The bear market has unfinished business

Are we still stuck in a long-term bear market? That sounds like a stupid question, says John Authers in the Financial Times. The S&P 500, which sets the tone for the rest of the world, has almost trebled since March 2009. It now stands at a new record high. But the question isn’t as straightforward as it seems.

In 2003, a multi-year rally began in Western markets. Many hailed a new long-term bull market. Others, including MoneyWeek, suspected that the rally was probably just a bounce within a long-term, or secular, bear market – a huge bear-market rally.

In 2008, we were proved right: the S&P plumbed new depths, proving that the post-2000 bear market had not ended. So could this rally be another massive bear-market rally? Yes. Here’s why.

Secular bulls and bears

Well over a century of US market history shows that stocks move in long cycles from high valuations to very low ones and back again. This mirrors human nature: people get swept up in crazes and overpay for assets.

They then overcompensate by being bearish for years, during which they avoid or sell assets until they become absolute bargains. These long-term valuation upswings and downswings – secular bulls and bears – last for 15 years on average.

In secular bulls, cyclically adjusted price/earnings (Cape) ratios rise from single digits to above 20. The pattern was evident in the big post-war rally of the mid-1940s to the mid-1960s and during the 1920s.

Between 1982 and 2000, the biggest secular bull on record, the S&P’s Cape rose from around seven to over 40, when the tech bubble peaked.

Conversely, the 1966-82 bear market ground valuations down from high double digits back to single digits. There was another secular bear from 1929 to the mid-1940s. 2000 marked the start of the latest one.

Fifteen years on, history suggests we should really be getting going on a new bull cycle. But the last bear may not have hit bottom yet. In 2000, the euphoria peaked and the Cape began to fall. But it was still historically stretched – in the 20s – when the 2003 rebound began.

Then, in 2009, it only fell to ten, not to six or seven, the sort of single-digit values that have historically heralded a secular bottom. Now it is back to overvalued levels. If the bear market isn’t over yet, it doesn’t necessarily mean that stocks must plunge.

The other way for valuations to fall to enticing levels is for earnings to rise as stocks grind sideways. Secular bear markets are usually a messy combination of the two.

It’s the economy

Ultimately, it is the macroeconomic backdrop that influences investors’ view of valuations, and here we find another clue suggesting the bear hasn’t lost its bite. BCA Research points out thatsecular trends have economic themes.

The 1966-82 bear was a result of inflation getting out of control; the following bull market was all about the defeat of inflation and deregulation. The post-2000 era can be seen as a long economic hangover.

Central banks inflated the credit bubble in order to mitigate the impact of the bursting of the tech bubble. Then they printed unprecedented amounts of money to temper the effect of the burst credit bubble. The sub-par global recovery shows we are still stuck in the hangover.

We certainly aren’t in an economic environment that history suggests accompanies a secular bull market.

It seems plausible that central banks’ continual liquidity boosts have prevented valuations from hitting the usual floor, making them pricier than the economic backdrop would warrant. Without constant money printing, stocks would be nowhere near this far ahead of the fundamentals.

Can central bankers put off the evil day forever? The shaky, artificial nature of the rally, and the still-lacklustre economic backdrop, makes us suspect that the post-2000 bear may yet have unfinished business.