Guest author: Ed Easterling, founder and President of Crestmont Research. Bio at end of the article. This article was posted May 17, 2011 at dshort.com.
There is a skeptical gremlin perched on the left shoulder for many investors. He often sneers at notions of “cycles” and other presumably predictable periods. When the word “secular” accompanies the word “cycle,” that gremlin becomes even more scornful.
Why do we use the term “secular cycle” with the stock market and what does it mean?
Figure 1 presents a view of the stock market over the past century. You will note periods of above-average returns (i.e., the green bar periods) and periods of below-average returns (i.e., the red bar periods).
Figure 1. Secular Stock Markets Explained
First, the periods are not random or sporadic — they follow each other. That’s why we call them cycles, rather than simply periods. Further, there is a fundamental driver of these periods; they are not coincidental phenomena. The driver is the inflation rate as it moves toward and away from price stability (i.e., relatively low, stable inflation). Trends of rising inflation and deflation drive market valuation lower and thus result in low returns. The return to price stability drives market valuation higher and generates high returns. This is reflected in the P/E ratio on the lower part of Figure 1.
Therefore, the word “cycle” better expresses the nature of market valuation trends and their impact on ultimate returns. Otherwise, investors might expect two above-average periods to follow each other, or investors might expect that an above-average period can occur without a sufficiently offsetting period.
In other words, for emphasis, after the past decade of near-zero returns some investors are hopeful that another above-average decade is on the horizon. It is not. Investors that understand the drivers of these periods know with confidence what lies ahead. There will be more about that shortly.
So if the term “cycle” is better than “period,” then why is the term “secular” used with it?
Look at the back of an American one-dollar bill. There, on the left side of the Great Seal of the United States, below the pyramid topped with an eye, is a banner with the phrase novus ordo seclorum — “new order of the ages.” One meaning of the term “secular” comes from the Latin word that means era, age, or extended period. Charles Thomson, a Founding Father and principal designer of the Great Seal, described the meaning of the phrase as “the beginning of the new American Era.”
When the word “secular” is applied to stock market cycles, it denotes an extended period with something in common throughout. Secular bull markets are long periods that cumulatively deliver above-average returns. Secular bear markets are the opposite; they bring cumulative below-average returns. Not only does the term secular refer to the cycles of returns, but also it refers to the underlying cycle of inflation that drives these periods. The term “secular” in one word complements “cycle” to define periods in the stock market, their causes, and their patterns.
So although the term secular stock market cycle may at first sound ethereal, it is actually grounded by fundamental principles.
One of the primary concepts behind secular stock market cycles is that the level of valuation (measured by the price-to-earnings ratio, P/E) generally drives the return ultimately realized by investors. Generally there are bounds to P/E: rarely has the normalized P/E declined to near 5 or exceeded 25. In addition, P/E does not jump around randomly; rather, it fluctuates back and forth between the outer extremes.
[dshort note: for more details about normalizing P/E, see P/E: So Many Choices, Part I posted on April 26.]
As a result, the change in valuation during an investor’s horizon can have a significant impact on total return. Further, valuation affects other aspects of total return. High valuations reduce the contribution of dividends to total return by lowering the dividend yield. Therefore, the starting level of P/E fundamentally drives subsequent returns.
To highlight the fundamental principles, let’s explore a chart developed through collaboration between Crestmont Research and dshort.com. The graphic reveals the principle that starting valuation drives ultimate investment returns. For Figure 2, Crestmont’s data has been extended back to 1871 and is developed on a monthly basis. The graphical layout and other methodologies are based upon dshort’s work.
The compelling message of Figure 2 is that the level of P/E drives future returns. There are two variables in the chart: total returns from stocks adjusted for inflation and the P/E ratio at the start of the period being analyzed. The period of 15 years was chosen because it is representative of most investors’ long-term investment horizons. Some investors use a decade (i.e., 10 years), while others think in terms of generations (i.e., 20 years). Rolling periods of 15 years seems to balance those two horizons. Thus, the chart includes all rolling 15-year periods starting on a monthly basis from January 1871 through April 1996 (fifteen years ago from last month).
Figure 2. Crestmont P/E and Rolling 15-Year Real Total Returns
In Figure 2, the relationship is apparent and the statistical correlation is high — high P/Es drive lower returns and lower P/Es drive higher returns. Most importantly, however, the chart and statistics are backed by the fundamental principles that were previously discussed. Therefore, the relationship is not a mere coincidence or an unexplained phenomenon. It represents a predictable and explainable relationship that offers significant implications for the future.
Currently, P/E is well above average. Future total returns are highly likely to be below-average. The magnitude of how much below-average depends upon whether P/E remains high or declines … and if it declines, a longer decline period may enable the current period to still have positive returns — albeit still well below average.
Investors should not retreat from investing in the stock market. Instead, given the current low return environment, investors need more diversified and actively-managed approaches to enhance returns. Alternatively, investors with passive buy-and-hold portfolios should realign their expectations for the inevitable reality of this secular bear market cycle.
(c) Crestmont Research (www.CrestmontResearch.com)
Ed Easterling is the founder and President of Crestmont Research (www.CrestmontResearch.com), an investment management and research firm that develops provocative insights and unconventional perspectives on the financial markets. In addition, he is the author of recently released Probable Outcomes: Secular Stock Market Insights, author of Unexpected Returns: Understanding Secular Stock Market Cycles, contributing author to Just One Thing (John Wiley & Sons: 2005), and coauthor of chapters in Bull’s Eye Investing by John Mauldin (John Wiley & Sons: 2004). Mr. Easterling serves as a Senior Fellow and Advisory Board Member with the Alternative Investment Center in the Cox School of Business at SMU.