We were initially going to have a bit of a rant about how Central Bank policies are not just ineffective at generating sustained economic growth, but how investors appear to be revolting against said policies as they appear to be having a detrimental impact on the financial system. In our opinion, this is all very true, and we will no doubt come back to have a look at this subject relatively soon. With many commentators (and clearly investors) beginning to question the efficacy of current QE/ZIRP/NIRP policies, we thought we would take a step back and look at a bigger concept that we think is crucial.
Before we get into the meat of today’s commentary, we do have to admit that equity markets have become dramatically oversold after the steep declines witnessed so far this year. In simple rate of change terms, markets are as oversold as they were during the 2011/12 period (US debt ceiling and European Sovereign debt corrections), although not nearly as oversold as they became during the time of Lehman’s collapse in 2008. We don’t think fundamentals are as bad as H2 2008, but the market structure may well be more fragile. Overall, we expect the rate of decline to diminish in the short term, and we certainly see the potential for a bit of a bounce if the “animal spirits” can summon up enough strength. We’ll see.
This week, we thought we would consider the concept of secular trends in equity markets. Despite what some academics tell us about the Efficient Market Theory, and the blaring propaganda from many on Wall Street, there are indeed times to be IN the market and times to be OUT. Yes, timing the market is extremely difficult, especially when Central Banks are employing extremely experimental policies designed to boost asset prices regardless of valuation. However, we do think that understanding the concept of secular bull and bear markets will be beneficial to true long term investors.
Crestmont Research have done some excellent work on this subject, and explain what they believe to be a secular cycle, as follows;
“The long-term view of the stock market reflects extended periods of surge and stall. These periods, known as secular bull markets and secular bear markets, are not optical illusions; rather they are extended periods when market valuations (i.e. price/earnings ratios: P/Es) are either multiplying the effect of rising earnings or mitigating them. Secular bull market periods have always started when P/Es were below average, and secular bear markets have never ended when P/Es were above average.”
As this concept is clearly long term in nature, it is simply not appropriate to use a single year’s corporate earnings in the analysis. Crestmont use what they call the P/E10 which is basically Robert Shiller’s CAPE or Cyclically Adjusted PE. The chart below vividly illustrates secular bull and bear markets over the last 110 years. The lower panel in the chart shows the P/E10 and the demarcation between secular bull and bear markets.
What is hopefully clear here is that secular bull and bear markets are judged on valuation criteria and not price alone. The chart shows clearly that as P/E multiples expand during secular bull markets, prices advance rapidly. In secular bear periods, price struggles to advance as P/E multiples contract.
The real story here is that long term investors will probably be better off ignoring virtually every other influence (we’re thinking Central Banks here), and concentrate on tried and tested valuation measures to gauge the level of their commitment to equity markets. In our opinion, the US equity market is still in a secular bear phase that began back in 2000, and with the P/E10 still at levels previously seen at secular bull market peaks, now is not the time to be heavily invested. Indeed, the start of the next secular bull market will only be seen if share prices fall dramatically in a short period of time, or track broadly sideways for another decade or more.
There has been a level of criticism over whether Shiller’s CAPE is actually a useful way of measuring fundamental value, and some have shown variations that illustrate the market is cheaper today than CAPE would indicate. Perhaps the problem with any earnings based measure of valuation is that it is far easier to distort earnings than other measures of value such as revenue or book value. Frankly, we think that CAPE is robust in its own right, but to illustrate valuation in a different way, let’s look at the q ratio, or current price relative to replacement cost.
Luckily, Andrew Smithers still updates his work on both q ratio and CAPE in the chart below. The calculation is a logarithmic rather than simple calculation, but the important thing to accept here is that we have two independent valuation measures that are both robust and consistent over the long term. Unfortunately, that message is that outside of the peak bubble period in 2000, the US equity market has never been more highly valued.
Although US equities appear to be the most high valued at the moment, work by the likes of Jeremy Grantham at GMO show that prospective real returns from all developed markets will likely be disappointing over at least the next 7 years. We would also contend that if US equities do move into a cyclical bear market (within a secular bear market), then that will drag down all equities markets, more or less.
Perhaps one last point in this brief consideration of secular trends. Equity markets have a horrible habit of going up the escalator and down the lift. By this we mean that years of gains can be wiped out in a matter of weeks or months. This does not matter so much in a secular bull phase, but absolutely does matter in a secular bear phase. Why? Because overall gains in a secular bear phase are close to zero for a buy and hold investor, and so it is crucial that gains from cyclical bull phases need to be cashed in, and cyclical bear phases avoided like the plague.
So, is there any way to avoid the cyclical bear phases? Well, we have always tried to use a variety of technical analysis techniques, and in the chart below of the MSCI World Equity Index, we have shown a very simple moving average model. We have used the 40 and 80 week moving averages (pink and green lines), and the thinking is that you should be long when the 40 week average is above the 80 week average, and a sell signal is generated when the 40 week falls below the 80 week. A new buy signal is generated when the 40 week average subsequently crosses back above the 80 week average. This is a “long only” model in that when a sell signal is in place, the model is in cash. There are no dividends included and not trading costs, so it is purely for illustration purposes.
Chart 3 – MSCI World Equity Index (price only) with 40/80 week model
Of course, these types of models are both simplistic trend following models and are by no means perfect. The whipsaw action in 2012 being a good example, with a sell signal generated in January followed by a new buy signal in September at a higher price. But the point of these models is to avoid the big downside moves, and this model does help, when analysing historic data. For example, if an investor bought on the buy signal in October 2003 and was still holding today, they would be sitting on a gain of 57% before dividends. If an investor had followed this model, then they would have generated a gain of 117%, avoided some nasty periods of price declines, and therefore enjoyed a much better risk reward.
So, the message we are trying to get out this week is that long term investors need to work out whether equities are in a secular bull or bear phase. In a bull phase, they can simply buy and hold even through cyclical bear phases which are often reasonably mild. However, in a secular bear phase, investors need to avoid the cyclical bear markets like the plague as it is simply not possible to hold onto gains made during cyclical bull markets during the secular bear phase. During all of this, investors are probably best served by ignoring all the noise that markets generate including any theories about how central bank policies are the best reason to own equities.
For what it’s worth, we not only believe that markets remain in a secular bear phase that began in 2000, but it appears that we have now entered a cyclical bear phase as well. It is time to be as underweight equities as you can be, according to the work we do.
We do believe that central bank policies are now leading to rising financial instability, and investors are questioning their belief systems about holding risky assets simply because of extreme and untested central bank policies. We have long believed that once investors begin to lose faith in the efficacy of central bankers’ current policies, it would be time to head for the hills. It appears that this time has come. The only thing that has surprised us is that it has taken this long.
Stewart Richardson
Chief Investment Officer
