Secular Bull or Secular Bear?

As the S&P 500 and DJIA continue to break new records the contentious question remains: Are we in a new Secular Bull Market or is this a Cyclical Bull Market within a Secular Bear?

If indeed we are in a new Secular Bull Market the Bear's obituary should read:

The "Secular Bear" born at the dawn of the "DOT COM" crash on March 24, 2000 and later bringing us the "Great Recession of 2007" was laid to rest on March 6, 2009. It holds the distinction of being the shortest Secular Bear Market in U.S. history and nearly as destructive as the Great Depression of 1929.

The U.S. has endured Secular Bear Markets dating back to 1906, 1929, and 1966 each lasting 16, 21, and 17 years respectively. If the current bear is dead, it died at the tender age of 9. From a historical perspective this Bear is just as likely to be in hibernation.

Dr. Robert Shiller, a 2013 Nobel prize-winning economist first gained fame by predicting the stock market collapse that began just 1 month after publishing his 2000 bestseller "Irrational Exuberance". He stated that he expected this decline to last 10 to 20 years.

Some Chartists may present the argument that the Secular Bear is dead because we have already exceeded the market highs of 2000 and 2007. But from an inflation adjusted perspective, the S&P 500 has not broken the 2000 S&P 500 high of 2,002 as calculated by Dr. Shiller. Admittedly we have broken the 2007 high but the 2009 low was much lower than the low of 2003. While technical analysis works well with raw data in daily and weekly charts it becomes skewed when applied to longer time-frames unless the data is adjusted for inflation.

Dr. Shiller's creation of the CAPE index helped lead him to predict the stock market collapse of 2000 by calculating the price earnings ratio of the S&P 500 over time, adjusting the ratio for inflation, and smoothing the results using a 10 year moving average. Dr. Shiller concluded that readings under 20 were in the "Green Zone" indicating that the stock market was fairly to undervalued. Readings between 20 and 28.8 are in the "Yellow Zone" suggesting overvaluation and caution and readings above 28.8 are in the "Red Zone" suggesting a "Bubble" has formed.

I took Dr. Shiller's CAPE index one step further by applying Upper and Lower Control Limits at 1, 2, and 3 standard deviations of the mean and discovered that his index held even more secrets.

In the chart below notice that at the market peak of 1929 the CAPE Index breached the Upper Control Limit at 2 Standard Deviations and the subsequent market bottom in 1932 touched the Lower Control Limit at 2 Standard Deviations.

Left Axis, Black Line - Inflation Adjusted S&P 500. Right Axis, Purple Line - CAPE Index

(click to enlarge)

Chart Courtesy of

In 1937 the S&P 500 peaked with the CAPE Index rising just shy of the Upper Control Limit at 1 Standard Deviation. At the cycle bottom in 1942 the CAPE Index breached the Lower Control Limit at 1 Standard Deviation.

The market peak of 1966 saw the CAPE Index breach the Upper Control Limit at 1 Standard Deviation followed by a market bottom breaking the Lower Control Limit yet again at 1 Standard Deviation in 1974.

The Super Bull Market of the 80's and 90's drove the CAPE Index past the Upper Control limit at 3 Standard Deviations for the first time in history! To date, the CAPE Index has yet to fall much past the mean let alone breach any of the Lower Control Limits.

With the S&P 500 currently at 1,800 and registering 25.18 on the CAPE Index we are only 100 points away from the 2007 CAPE index peak of just under 28.

Unless the market is redefining fair value, the downside target is grim. Assuming earnings growth continues at its current pace, the S&P 500 will need to drop to 1,180 just for the CAPE to revert back to the mean. To reach the Lower Control Limit at 1 Standard Deviation it will need to drop to 716. At 2 Standard Deviations we are looking at the S&P 500 falling to 360. While the S&P 500 dropping to 360 is unconscionable, I believe reversion to the mean is inevitable and a drop below 1 Standard Deviation is probable. To negate this theory, earnings will need to rise significantly faster than the rise in the S&P 500.

If the S&P 500 were to peak at 1,900 and drop to 1,180 it would equate to a 38.2% Fibonacci retracement as well as a reversion to the CAPE mean. A further decline to 716 would equate to a 61.8% Fibonacci retracement as well as a decline to the Lower Control Limit at 1 Standard Deviation.

In the second edition of Dr. Shiller's book, "Irrational Exuberance", published in 2005, Dr. Shiller predicted that is was just a matter of time before the "Housing Bubble" burst. And it did in fact burst in 2007. I briefly met Dr. Shiller two weeks ago after his key note speech at the "American Association of Individual Investors" Conference and showed him the work I had done with Upper and Lower Control Limits as applied to his CAPE Index. Unfortunately Dr. Shiller had a plane to catch so I was unable to get his full reaction to my findings. But he did reiterate that the current CAPE reading of 25 is still too high. In retrospect I shouldn't have expected much feedback. After all, I imagine he is experiencing a bit of the "Allen Greenspan" syndrome where his every word is analyzed as if it were a window into the future. I don't expect Dr. Shiller to ever publish a book again predicting any type of market collapse for fear that it might turn out to be a self-fulfilling prophecy. But you never know.

While Dr. Shiller is famous for developing the CAPE Index and the Case-Shiller Housing Index much of his work is focused on "Behavioral Finance". His work has shown that Market Bubbles can be identified when "Irrational Exuberance" begins to drive prices to extreme levels in an environment that often feels euphoric. While it has been reported that 60% of investable assets held by individual investors are being held in cash or cash equivalents the trend has begun to shift toward equities over the past 12 months. Institutional and seasoned investors on the other hand are already showing signs of "Irrational Exuberance". The "Investors Intelligence Sentiment Index", the oldest and one of the most respected sentiment indexes, recently reported that the index hit a 26 year low point of 15.5% Bearish. The last time this contrarian indicator hit 15.5% was 6 months before the historic market crash of 1987 when the S&P 500 plunged 34% in the course of 15 days.

The argument that the Bear still lives is compelling across all disciplines: historic; statistical, fundamental; technical; and behavioral finance. I have searched high and low for a fact based compelling argument to the contrary other than "don't fight the Fed" and have come up short.

PIMCO CEO Dr. Mohamed El-Erian used the analogy of a forced marriage in an NPR interview on November 26th to describe today's stock market. To paraphrase: "Just as a marriage without conviction is doomed to fail so is the stock market. We currently do not find strong conviction in the stock market based on fundamental values. What we see is that the stock market is the only game in town because the Federal Reserve is artificially forcing down interest rates through their policy of Quantitative Easing. The Fed is forcing this marriage by removing viable alternatives. When interest rates begin to rise, many investors will divorce equities and turn to safer more attractive debt securities."

In summary, this is not a good time for new money to enter the market and a prudent time to take profits and lower ones exposure to equities. If in fact a new Secular Bull is emerging we will have many years ahead of us to reap the rewards. But if the Bear does re-awaken he will be hungry and the onslaught could be swift and painful.

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