Jim Kopas

The following is an excerpt from the July 2010 Pring Turner Newsletter:

The second quarter proved to be a real challenge for investors.  A dramatic 17% stock market drop during the quarter was particularly rough, but not for the typical Pring Turner Capital client.  Our April client newsletter warned, “investors should expect a deeper price decline than experienced to date”. More importantly, we stated we would act to temporarily take a more defensive posture, and we did. The result was relatively stable portfolio performance and your valuable assets were protected during the market’s sharp decline.  Despite one of the worst quarters for stocks in the last decade, your portfolio (adjusted for any withdrawals or contributions) stayed within a few percent of achieving an all-time high valuation.  

A number of factors contributed to the steep market slide and increasing investor fears; the escalating European sovereign debt crisis, ongoing Gulf of Mexico oil catastrophe, and most importantly fear the U.S. economy is slipping back into recession—often described as a “double-dip” recession. History shows “double-dip” recessions are a rare occurrence (there has only been one instance in 90 years!). Still, a number of clients have expressed concern and asked our opinion on this probability.

As pointed out in our “Another Lost Decade” research report (November 2009), we do expect shorter expansions and more frequent recessions in the next decade. So, is this business cycle’s nascent expansion already over? Our research shows no recession is imminent, only a throttling back of the growth rate. Slowing down the rate of growth is not a recession. Simply put, we will not experience a “double-dip” recession this year.

 

One forecasting tool that anticipates changes in business conditions is the Institute of Supply Management Index (ISM index) pictured above. The ISM survey (formerly known as the Purchasing Managers Index) is a monthly poll of members involved in corporate purchasing activities.  The ISM index is considered one of the most reliable leading economic indicators available and is a valuable tool to monitor the level and direction of manufacturing activity.  A reading higher than 50% indicates the economy is expanding.  In contrast, a sustained reading in the low 40’s warns of impending recession. The latest reading of 56.2% is down a few points from its peak but signals the economy is still expanding, albeit at a slower rate. One of the firm’s primary strengths is our career-long dedication to seeking mastery of understanding business cycles and their influence on investments. Rest assured, our attention is focused on our economic dashboard and we are prepared to make any necessary portfolio changes for you.

 Tactics Looking Ahead

After a strong bounce off recession lows it is normal for the economy to gear down to a steadier pace. The financial markets are in the process of adjusting to a slower economic growth trajectory and for investors that means slightly different portfolio tactics. Income becomes more important. Dividends and interest will be an even more significant part of your total return (appreciation plus income). We continue the search for attractive dividend paying companies in order to build up the income side of your portfolio. Dependable income is a key to consistent performance with less volatility.

A second tactic to protect and grow your wealth is to recognize and act upon the increased market volatility. Without a doubt, the market has become a more volatile place. We are adapting to this quicker moving environment and being more active in making portfolio adjustments. These adjustments are helping us better fulfill our mission to protect and grow your valuable assets.

Once the clouds of uncertainty clear and the markets recognize a “double-dip” recession is not in the cards, we expect a sustained stock market advance. It may take a few more months before the market lifts off in earnest. But once the advance begins it will be led by quality, dividend-paying securities, many of which are core holdings in your portfolio.

Jim Kopas Investments

Our research indicates the strengthening U.S. economy has recovered to the point when interest rates will begin to move up (bond prices go down) for the duration of the current business cycle expansion. Even more important, we believe the secular (or very long-term) direction of bond prices is at a critically important turning point and a secular bear market may have already begun. Most investors do not fully understand, nor appreciate the potential devastating capital losses bonds will suffer in a secular bear market

Bond investors have enjoyed a thirty-year trend of lower interest rates and are likely ill prepared to deal with a trend reversal to higher interest rates. Are you prepared for a secular bear market in bonds? Our goal with this report is twofold: 1) to provide evidence to support our cyclical and secular bond forecast and 2) introduce tactics to help protect and grow your wealth in a hostile environment for bonds.

