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History stands in Wall Street's way

12 Nov 2012 SYDNEY MORNING HERALD - MATTHEW KIDMAN


Captain Barack Obama and his star quarterback "Helicopter Ben Bernanke" will have to defy history to replicate their first-term performance in the coming four years.

From November 2008 when Obama was first elected to the White House until last week, when he was voted in for a second time, the Dow Jones index rose about 60 per cent.

If this scenario is repeated between now and November 2016, the Dow Jones will be sitting at some 21,000 points and the global financial crises will have been consigned to the recycling plant.

Unfortunately, previous US secular bear markets suggest this is not going to happen. In fact, events over the past 112 years strongly indicate the US sharemarket has a long way to go before it is out of the woods.

In the 20th century, the US sharemarket had three distinct secular bear markets. A secular bear market is characterised by a long-term down trend punctuated by sharp rallies that can last several years.

The first of these was between 1900 and 1920. In that period the sharemarket fell a stunning 69 per cent once adjusted for inflation.

The second secular bear market was kicked off by the great crash of 1929. Stock prices fell an inflation-adjusted 67 per cent over 19 years before starting a new secular bear market.

The third and final secular bear market was triggered in 1966 and lasted 16 years, with stocks falling an inflation-adjusted 62 per cent.

The current market has been in a secular bear trend since 2000 (12 years) and has fallen 30 per cent once inflation is taken into account. If the secular bear market is over, then this will be a baby compared to previous experiences. From an historical point of view this seems remote and investors would be getting off very lightly given the preceding secular bull market ran from 1982 to 2000 and delivered a 1400 per cent gain.

If, say, the sharemarket repeated the inflation-adjusted period from 1966 to 1982, the Dow Jones Industrial Average would bottom out close to 9000 points in 2016. That sounds scary. It would be even worse if the two secular bear markets from the early part of the 20th century proved to be the blueprint for today. The US sharemarket would fall all the way to 2019.

Supporting this case for further pain in the market are valuations. In previous secular bear markets stocks have gone from severely overvalued to incredibly undervalued. One way of measuring this is the Shiller price to earnings multiple. This PE is calculated by using the average company earnings over 10 years instead of current-year earnings.

At the moment, the Shiller PE model shows US stocks are still 20 per cent higher than the long-term average of about 15 times. In fact the Shiller PE never got below the long-term average through the entire current bear market, even during March 2009. In previous bear markets the Shiller PE has fallen well below the average into single-digit territory.

This all sounds horribly depressing. For Australians, though, there may be a silver lining. As pointed out by the US investment house Pring Turner, commodity prices have a history of rising strongly during all secular bear markets. The current period is no exception with commodity prices, led by gold and oil, hitting bottoms and heading progressively higher from about 2000.

In the previous equity secular bear market from 1966 to 1982, commodities marched higher and only when this came to an end did sharemarkets find traction.

The logic for this inverse relationship comes down to higher commodity prices feeding through to higher costs for companies and depresses earnings. In addition, consumers are slugged with higher prices for a range of goods including fuel, food and clothing at a time when incomes are stagnant. Conversely, lower commodity prices support growth in company earnings and frees up household incomes.

More recently, the slowdown in Chinese economic growth, together with the dire state of economic affairs in Europe have seen a range of commodity prices, including oil, copper and bulk metals, come off the boil.

With China's economic situation stabilising and the US Federal Reserve kicking off QE3 (better known as quantitative easing unlimited) next week, commodity prices may start to fire higher again. Some pundits like to call this the unintended consequences of the Federal Reserve printing money to stimulate its domestic economy.

Higher commodity prices would be tremendous news for our mining and agricultural companies that represent about 30 per cent of our market. For investors, it would mean hiding out in places like gold and oil stocks, while the rest of the equity market stumbles to the end of the secular bear market.

Ideally though, sharemarkets around the globe would love to see a major downtrend in commodity prices. This would provide the fillip for companies to thrive and print better earnings.

Even the Australian sharemarket would perform better under this scenario, with about 65 per cent to 70 per cent of stocks having no benefit from the mining boom.

History tells us though, that Obama and Bernanke are at long odds to achieve this desired outcome.

matthewjkidman@gmail.com