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As mentioned last week (1/14/10, Secular Trends), up years in secular bull markets and secular bear markets that occurred from 1901-1999 had similar weighted average values (19% and 21%, respectively). It was the down years in secular bears that did damage to portfolio returns. The average weighted decline was 18% versus 5% during secular bulls. In addition, this says nothing about the declines and volatility that occurred during the year. Given the assumption that we remain in a secular bear, it seems appropriate to breakdown those declining year stats a bit.

The market data for the Dow Jones Industrial AverageSM (INDU) uses a Worden Brothers TeleChart export and statistics on secular markets use Ed Easterling's 2005 book, Unexpected Returns: Understanding Secular Stock Market Cycles, as a source. Again, it's a great read if you have the chance to check it out.

Table 1: Easterling's Secular Bear Stats (1901-1999)

Easterling used peaks and troughs in the Price to Earnings ratio to identify the different secular periods. While the ratio swings may display some symmetry, it appears the index net change is a bit less uniform. Although the net change increases the longer the market remained in a secular bear, no doubt compounded losses caused problems along the way.

Avoiding Averages

It seems pretty natural to assess returns using average values and consider starting versus ending levels to judge different periods of time. I've already caught myself going right to the secular bear stat for down years and thinking that an 18% decline is not really catastrophic for investors. That seems to reflect the notion that my fears go beyond an 18% decline.

With that in mind, Figures 1 & 2 display daily closing and return data for each to better view the shorter term market movements. It captures drawdown versus calendar year changes.

 

Figure 1: INDU Daily Closes with Return Data 1929-1932 (Worden data)


 

Figure 2: INDU Daily Closes with Return Data 1937-1941 (Worden data)

Market movements don't repeat themselves exactly; however, I believe that cycles and patterns reflecting investor psychology do provide some insight. Rather than assessing lagging economic conditions for the period, I know I personally need to consider the worst case scenario from price action and take reasonable precautions.

Getting That Black Swan Off My Back

Last year's obsession with reviewing different mechanical hedging approaches clearly reflects the types of markets I've experienced as a trader and my bias toward the downside. Looking at it from a glass as half-full attitude, the good news when I'm wrong is that it suggests there's an improving economy ahead. Allocating more to cash than bearish positions helps too. It's still not a recipe for achieving certain return targets however.

The holiday break provided the perfect opportunity for me to step back so I could recognize my true concerns" it's not the returns around the center of a histogram that are affecting me, it's the ones that appear to the left of graph. The hedging exercise was more focused on shorter-term risk from a trading standpoint and I realized I needed to be aware of potential portfolio risk associated with negative return outliers.

Chart Specifications:
INDU Daily Line Chart (arithmetic scale)
Daily Price Change with Average +2SD and Average -2SD Boundaries

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.

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

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