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Markets behave differently in long-term bull and long-term bear markets, also referred to as a secular bull and a secular bear. Bearish corrections can take place in the former while bullish rallies can occur in the latter. A really nice reference that provides a great deal of specifics on these differences is Ed Easterling’s 2005 book, Unexpected Returns: Understanding Secular Stock Market Cycles. 

After comparing annual returns for the stock market during secular bulls and secular bears, Easterling noted that rallies occurring within both were pretty similar. It was corrections in secular bears that really do the damage. Easterling identifies four secular bulls and four secular bears from 1901 through 1999. Here are some quick stats on these:

• Secular Bulls: Average was 13.5 years with the longest running for 24 years (1942-1965) and the shortest running four years (1933-1936). These periods saw rising price to earnings ratios [PE] and inflationary environments moving towards stability. 83% of the years were bullish during a secular bull market with an average weighted gain of 19%. The remaining 17% of the time the average weighted loss was 5%.
• Secular Bears: Average was 11.3 years with the longest running for 20 years (1901-1920) and the shortest running 4 years (1929-1932). These periods saw declining to stable PEs and stable environments moving towards inflationary ones. 42% of the years were bullish during a secular bear market with an average weighted gain of 21%. The remaining 58% of the time the average weighted loss was a whopping 18%.

So while fear is present in bears and bulls (the fear of missing out), it is the declines in a secular bear that we usually must be most prepared to manage.

Where Are We Now?

Since staying grounded in major prevailing trends is an important task for traders, the question of whether or not we have passed from a secular bull to a secular bear or vice versa is an important one … at least from a market decline standpoint. Suffice it to say, we entered a secular bear in 2000 after reaching pre-bubble burst, record high PEs in 1999. Given relatively typical market returns from 2003 through 2007, it’s reasonable to say the 2008 decline continued the secular bear.

So where are we after the 2009 rally? Low inflation and current PE levels keep me in the secular bear camp for now—unfortunately hindsight is required to definitively identify transitions. The next couple of charts from Robert Shiller may help you make your own assessment.

The information that follows is available from Mr. Shiller’s Yale School of Management Web pages, which include current earnings and dividend charts and data for the S&P 500^® Index (SPX). This data is provided in both nominal and real values using Consumer Price Index [CPI] providing a nice analytical resource (www.econ.yale.edu/~shiller/data.htm).

Figure 1 provides Shiller’s SPX PEs versus long-term interest rates going back to 1880. According to Easterling, PEs for the S&P 500^® Index averaged 15.8 from 1900-2000.¹ The four secular bulls from that century were initiated when PEs ranged from a low of 5 to a high of 11 since the declining trend in the ratio overshot, rather than reverted to, the mean. Beginning PEs for secular bears ranged from a low of 19 to a high of 42 (2000).

It is quite possible that the 13.32 PE low in Mar-2009 satisfied an overshooting of the mean, but the rapid ascent of the ratio and Shiller’s current PE projections of 20.76 for SPX make it seem less likely and a bit unsustainable. Perhaps when looking back we will see that the recent secular market durations were closer to shorter termed ones, but for now erring on the side of caution simply means recognizing the potential for a high than average (all years) decline in the event there are losses for 2010.

 

Figure 1: PE (Cyclically Adjusted) Versus Long-Term Interest Rates (yale.econ.edu)

Figure 2 which displays real SPX levels versus real earnings for the components is a little bit more disconcerting. While a variety of companies have provided positive outlooks with recent earnings, it seems some relative earnings strength would be needed to sustain a bullish move.

 

Figure 2: Real SPX Index Levels versus Real SPX Composite Earnings (yale.econ.edu)

2010

Whether we are transitioning to a secular bull or remain in a secular bear for 2010, an up year in the market during either has averaged respectable returns of approximately 20%. Being bearish given the current secular bear could cause some portfolio pain. On the other side of the coin, a four-year cycle low projected for 2010 may mean some good market swings that provide traders with opportunity. The year could end with a 4% decline that combines a 20% decline followed by a 20% rally to end the year.

When completing your analysis, it may be particularly advantageous to identify the objective tools you will use this year to stay on the right side of the primary swings. In order to do that you must first consider your preferred time horizons and how they fit into a bigger picture view. If a potential bear has you concerned, use this time to also map out your portfolio protection game plan.

Short-term traders may not feel impacted at all by secular conditions or longer-term cycles, but I find it’s helpful to have some perspective on the current environment. It helps minimize fear (bearish & bullish) by forcing me to step away from the shorter-term noise that feels much more difficult to decipher.

To wrap up the secular market discussion, Figure 3 provides a 48 year history of the Dow Jones Industrial Average^SM using quarterly data. A portion of Easterling’s secular bulls and bears are highlighted in green and red, respectively.

 

Figure 3: Quarterly Secular Line Chart of Dow Jones Industrial Average (1962-2009)

Chart Specifications: INDU Quarterly Line Chart (log scale)

¹ Easterling, E. (2005). Unexpected Returns: Understanding Secular Stock Market Cycles. Fort Bragg, CA: Cypress House (97)

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

Questions for Clare? Please visit the discussion board on the homepage of Optionetics.com.

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