Are we stuck in the bear cage?

PORTFOLIO POINT: History shows that secular bear markets can run for decades. The bulls are getting ready, but there may be a lot further to go before real recovery.

Last week I put the case that global economic conditions, combined with past trends, indicate we could be on the cusp of a bull market (Read Is the bull market gate about to open?). But forecasting is never an exact science, and this week I explore the opposite viewpoint that the global secular bear market which started in 2000 has many more years to run.

A popular American market commentator reports:

“Some Wall Street bulls are now saying that the Dow could skyrocket as far as17,000 in 2013 — and make a lot of investors very rich in the process.

“But die-hard bears insist it will it crash and burn ... plunge as low as 7,000 ... bankrupt millions of investors ... and leave Wall Street a smouldering ruin.”

Source: Dr Martin D. Weiss, The Dow in 2013: 17,000? Or 7,000? Weiss Research Inc. 28^th November 2012

Secular bear markets usually last a long time

The starting point for pessimists is that historically secular bear markets have lasted for long periods. The following chart shows there have been eight secular bear markets since 1700, two of which started with horrific crashes. Their average duration exceeded 25 years. Excluding the several depressions from 1720-1790, their average length was at least 19 years. A secular bear market is defined here as a market than ranges (i.e. swings sideways) for at least 10 years. Great crashes (i.e. 1720-22 and 1929-32) are treated as abnormal starts to such ranges.

• 1690s-1715: 15 years
• 1720-1790: 70 years
• 1800-1812: 12 years
• 1835-1865: 30 years.
• 1875-1899: 24 years
• 1929-1949: 20 years
• 1965-1982: 17 years
• 2000-         12 years so far

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If the secular bear market ended in March 2009, then this is the shortest one in the last 200 years with the exception of 1800-12.

Furthermore the current secular bear market in Japan has been going for 22 years, with so far no end in sight.

Deleveraging is a prolonged process

The global financial crisis resulted from the bursting of a credit-fuelled asset bubble. This left a huge mountain of private debt that could take until 2028 to get back to a sustainable level.

In Europe banks owe too much money to too many creditors. They have neither the capital or income to sustain those debts. Also they are major holders of bonds from governments that could default.

Around the world public debt has exploded as government revenues have collapsed and additional government spending has gone on rescuing banks, insurance houses, motor corporations and the unemployed. Unless governments can now prune their spending or increase taxes, their large deficits will continue to expand their debts.

According to the gloomiest forecasters, the slow deleveraging process means the secular bear market will persist for at least another 16 years. This is not to say this period won’t experience bull markets, it will. But they will be primary bull rallies within a larger secular bear market like Japan has experienced since 1990.

The show is not over until the fat lady shrinks

Cresmont Research, which analyses long-term share market data, argues that secular bear conditions don’t end until the stockmarket’s cyclically adjusted price earnings ratio falls below 10. As can be seen in its chart of the S&P 500 index, the US market has still to shrink to this level. That can only happen through share prices falling, earnings rising or a combination of both. Hence the bears argue that the worst won’t be over until “the fat lady shrinks”.

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Professor Robert Shiller, whose book “Irrational Exuberance” was published just before the 2000 stock market crash, proffers a similar argument. His cyclically adjusted P/E ratio shows that while America’s market looks cheap compared with the last decade, it is expensive compared with its average ratio of 16.5 for the last 142 years. Past secular bear markets have not ended until the ratio shrunk below 7.

An ageing population is depressing sharemarkets

Harry Dent, in his best seller The Great Crash Ahead (2011), says that peak household spending occurs when the primary family income earner is aged between 46 and 50 years.

He has tracked the number of such peak spenders back to 1956 and projected them forward to 2056. When he compared the results with the movement of the Dow Jones index adjusted for inflation, he found a strong correlation. His conclusion was that the sharp fall in peak spenders between 2007 and 2021 would drag down the sharemarket with it. As such, the next secular bull market won’t start until 2020.