In the summer of 1985 we wrote an article published in Barron’s correctly calling for a secular reversal in interest rates from high to lower levels. At their peak, 20-year government bonds yielded 15% and after reaching a low of 3.1% have recently rebounded to 4.5%.  History shows secular trends do not last forever and after almost 29-years it’s time to see if there are signs of a major reversal.

Bond holders have benefited the past three decades as interest rates declined, and conversely bond prices advanced. Bonds have also been a safe place to hide especially in the last 10-years as the secular bear market in equities has unfolded. But if a secular advance in yields is underway, long-term bonds will decline in price and will no longer be the safe haven for investors. Just as it was difficult to believe that the 15% yields in 1981 would experience a historic decline, now it is equally challenging to accept that over the next few business cycles, rates could double or more and find themselves back up to the 8-10% range. Yet, if we look at previous cycles such numbers are not unreasonable. For example, between 1900 and 1920 corporate bond yields rose from 3.6% to 6.4% and between 1946 and 1981 they rallied from 2.5% to 15.4%.

An unexpected advance in yields will be quite damaging to bond investors. Figure 1 illustrates several interest rate scenarios. For example if the rate on a 20-year government bond rose from its current level of roughly 4.5% to just 6.5% over the next two years an original $100,000 investment including interest would fall to $87,800.  Today’s paltry coupon income provides little protection to offset price losses with even a small increase in interest rates.

 

Bonds: The Technical Position

 

In order to assess the current technical secular structure we need to look at what has happened in the past. Chart 1 for instance shows corporate bond yields on an annual basis back to 1857. The blue arrows indicate that there have been five secular trends since that time, three down and two up.

 

If we assume that 2008 represented the interest rate low, which has so far been the case, the average trend duration was 30-years, not far from the duration of the most recent decline. Useful trend reversal signals have been generated in the past when the 3-year oscillator has crossed above and below its 24 year moving average and been confirmed by a trend break in the yield itself. The time of the only false momentum signal in 1976 there was not confirmed by a trendline violation. This momentum indicator triggered a signal for higher yields recently and also violated its 27-year down trendline.  This study has already signaled a reversal in the secular trend.

Bond Yields and Commodity Trends

 

One of the most important fundamental influences on bond yields is the course of industrial commodity prices. The two are compared in Chart 2. Rising or declining commodity prices reflecting economic demand are inexplicably tied to inflation levels and trends.  Rising inflation is the arch nemesis of bond owners as it robs those bond investors of purchasing power.  When inflation begins moving higher, bond buyers will demand (and get) higher interest rates in order to get a ‘real’ return for lending their money. The arrows show at virtually every turning point commodities lead bonds. During the 1980’s and 1990’s commodities experienced a trading range as yields softened, but for the last 10-years commodities have been rising thereby fulfilling their leading characteristics once again. 

 

The commodity index is featured on its own in Chart 3, along with a long-term price oscillator that captures secular trends.  Swings in the oscillator fit nicely with the secular bull and bear markets. Reversal signals are generated when the oscillator crosses above and below its moving average and this is later confirmed by a trend break in the Index itself.  At the moment the secular trend for commodities is up because the oscillator is rising and the Index is above its green breakout trendline. In addition, the series of rising cyclical peaks and troughs is intact. These factors all suggest that commodities are headed higher over the next 5 to 10 years. 

What about the current business cycle picture?  For that we turn to our proprietary Inflation Barometer, a model consisting of 10 reliable technical and fundamental indicators designed to capture inflation changes caused in every new business cycle. When it moves above 50%, it triggers an “inflation” buy signal for this business cycle suggesting higher commodity prices. Readings above 50% are represented by the green highlights in Chart 4. The green arrows show that when the Barometer first reaches the 100% level in the cycle. This 100% level is often an early event and substantially higher inflation and commodity prices generally follow.

