Where to from here?

Investor Question I get frequently:  “When is this bear market going to end and when is the next bull market going to start?” My Answer:   “I don’t know and anyone that says they know is lying to you. However, I know it won’t be soon.” I know, just call me a “big bowl ‘o investing sunshine”! But wait! All is NOT gloomy here at Volk and Associates Inc. This secular bear market we are currently in year 13 of, started in 2000 and has shown no signs of ending any time soon. Am I violating Volk and Associates’ self-imposed “no predictions’ mantra? No. And here’s what the facts say about why it won’t be ending any time soon, and how we can nevertheless still fare pretty well. Clients and observers of our investing models know this first hand. First, let’s take a look at where the market is in relative terms. One way to do this is to use Yale Professor of Economics Robert Schiller’s cyclically adjusted PE ratio on the S&P 500, the most common measure of the market.* (yes, an economics professor…if you’ll recall, I did say that their information is good, it’s just in the implementation they take a left turn.) Also known as the ‘CAPE’ for “cyclically adjusted price earnings”, it represents a rolling 10 year moving average PE on the S&P 500. Schiller has tracked this number for years and has gone back in history to plot that also. This can be found at www.multpl.com If we were to overlay this chart with market performance, we would see that no long term bull market has ever started from anything other than a single digit reading on this number. Given that we are currently at a 22.81 reading on this measurement, it provides part of the answer to our question of when the next bull market will begin- not soon. There are only two ways to go from where we are right now down to a single digit PE ratio:

  1. Earnings more than double on the S&P 500; or
  2. The S&P 500 takes a more than 50% drop.

So which will it be? -Do you think the American economy will be able to more than double the profits of the S&P 500 over the next 5 or 10 years?  Using the “Rule of 72”, we know that over a 10 year span it takes 7.2% per year to double an investment. Has the U.S. economy EVER grown at a 7.2% rate in the past 100 years? I seriously doubt it. And if it does, where does that say inflation will be? Consider that in the greatest economic boom our country has ever seen, the U.S. only averaged about 4%, and the 1980’s-1990’s economic growth was at about a 3% rate. -OR- -Do you think the S&P 500 will take a more than 50% haircut? The answer will probably be a combination of the two, but we have no idea what mix that combination will be. Let’s say the growth rate is an optimistic 3% (the reason I say optimistic is because the facts say the driver of the last 50 years of economic growth in the U.S., the Baby Boom generation, is now retiring at the rate of 10,000 every day and will for the next 19 years or so. What effect will that have on the stock market? For one answer, we can take into account the report the San Francisco Fed branch put out last August, entitled  “Boomer Retirement: Headwinds for U.S. Equity Markets?” So without much hope for help through economic growth, that leaves us with taking a greater-than-50% ‘hit’ to the S&P 500. So what’s an investor to do? Head for the hills? Not if you want to make any money. Now that we know the market is not going to head north on a secular (meaning lasting years and decades) bull market any time soon, we can take advantage of knowing where we stand. You see, the great part of a bear market is that while it is busy burning off that excess PE, it behaves in some fairly reliable ways. For instance, if we absolutely must invest in the United States markets, it’s good to know some historical facts of previous long term secular bear markets. For instance, they are characterized by continual shifts from the shorter term cyclical (months and years) bull markets (which we may be seeing the end of one now) to cyclical bear markets. These ‘shifts’ alternate, on average, about +/- 25%. That is a valuable observation to know. Another valuable observation to know is that the investments that perform worse than the overall market in the cyclical bull runs, stand a good chance of performing worse than the overall market in the cyclical bear run that ensues. While it oversimplifies the matter at hand almost grotesquely, it does do an acceptable job of illustrating at a 50,000 foot view of what we do to produce strong results for our clients in their company sponsored 401(k) accounts, their IRA’s, their variable annuities and their brokerage accounts. It forces us to be continually adapting and flexible, something that will be more and more critical in the future. Static investment theories and hypotheses will suffer irreparable harm if the markets are not in their favor, mainly due to their static nature. How much harm? That provides us the subject for our next blog entry, as most investors have no clue as to how much damage happens to their portfolios in down years. As I’ve said many times before, it’s o.k. to be wrong, it’s not o.k. to STAY wrong. As the old market adage relates, cut your losses and let your winners run. It’s comforting to know that our systematic, disciplined approach to the markets will automatically yield this type of situation. -Eric Volk

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