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The economic outlook is subdued

Declining confidence throughout the developed world has led the OECD to slash its GDP growth forecast for 2013 from 2.2% to 1.4%. The organisation’s chief economist, Carlo Padoan, warns: “The risk of a major contraction cannot be ruled out.”

Bears contend that the great deleveraging has resulted in households viewing saving as the new spending. Thrift is the new norm as people save to rid themselves of debt. Companies and banks are also trying hard to fix their balance sheets by reducing leverage.

A secular bull market built on credit creation won’t begin until households and businesses have eliminated their existing debt overhangs. This could take a long time.

America’s economy is recovering, but note how it is underperforming compared with its long-term trend growth. But for the US government spending $1.1 trillion more than it collects in taxes, this undershooting of the economy would be even worse.

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Professors Carmen Reinhart and Ken Rogoff in their important research paper, “Growth in a Time of Debt”, found that for the past 200 years, once a country exceeded a 90% gross public debt/GDP ratio, its economic growth slowed by nearly 2% for an average duration of nearly a decade. Most developed countries now face that fate.

Capital spending is set to crash

David Rosenberg, chief economist at Gluskin Sheff & Associates, says that each of the two last US recessions was preceded by a collapse in non-defence capital spending (excluding aircraft). He says the latest data shows that such spending has now fallen to a level suggesting that a recession is just around the corner.

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Non-defence spending defined the US secular bear market of the last dozen years. If Rosenberg is right, the next move in the S&P 500 index could be another crash such as witnessed in 2000-2003 and 2007-2009. On this scenario, the secular bear market has at least another two years to run.

In Australia the picture is even bleaker. Companies have scaled back their capital expenditure plans for 2012-13 by 3%. Except for a small dip in 2010-11, Australia has not suffered a setback to corporate investment since the survey was started in 1976. It shows the mining led investment boom is faltering faster than forecasters anticipated. Unless something else fills the spending gap Australia could face a recession.

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Earnings have peaked

Twelve month inflation adjusted S&P 500 earnings slumped by 92% from a peak in Q3 2007 to a trough in Q1 2009 matching the fall of the 1920/21 recession and the lows of the great depression. Thereafter S&P 500 earnings surged to its credit bubble peak. Since Q4 2011, however, earnings have gone flat and are now declining. Unless profits vault higher as they did in the 1920s, 1950s and 1990s the secular bear market will continue.

Central banks won’t save the world

Reserve Bank Governor Glenn Stevens is sceptical that central banks can revive the world economy through quantitative easing (i.e. money printing).

He recently said: “The Bank of Japan has been doing this; they have had zero interest rates since 1999 or 2000. They have had quantitative easing for a little shorter time than that, but still quite a long time, they are still deflating.”

Japan got a preview of the GFC in 1989 when its property and equity market bubbles burst, causing its banking system to collapse. Since then it has suffered ongoing deflation and low growth. Whenever attempts have been made to cut the government deficit the economy has lapsed into recession. Public debt to GDP now exceeds 220%, almost double that of Greece. This has been funded by Japanese switching from shares to bonds, but now that many are retiring they want to draw down their savings threatening the government’s borrowing capacity.

The Economist magazine has said the West is going Japanese. If that happens, then the secular bear market could exceed 20 years as it’s done in Japan.

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Conclusion

This is the depressing case for the bears. Before you slash your wrists, re-read last week’s uplifting case for the bulls.

In any event my motto is “Bull or Bear, We Don’t Care”. That’s because trend-followers make money in rising and falling markets. The only thing I dislike is choppy markets without sustained up or down-trends, because they generate pesky whipsaws.

Next week I will examine how to invest, whether the future is bright or bleak. I shall explore strategies for achieving good returns while minimising downside risk. Don’t miss the final installment of this series.

Percy Allan is a director of MarketTiming.com.au For a free three week trial of its newsletter and trend-trading signals for listed equity funds click here.