 

Our Inflation Barometer hit 100% January 2010 and is still at the maximum reading today (April).  We expect sustainable higher commodity prices for as long as the current business cycle strength continues.  Higher commodity prices mean higher inflation pressures which means higher interest rates, which means lower bond prices!

 

The Business Cycle Trend of Bond Yields and Prices

 

Chart 5 features our Bond Barometer, a model that comprises monetary, economic, and technical indicators.  Like its inflation counterpart, it goes bullish for bond prices with a reading in excess of 50% and bearish for prices with a reading below 50%.  In March it fell from 56% down to 29% flashing the first warning sign for bonds since December 2006.

Note how much more time bonds prices rose (green) than fell (red) during the last 29 years’ secular bond bull market.  Compare this to the last secular bear market (1953-1981) when bond prices spent more time falling (red) than rising (green). If, as we expect the secular trends for interest rates are reversing, investors will have to struggle with longer adverse periods of falling bond prices than experienced in the last three decades.

  

What Does This Mean for Bond Investors?

 

A secular reversal in long-term U.S. interest rates has likely been signaled. Investors should be alert to this monumental and critically important change.

1.   A momentum indicator based on annualized data for corporate bond yields and a trendline for the yield itself have already signaled a secular reversal in bond yields (chart 1).

2.   We expect higher commodity prices will lead to higher bond yields (lower bond prices).  Commodities lead bond yields and have been rising for 10-years, whereas bonds have been in a trading range for the latter part of that period (chart 2).  

3.   Since the Bond Barometer is at a bearish 29% level and the Inflation Barometer is at 100% reading, the expected rise in yields for the current cycle will be sufficient to trigger a longer-term reversal.

In summary, if you want to wait for even further confirmation, the signals we would look to confirm a secular trend reversal would be a monthly average for 20-year government bond yields in excess of 5% (currently 4.5%) and for Moody’s AAA Corporate Yield an average above 6% (currently 5.35%).  If this secular trend reversal is confirmed, new tactics will be required to successfully manage and protect your portfolio.

  

Tactics For a Secular Bear Market in Bonds

 

Our proprietary bond barometer has just given the first sell signal for bonds in three years, putting bond investors on high alert. In addition, we have evidence the secular or long-term trend for interest rates is at an early critical juncture. A trend change away from the favorable environment for bond prices that has existed from a business cycle time frame (past 3 years), and secular time frame (past 29 years) requires an investor to carefully re-evaluate their bond strategy. Faced with potential devastating capital losses from bond investments, tactical and strategic portfolio changes have to be acted upon.

Basic changes for a hostile bond environment include 1) reducing bond allocation percentage, 2) reducing the average bond portfolio maturity, 3) raising the overall quality of bond holdings, and 4) increase exposure to inflation-sensitive investments.

One example of reducing the average maturity can be executed with a short-term bond ladder that ensures full return of capital within a shortened time frame. This laddering strategy enables the investor to continuously roll over maturing bonds at higher and higher rates and protect principal values. Raising the quality of the bond portfolio makes certain your principal will be returned in full upon maturity.  A tactic that increases exposure to inflation sensitive investments could include short-term international bonds emphasizing currencies denominated in strong natural resource based countries, such as Canada or Australia. The current 100% reading in our Inflation Barometer further argues for reducing the percentage of bonds and instead emphasizing inflation beneficiaries such as natural resources like energy, metals, mining, agricultural and forest products. Combining these tactics will help insulate portfolios from higher inflation, rising interest rates and lower bond prices.

Even within this difficult secular bear market, there will be rewarding tactical opportunities.  The key to successful exploitation of these opportunities will be the application of business cycle analysis.  Bond investor success will depend upon these tactics and taking advantage of cyclic opportunity that occur every business cycle.  The benefits of knowing cyclic and secular interest rate increases are coming will help you protect and even grow your capital in the coming hostile environment for bonds.

Go to www.pringturner.com to view our Long-Term Stock and Bond Market Outlooks   

Jim Kopas Investments

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