Jim Kopas

Many investors and members of the financial press are only now recognizing that stock prices have lost ground over the last 10 years, labeling this period as the “Lost Decade”.  In April 2003, Pring Turner Capital Group published an article which posed the question: “Whither the Secular Trend of Equities?” This piece laid out our case that the year 2000 was a secular or “long-term” peak for the U.S. stock market. The article also forecast a wide trading range market in the years ahead. Our goal with the forecast in this report is to help you prepare for the next ten years.

Our opinion, based on extensive studies of previous secular bear markets, strongly suggests that investors should anticipate another “Lost Decade”.  As we will explain in more detail later in this report, 2009 could mark only the mid-point in this secular bear market.  The report will also describe the historic characteristics of long-term secular bear markets and when to anticipate the end of the current secular bear market.  Subsequent updates will cover the low-risk money management techniques we have successfully employed in growing client portfolios for the last 10 years. Forewarned and armed with this knowledge, you will be better prepared for the investment battle that lies ahead.  Now more than ever investors cannot afford to sit back and relax, but should prepare for another “Lost Decade”.

What is A Secular Trend?

First let us define what a secular or long-term trend is and why it is important for investors to be able to identify it. Our investment decision-making process is heavily influenced by the sequential rhythm of the business cycle, which for the last 150 years has alternated between expansions and contractions.  A secular trend is formed when a series of business cycles are linked together establishing long periods of stock market out or under-performance. These patterns typically last up to 20 years.  In order to successfully protect and grow wealth, investors need to correctly identify which long-term price trend prevails. That is because the secular trend determines whether investors act primarily to accumulate wealth (secular bull) or to preserve it (secular bear).

What is the Current Secular Trend?

The 18-year period from 1982 to 2000 embraced the most recent secular bull market.  Stocks were grossly over-valued and investors were wildly optimistic with unrealistic expectations at the conclusion of this secular bull. Since 2000, we have embarked on a much different and far less investor-friendly journey, which represents only the first half of a secular bear market. Chart 1 shows U.S. stock prices adjusted for inflation back to 1870. It strongly suggests we are currently in the 4th secular decline since 1900.  The prior three secular trends began in the years 1901, 1929, and 1966 respectively, and lasted on average nearly 20 years.

When Will the Current Secular Bear Market End?

With the benefit of over 150 years of financial history, it is possible to establish benchmarks that tell us when valuations have reached pessimistic extremes. These yardsticks are consistent with an end to a secular bear market. There are many viable benchmarks that can be used to identify secular turning points, but we want to introduce two basic measures that support our outlook.

The first benchmark to compare secular bear markets is duration.  Chart 2 and Table 1 both show that the last three lasted on average 18 years and 7 months. As of December 2009, the current trend has only lasted 9 years and 7 months, indicating greater potential if it is to even approach the average. As well as being measured in time, duration can also be looked at from the number of business cycles experienced. Prior secular bear markets averaged between 4 and 6 recessions. So far we have only experienced two. Allowing for a best-case scenario of 4 business contractions, this also suggests that we are barely halfway through the current cycle.

Valuation is the second benchmark to use for comparing secular bear markets. Arguably the most popular long-term measure of stock market valuation is the price investors are willing to pay for corporate earnings (Price to Earnings, or P/E Ratio).  Why at one time are fearful investors only willing to pay $6.64 for $1 of earnings, (i.e. 1982 Secular Bottom) while at another time investors are eager to pay $44.20 for that same $1 of earnings (i.e. 2000 Secular Peak)?  The answer lies in the extremes of confidence or lack thereof only seen at major secular turning points.  Take a moment to study the 1Shiller P/E series at the bottom of Chart 1 and the key turning points as summarized in Table 1. Notice at the beginning of secular bear markets, the average P/E ratio is 31.5 (confidence high), in contrast to the average P/E ratios at the end of these periods that are 6.95 (confidence low). The current Shiller P/E reading is 20.79. We may have traveled a long way from the 2000 historic overvaluation peak (P/E 44), but clearly there is a long way to go to reach truly undervalued levels once again.

Based on previous cycles, it is therefore not difficult to conclude that the current secular bear market has further to run in duration (we are only halfway there in terms of years and recessions) and valuation (P/E ratios must return to bargain levels). The combination of duration and inflation-adjusted price declines grind away and erode investor hope. This is why it is not difficult to rationalize any number of economic or geo-political problems, yet to be addressed, that will push us toward the secular bear market bottom.

When will this current secular bear market finally reach bottom? The answer is probably in the next 6-10 years when stock prices (adjusted for inflation) finally gravitate towards the target area outlined in Chart 2.

Is it Possible to Build Wealth During a Secular Bear Market?

