Jim Kopas

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

In recent weeks the growing unemployment rate has garnered a great deal of attention from members of the financial press in addition to stock market investors. In an attempt to ease the collective nerves of these individuals I published an article “10% unemployment: A Remarkable Signal for Stocks,” which revealed that over the last 40 years the stock market has performed exceptionally well after unemployment has peaked.

Unfortunately, my article failed to touch on the performance of the stock market prior to the peak in unemployment.  With unemployment still on the rise some readers had doubts about the near term prospects of the stock market. So how has the stock market performed prior to the peak in unemployment? Surprisingly stocks are more profitable prior to peaks in unemployment then they are after!

Stock Market Performance Prior to Peaks in Unemployment

Many will be shocked to learn that the stock market has actually performed better right before the peak in unemployment the then it has right after the peak.  As illustrated in the table below, the short term time frames before the peak in unemployment all substantially outperform the periods after the peak. Contrary to popular belief, there is actually a lower risk for stocks near unemployment rate peaks (indicated by the green arrows) then there is during unemployment lows (indicated by the orange arrows).

Why does the Stock Market Perform Better Prior to the Unemployment Peak?

On several occasions I have mentioned leading, coincident, and lagging indicators; and their ability to help anticipate changes in financial markets and the economy (see 3 Crucial Economic Indicators).  The key reason why stocks yield strong returns prior to the peak in unemployment is because unemployment is a lagging economic indicator and will only start to improve months after the stock market (leading indicator) and economy (coincident indicator) have recovered. In fact, if you analyze all the economic data since WWII unemployment peaks (on average) 9-12 months after the stock market bottoms.    

Now let us take a look at how these economic indicators relate to the current financial landscape.  In the beginning of the year the Fed dropped their target rate to a historic low of .25%, which remains at that same level today.  In March, the U.S. stock market formed a significant bottom and continued to advance with little resistance throughout the year.  Recently we received even further confirmation of the economic recovery from the third quarter GDP growth rate, as it expanded at a better then expected rate of 3.5%.  The next logical step in the economic sequence is to see improvement in employment numbers and other lagging economic indicators. 

What Does this All Mean for Investors?

Only after a confirmation of the peak in unemployment will the Fed decide to raise the federal funds rate and begin to slow down the growth of the economy.  As of today, the Fed is still several months away from beginning to raise rates. In keeping with business cycle history, the Fed’s loose monetary policy has led to stock market strength prior to the peak in unemployment.

As you can see the unemployment rate alone is clearly not a valid reason for investors to be sitting on the sidelines during this ongoing cyclical bull market. In contrast, the current unemployment numbers suggest that investors should expect higher stock prices in the months ahead.

Thank you for reading and I look forward to writing more articles in the future! As always, please feel free to contact me should you have any questions or concerns regarding the website.

-Jim

Special Message

During the past week this website has received two accolades’ that I would like to share with everyone.  First, you might have noticed the new Seeking Alpha Certified graphic in the sidebar. That graphic has been added to the website because I was invited to become a contributor to the financial website.  Please click here to become a follower of my postings on Seeking Alpha!

Secondly, the website was also placed on Accredited Online Colleges List of Top 100 Money Experts you should follow and learn from on Twitter. Click here to read the full article; I am listed at #56.  

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.

Duration:

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 November 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:

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 Shiller 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 18.77. 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 nine 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.

Summary

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.

Over the next few months we will publish additional articles to expand on the secular outlook and review tactics and strategies to best capture opportunities and build wealth in the difficult period ahead.

Written by: Martin Pring, Joe Turner, and Tom Kopas of Pring Turner Capital Group

Jim Kopas Investments