The Lunacy of Believing in a New Secular Bull Market

I have addressed this before, but I was catching up on some reading and thought a recent piece from Hussman provided a great synopsis while the belief in a new secular bull market is just lunacy (my words). Here is an excerpt.

As I noted in Hanging Around, Hoping to Get Lucky, extended "secular" moves from extreme undervaluation to extreme overvaluation (or vice-versa) have historically taken about 15-18 years in each direction. At secular bear market lows, the Shiller P/E (S&P 500 divided by the 10-year average of inflation-adjusted earnings) has typically been about 7, as we saw in 1942-1950 and in 1982. By contrast, at secular bull market highs, the Shiller P/E has typically exceeded 24, as we saw in 1929, 1965, and 2000 (the present multiple is 22.7). Doug Short  presented a good historical overview of valuations last week using a variety of metrics. By our own estimates, we expect the nominal total return on the S&P 500 over the coming decade to average about 3.8% annually, though with very broad cyclical fluctuations producing that overall result. 

The near-zero return in the S&P 500 over the past 13 years was the consequence of extraordinary overvaluation in 2000. The secular bull market that ended in 2000 took valuations dramatically above anything seen even at the 1929 peak. We correctly estimated at the time that the 10-year total return of the S&P 500 was likely to be negative even with optimistic assumptions about the valuations that might prevail at the end of that 10-year period. The S&P 500 Index lost half its value in the 2000-2002 plunge. The 2007-2009 bear market decline wiped out not only the bull market advance that followed the 2002 low, but the entire total return of the S&P 500, in excess of Treasury bills, all the way back to June 1995. Yet the 2009 decline brought market valuations only briefly below the historical norm, and even that level of valuation is long gone. 

Given the extent and maturity of the recent advance, it’s very odd that analysts are now beginning to toss around the idea that stocks have entered a secular bull market. These notions are based not on the level of valuation, nor on the typical 15-18 year duration secular bear markets (if this is a secular bull, it follows that the secular bear lasted only from 2000 to 2009). Instead, it is based on the idea that stocks have gone nowhere for a long time and the recent advance might be enough to break the downtrend we’ve seen in the inflation-adjusted S&P 500 since 2000. 

Unfortunately, secular bull markets do not begin simply because stocks have gone nowhere for a long while or because the market breaches some trendline. They begin at the point that valuations become so depressed - again, about 7 on the Shiller P/E - that strong and sustained long-term returns are baked in the cake. Similarly, secular bears tend to begin at the point where valuations are so extreme - about 24 or higher on a Shiller P/E - that weak and ephemeral long-term returns are baked in the cake. The intervening secular moves simply take the market from one extreme to another over the course of something on the order of 15-20 years.

We can show this with basic arithmetic. Historically, nominal GDP growth, corporate revenues, and even cyclically-adjusted earnings (filtering out short-run variations in profit margins) have grown at about 6% annually over time. Excluding the bubble period since mid-1995, the average historical Shiller P/E has actually been less than 15. Therefore, it is simple to estimate the 10-year market return by combining three components: 6% growth in fundamentals, reversion in the Shiller P/E toward 15 over a 10-year period, and the current dividend yield. It’s not an ideal model of 10-year returns, but it’s as simple as one should get, and it still has a correlation of more than 80% with actual subsequent total returns for the S&P 500:

Shorthand 10-year total return estimate = 1.06 * (15/ShillerPE)^(1/10) – 1 + dividend yield(decimal)

For example, at the 1942 market low, the Shiller P/E was 7.5 and the dividend yield was 8.7%. The shorthand estimate of 10-year nominal returns works out to 1.06*(15/7.5)^(1/10)-1+.087 = 22% annually. In fact, the S&P 500 went on to achieve a total return over the following decade of about 23% annually.

Conversely, at the 1965 valuation peak that is typically used to mark the beginning of the 1965-1982 secular bear market, the Shiller P/E reached 24, with a dividend yield of 2.9%. The shorthand 10-year return estimate would be 1.06*(15/24)^(1/10)+.029 = 4%, which was followed by an actual 10-year total return on the S&P 500 of … 4%. 

Let’s keep this up. At the 1982 secular bear low, the Shiller P/E was 6.5 and the dividend yield was 6.6%. The shorthand estimate of 10-year returns works out to 22%, which was followed by an actual 10-year total return on the S&P 500 of … 22%. Not every point works out so precisely, but hopefully the relationship between valuations and subsequent returns is clear. 

Now take the 2000 secular bull market peak. The Shiller P/E reached a stunning 43, with a dividend yield of just 1.1%. The shorthand estimate of 10-year returns would have been -3% at the time, and anybody suggesting a negative return on stocks over the decade ahead would have been mercilessly ridiculed (ah, memories). But that’s exactly what investors experienced. 

The problem today is that the recent half-cycle has taken valuations back to historically rich levels. Presently, the Shiller P/E is 22.7, with a dividend yield of 2.2%. Do the math. A plausible, and historically reliable estimate of 10-year nominal total returns here works out to only 1.06*(15/22.7)^(.10)-1+.022 = 3.9% annually, which is roughly the same estimate that we obtain from a much more robust set of fundamental measures and methods.

Simply put, secular bull markets begin at valuations that are associated with subsequent 10-year market returns near 20% annually. By contrast, secular bear markets begin at valuations like we observe at present.

The whole article can be found here.