It is possible to build wealth during a secular bear market, but investors must first discard the buy and hold, indexing, and passive asset allocation strategies that worked so well in the prior secular bull market. In a negative secular environment the same static methods result in severely inadequate returns. The crucial determinant to wealth-building success in a secular bear market is to adopt a more pro-active plan of action. Even in this difficult uphill overall negative atmosphere there will be rewarding opportunities. The cyclical bull market that began in March 2009 is a typical example. Others with moves in excess of 25% have been flagged in Chart 3.  These primary bull markets reflect the normal transition of a business cycle from economic recession to expansion. The key to the successful exploitation of these moves is the application of the proper business cycle forecasting tools and disciplines.

Why is Business Cycle Analysis More Important Than Ever?

From a business cycle viewpoint it is worth noting that the last secular bull market (1982-2000) covered 18 years but contained only 2 recessions lasting a total of 12 months­ — that is less than 6% of the time. Compare that to the last ten years in which the secular bear market experienced two recessions lasting a total of 28 months or about 27% of the time. That is far closer to the US experience of the past 150 years where the economy spent an average 31% of the time in recession. If the lessons of previous secular bear markets play out, then the next ten years will experience increased business cycle volatility similar to the 1970’s. Since recoveries will be briefer and contractions more extended, investors will need to be more nimble and opportunistic during bull markets and far more defensive during the longer periods of economic downturn.

The last 150 years of economic and financial history shows that markets are linked in a logical way to business activity. The economy goes through a set series of chronological sequences just like the seasons of the year. Recognizing these “seasons” and correctly applying the appropriate asset allocation have always had a beneficial impact on investment returns. Chart 4 shows an idealized business cycle and is intended as an investor roadmap that helps drive important tactical asset allocation decisions as the business cycle unfolds.

As to the current business cycle position, Chart 4 shows that the stock market has been advancing for 10 months while the economy is just now coming out of a deep recession. For their part, interest rates and inflation are near their lowest levels of the cycle. The shaded area flags where we are today — indicates stocks can be expected to continue to do well as economic growth strengthens, and ultimately interest rates and inflation turn up.  Corrections will develop along the way but tactical asset allocation continues to call for stocks to be emphasized in portfolios. As time progresses, bonds will become vulnerable to heightened risks of interest rate increases. A quick business cycle analysis suggests risk of capital loss for bonds is very high. It is important to remember that even a relatively small increase in interest rates will quickly wipe out the paltry income bonds provide at today’s historic low interest rate levels.

Buy and hold, indexing, and static allocations may work in a secular bull market but they are losing strategies in a secular bear market. In the current environment it is more important than ever to pay attention to the business cycle for financial success. Essentially, an investor needs two game plans, one for defense, to protect assets in difficult periods and one for offense, to grow wealth during favorable conditions. A prudent and profitable investment strategy should be flexible enough to actively adjust portfolio asset allocation, depending on where we are in the business cycle and the direction of the secular trend. With knowledge of business cycles, secular trends, and tactical asset allocation, it is possible to create better returns with less risk and most importantly to experience peace of mind.

Go to www.pringturner.com for the full report on the Lost Decade

Jim Kopas Investments

The 2007-2009 global financial panic and collapse provided investors with a once in a lifetime rollercoaster ride as all asset classes except for treasury bonds dropped to extreme lows. A vast spectrum of emotions accompanied investors on this thrill-ride and not surprisingly many of these emotions are shaping investors current investment decisions.

In search for safety and income investors are stampeding into the apparent safety of government bonds and bond mutual funds. Over the last year bonds have been purchased in record amounts despite historic low interest rate levels.  It is likely that many of these investors do not understand the risks in bonds.  These investors, with a false sense of security, are unknowingly setting themselves up for another rough rollercoaster ride ahead.  

Warning Sign: High Level of Flows to Bond Funds

Despite the remarkable rally in stocks over the last nine months the distrust in equity markets is still widespread.  The cash flow figures into bond mutual funds this year illustrate this point (see chart below) as almost $313 billion has been invested in bond funds compared to the $2 billion added to stock funds through October. In addition, insignificant yields on money market funds are testing investor’s patience and are yet another reason for the remarkable cash flow into bonds.    

History shows that cash flows to mutual funds tend to follow strong outperformance by a particular asset class and can provide a contrarian warning sign when a particular class is becoming too popular.  For example, in 1999-2000, the cash flow to mutual funds was a mirror image of today’s environment as investors were taking money out of bond funds to invest in stock funds. The dilemma that many investors face today is that they are too afraid to invest in stocks and too impatient to wait for money market yields to increase. Unfortunately these investors are settling for bonds without fully understanding the risks involved.

The Risk in Bonds

The biggest risk bond investor’s face is the potential for interest rates to rise.  Bond prices move inversely with interest rates (as interest rates rise bond prices fall and as interest rates fall bond prices rise).  In addition, the lower the coupon rate of a bond the more vulnerable it is to interest rate risk.  With interest rates at historic low levels and likely to rise in the year ahead, now more then ever, bonds are highly susceptible to interest rate risk. 

