Are You Prepared for Another Lost Decade?

Many investors and members of the financial press are only now recognizing that stock prices have lost ground over the last 10 years, labeling this period as the “Lost Decade”.  In April 2003, Pring Turner Capital Group published an article which posed the question: “Whither the Secular Trend of Equities?” This piece laid out our case that the year 2000 was a secular or “long-term” peak for the U.S. stock market. The article also forecast a wide trading range market in the years ahead. Our goal with the forecast in this report is to help you prepare for the next ten years.

Our opinion, based on extensive studies of previous secular bear markets, strongly suggests that investors should anticipate another “Lost Decade”.  As we will explain in more detail later in this report, 2009 could mark only the mid-point in this secular bear market.  The report will also describe the historic characteristics of long-term secular bear markets and when to anticipate the end of the current secular bear market.  Subsequent updates will cover the low-risk money management techniques we have successfully employed in growing client portfolios for the last 10 years. Forewarned and armed with this knowledge, you will be better prepared for the investment battle that lies ahead.  Now more than ever investors cannot afford to sit back and relax, but should prepare for another “Lost Decade”.

What is A Secular Trend?

First let us define what a secular or long-term trend is and why it is important for investors to be able to identify it.Our investment decision-making process is heavily influenced by the sequential rhythm of the business cycle, which forthe last 150 years has alternated between expansions and contractions.  A secular trend is formed when a series of business cycles are linked together establishing long periods of stock market out or under-performance. These patterns typically last up to 20 years.  In order to successfully protect and grow wealth, investors need to correctly identify which long-term price trend prevails.That is becausethe secular trend determines whether investors act primarily to accumulate wealth (secular bull) or to preserve it (secular bear).

What is the Current Secular Trend?

The 18-year period from 1982 to 2000 embraced the most recent secular bull market.  Stocks were grossly over-valued and investors were wildly optimistic with unrealistic expectations at the conclusion of this secular bull. Since 2000, we have embarked on a much different and far less investor-friendly journey, which represents only the first half of a secular bear market. Chart 1 shows U.S. stock prices adjusted for inflation back to 1870. It strongly suggests we are currently in the 4th secular decline since 1900.  The prior three secular trends began in the years 1901, 1929, and 1966 respectively, and lasted on average nearly 20 years.

When Will the Current Secular Bear Market End?

With the benefit of over 150 years of financial history, it is possible to establish benchmarks that tell us when valuations have reached pessimistic extremes. These yardsticks are consistent with an end to a secular bear market. There are many viable benchmarks that can be used to identify secular turning points, but we want to introduce two basic measures that support our outlook.

Duration:

The first benchmark to compare secular bear markets is duration.  Chart 2 and Table 1 both show that the last three lasted on average 18 years and 7 months. As of November 2009, the current trend has only lasted 9 years and 7 months, indicating greater potential if it is to even approach the average. As well as being measured in time, duration can also be looked at from the number of business cycles experienced. Prior secular bear markets averaged between 4 and 6 recessions. So far we have only experienced two. Allowing for a best-case scenario of 4 business contractions, this also suggests that we are barely halfway through the current cycle.

Valuation:     

Valuation is the second benchmark to use for comparing secular bear markets. Arguably the most popular long-term measure of stock market valuation is the price investors are willing to pay for corporate earnings (Price to Earnings, or P/E Ratio).  Why at one time are fearful investors only willing to pay $6.64 for $1 of earnings, (i.e. 1982 Secular Bottom) while at another time investors are eager to pay $44.20 for that same $1 of earnings (i.e. 2000 Secular Peak)?  The answer lies in the extremes of confidence or lack thereof only seen at major secular turning points.  Take a moment to study the 1Shiller P/E series at the bottom of Chart 1 and the key turning points as summarized in Table 1. Notice at the beginning of secular bear markets, the average P/E ratio is 31.5 (confidence high), in contrast to the average P/E ratios at the end of these periods that are 6.95 (confidence low). The current Shiller P/E reading is 18.77. We may have traveled a long way from the 2000 historic overvaluation peak (P/E 44), but clearly there is a long way to go to reach truly undervalued levels once again.

Based on previous cycles, it is therefore not difficult to conclude that the current secular bear market has further to run in duration (we are only halfway there in terms of years and recessions) and valuation (P/E ratios must return to bargain levels). The combination of duration and inflation-adjusted price declines grind away and erode investor hope. This is why it is not difficult to rationalize any number of economic or geo-political problems, yet to be addressed, that will push us toward the secular bear market bottom.

When will this current secular bear market finally reach bottom? The answer isprobablyin the next 6-10 years when stock prices (adjusted for inflation)finally gravitate towards the target area outlined in Chart 2.

Is it Possible to Build Wealth During a Secular Bear Market?

It is possible to build wealth during a secular bear market, but investors must first discard the buy and hold, indexing, and passive asset allocation strategies that worked so well in the prior secular bull market. In a negative secular environment the same static methods result in severely inadequate returns. The crucial determinant to wealth-building success in a secular bear market is to adopt a more pro-active plan of action. Even in this difficult uphill overall negative atmosphere there will be rewarding opportunities. The cyclical bull market that began in March 2009 is a typical example. Others with moves in excess of 25% have been flagged in Chart 3.  These primary bull markets reflect the normal transition of a business cycle from economic recession to expansion. The key to the successful exploitation of these moves is the application of the proper business cycle forecasting tools and disciplines.

Why is Business Cycle Analysis More Important Than Ever?

Summary