Secular markets are the larger scale long-term market tends that last for years and include smaller scale bullish and bearish phases within them. Looking at secular trends provides clear information about historical moves rather than using recall, which can result in a view distorted by emotions. In terms of an outlook, secular trends are the big picture for market movements. By being aware of where the market stands on a secular basis and knowing what typically occurs during such periods, you are better able to map out a plan of attack for your equity investments

A great book on the topic of secular markets written by Ed Easterling of Crestmont Research titled, Unexpected Returns: Understanding Secular Stock Market Cycles, was released in 2005. We are currently in a secular bear market, which began in 2000. As with other trend developments, changes in secular phases are confirmed after the fact. Conditions currently supporting the secular bear include:

1. Relatively high P/Es (declining during the life of the bear)
2. Low interest rates
3. Price stability that moves towards inflation
4. Relatively low dividend yields (increasing during the life of the bear)

Easterling identifies the following four secular bulls (average 13.5 years) and secular bears (average 11.3 years) since 1900:

1. 1901-1920 (20 years)
2. 1921-1928 (8 years)
3. 1929-1932 (4 years)
4. 1933-1936 (4 years)
5. 1937-1941 (5 years)
6. 1942-1965 (24 years)
7. 1966-1981 (16 years)
8. 1982-1999 (18 years)

Assuming the current phase started in the year 2000, we are entering the eighth year of the secular bear. The first part of the trend was pretty nasty while recent years have included one of the longest sustained bull markets.

The Case for the Bear

Is it possible that the secular bear ended in 2003? Sure that’s possible, but some of the characteristics of a secular bear didn’t quite resolve themselves in ‘03. Historically, the P/E for the S&P 500 tends to be about 16. During a secular bear the market decline, that mean level is typically overshot so you can expect P/Es to fall below 16. According to reported earnings and estimates available from the Standard & Poor’s website, the index P/E was 26 in Sep 2003. Although it has declined pretty steadily since that time (this past Sep the P/E was approximately 19), it seems things favor continued declines.

Since there are two measures in the P/E calculation, trends in both should be considered. Secular bulls and bears include periods of rising earnings, so it is possible for continued declines in the P/E to be driven by an increase in earnings. Earnings momentum was pretty good from 2003 to 2007—will earnings continue to rise in the first half of 2008? That remains to be seen, but if this secular bear is like others with P/Es falling below the historic average of 16, it’s likely that will come with continued declines in price levels.

Implications of a Secular Bear

Assuming earnings remain steady rather than rise or decline significantly in the next twelve months, the S&P 500 would need to reach the 1150 level to yield a P/E of 15. This isn’t a projection or prediction, just food for thought. Given the 2007 closing value of 1468 for the S&P 500, a move to 1150 represents nearly a 22% decline. Such an amount is pretty extreme but only slightly more than the average decline for losing years in secular bears. Although the P/E level is just one of a few measures to consider when gauging market conditions, advantages to using it include the availability of specific historic levels for analysis purposes and the ability to use those levels to identify potential numeric targets going forward.

If we assume that we are in a secular bear market and it will remain as such over the next twelve months, the prospect of a down year supports the case for portfolio protection in 2008. It’s not an argument for removing all of your equity investments unless you have a crystal ball or it’s consistent with your previously defined long-term plan. Years with gains during secular bear markets average around 20%; that’s approximately the same as average gains during secular bulls. So while mapping out your game plan at the beginning of 2008, consider including a systematic approach to hedging that will allow you to reap the awards of upside movement in the market while protecting your holdings during nasty down drafts that can occur.

To access other articles written by Clare White, please click here.

Clare White
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
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