The chart above demonstrates how higher interest rates can effect the value of a 10-Year U.S. Treasury Note.  The chart answers the question: how much will a $100,000 investment in treasury notes be worth in one year?  The value of the note depends on the future interest rate. For example, an investor’s initial $100,000 purchase would drop in value to $89,479 in one year if interest rates simply recovered to the June 2007 level of 5.3%.  If investors choose to invest in bonds with longer maturities then the negative returns due to interest rate risk will be amplified.  This chart clearly shows the potential loss of principal due to modest interest rate increases that would eliminate any potential gains from coupon payments.              

What Can Bond Investors Do?

The premise of this post is not to convince bond investors to liquidate all holdings, but to alert them to change their investment tactics. Bonds are a vital element of investment success as they provide diversification which can significantly temper the risks of an investment portfolio. However, it is critical that investors stick to bonds with short term maturities and not over-emphasize long term bonds at this time.  

Today’s low level of interest rates is only a temporary condition of this business cycle.  Interest rates will continue to move up as the economy picks up steam, offering patient investors a better opportunity to receive higher levels of income from bonds. Our business cycle research at Pring Turner Capital Group indicates it is very late and too risky to be pouring money into bonds.  Potential losses in principal value will quickly swamp any income received as interest rates inevitably move up and bond prices decline.

As always, thanks for reading and please feel free to voice your opinions in the comments section below. I hope you all have a Happy and Safe New Year! -Jim

Jim Kopas Investments

The 2007-2009 global financial crisis, the second most vicious bear market of the last century, caught many off guard and displayed unexpected characteristics when compared to past economic downturns.  With the decline being so atypical many are surprised to learn that the road to recovery has been just the opposite, as the economy has mirrored the typical business cycle recovery. 

In simplified terms, the sequence of events for a business recovery is first the stock market bottoms (March 2009).  Then the recession ends several months later (June/July 2009).  Next, the unemployment rate continues higher long after the recession ends, until economic expansion eventually brings job growth.  Finally, some time after unemployment peaks, the official end of the recession is announced – long after the stock market has bottomed (see table below).  Now the next logical step in the business cycle sequence is to see job growth and a peak in unemployment.  So when can we expect more jobs and how many will be created?

 When Will Jobs Rebound?

In recent weeks, some positive developments in the labor market have emerged amid the discouraging news about the climbing unemployment rate.  In November, the average workweek bounced to 33.2 hours from 33.0, which represents the biggest monthly rise since March 2003.  This is a strong precursor for the job market as business owners will typically ask current employees to work more hours prior to hiring new employees.  Ned Davis Research estimates that “the rise in the average workweek is roughly the equivalent of creating another 800,000 jobs!”

Another positive indication for the labor market is the recent growth of temporary employees. Temporary employees are the first to be let off in economic downturns and the first to be re-hired during expansions. Through October and November the number of temporary employment positions increased by 44,000 and 52,000 respectively.  Initial jobless claims represent yet another indicator for the future prospects of the job market.  The initial jobless claims 4-week moving average currently resides around 475,000.  Economists believe that job growth will occur should the average continue down below the 400,000 mark. 

Even as the unemployment rate continues to rise we are seeing some positive indications within the economy that should lead to job growth in the near future.  Former Federal Reserve Chairman Alan Greenspan echoes this sentiment, “We have a level of employment at this stage which is barely adequate to staff the level of output.  It seems to me virtually inevitable – if nothing else were to happen – that employment would start to come back fairly quickly.” So we are on the verge of experiencing job growth, but just how much job growth is the important question?  

How Many Jobs Will be Created?

At the cost of stating the obvious, jobs are highly correlated with the growth of the economy. Quite simply, the higher the economic growth rate is over the next year, the larger the increase in jobs and decrease in the unemployment rate.  A recent blog post on calculatedriskblog.com titled, “Employment and Real GDP” forecasts the expected unemployment rates under varying economic scenarios.

According to their data, “A 3% increase in real GDP (over the next year) would lead to about a 1.5% increase in payroll employment.  With approximately 131 million payroll jobs, a 1.5% increase in payroll employment would be just under 2 million jobs over the next year – and the unemployment rate would probably remain close to 10%.”  The table below summarizes the wide range of economic and job growth scenarios.

In my opinion the global financial crisis and rapid deterioration of the U.S. economy frightened business managers so terribly that they cut their payrolls more swiftly then they had in the past. Therefore, the payroll growth provided in the model and table could be understated.  Nevertheless, this forecast provides us with a general understanding of the relationship between the economy and the labor market. It certainly appears that the U.S. economy is well on its way to creating new jobs and taking its next step in this business cycle recovery.

As always, I look forward to hearing your opinions so please feel free to add a comment below.

–Jim   

Jim Kopas Economy