

 

I expect that the falling 50 MMA will become a strong resistance to higher prices in 2012 and it will pull the Actual S&P 500 price down below the 200 MMA.  Then both the Actual price and the 50 MMA will stay below the 200 MMA for some years until we see the beginnings of a new uptrend later in this decade.

 

Here’s a shorter term look at the same data.

 

 

 

- Short term recommendations

 

I believe that it is now a good idea to limit your exposure to the stock market.  Cash and short term bonds issued by the highest quality governments and corporations are called for.

 

 

FOOTNOTES

 

(1) These great historical stock market events have been well described in Anatomy of the Bear: Lessons from Wall Street's Four Great Bottoms by Russell Napier

 

(2) The cyclically adjusted PE ratio (CAPE) was developed by Robert Shiller in his book Irrational Exuberance.  It is a modification of the PE ratio to account for the effect on profits of the economic cycle.  The PE ratio calculated at any point in time is affected by the current state of the economy.  This effect is, of course, particularly strong in the case of cyclical shares.  The simplest and most widely used approach is to use a simple average of annual EPS over ten years. It is also common practice to adjust the EPS into real terms, essentially making this a long term PE corrected for inflation. Only the EPS needs adjustment, not the price.

 

(3) I’ve shown two bear markets that began in 1929.  One finished in 1932 and another one lasted until 1942.  The sharp and sudden fall of 1929 is an anomaly in our market history.  The fall was so deep (about 85%) that it set off 20 years of financial and economic turmoil which created an environment where two other great buying opportunities occurred one in 1942 and the other in 1949.  For the sake of clarity and brevity I have only included the 1942 low on my chart.

 

(4) http://www.federalreserve.gov/releases/z1/Current/ The Q ratio chart contains instructions on how to make the calculation.

 

(5) http://www.smithers.co.uk/page.php?id=34 ; http://www.smithers.co.uk/faqs.php

 

(6) Unless we get a large burst in consumer price inflation, which would push up the denominator of the Q ratio.

 

(7) The classic example of disinterest in equity investing at the nadir of a bear market.  Business Week’s famous 1979 cover “The Death of Equities, How inflation is destroying

the stock market”

 

 

 

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MORE DETAILS

 

 

Total return on capital from start to finish / No dividends

 

 

 

Total return on capital from start to finish / Dividends reinvested

 

 

End cycle valuations and 10 year Treasury yield

 

 

 

(c) Emil Zamarelli