Download A secular period is a long term cycle in the market which generally

A secular period is a long term cycle in the market which generally lasts about 16-18 years and, of
course, the last secular BULL market that began in 1982 ended in 2000, ironically, 18 years. The cycle
previous to that was a secular BEAR market that began in 1966, and ended in 1982, or 16 years.
During this period of time the market only gained an average return of .01%.
That 70’s Show
To answer the question of what type of secular period that we are most likely in, we will need to
understand what type of environment is necessary to create a secular BULL market in the first place.
For the answer to this question we will have to travel back in time to 1973-1974 which was the end of
the last major secular BEAR market that gave the beginning to the secular BULL market of the 80’s and
90’s.
First, let’s take a look at the S&P 500. In the chart above, you will notice that the markets look very
familiar. In 1974 the markets found a bottom after an agonizing period that begin in 1966. This
bottom in 1974 was the final bottom in the secular period that began in 1966.
Interestingly enough, the S&P 500 looks as if it formed a bottom in October of 2002 and has now made
about the same level of retracement from that bottom as had occurred in 1974. The question we must
now ask – are the ingredients the same to start the same secular bull period from this point forward.
A Teaspoon of Interest
First, let’s start by taking a look at interest rates. Interest rates have a direct effect on the stock
market because it increases the cost of borrowing by companies which ultimately reduces their bottom
line profitability. Therefore, lower earnings mean lower valuations and lower valuations mean lower
stock prices.
In 1973-74 interest rates on the long bond had been on its way up for several years finally topping and
beginning a very long decline in long term interest rates. Therefore, by extrapolation if high interest
rates are bad for stocks, low interest rates are good for stocks. Now, look again at the chart. You will
notice that interest rates in the current period are extremely low. Again, by extrapolation, if interest
rates are as low as they have been in 40 years and we are indeed in the midst of a recovering economy
– then interest rates will surely rise over the next few years. Rising interest rates causes lower
earnings and valuations of companies and thereby their prices.
One Pinch of Inflation
Inflation is the dreaded enemy of any economy. As inflation rises, the costs of manufacturing those
goods also rise. This lowers the earnings of the company that makes the product. Furthermore, as the
cost of manufacturing a product rises that cost is passed on to the consumer who is forced to pay
higher prices.
Since the consumer only has a finite amount of money to spend the consumer is forced to buy less.
Thereby again plying pressure to company’s earnings because now not only does in cost more to
manufacture – they are selling less. The double whammy of inflation can zap bottom line profitability
in a heartbeat which ultimately leads to lower stock prices.
Again looking back at the 1973-1974 period you can see inflation topping at around 12 and beginning
to fall. Falling inflation, again by extrapolation, is good for the financial markets for the exact opposite
reason rising inflation is bad. Looking at today’s markets and economy inflation is still extremely low
with only one way to go…up.
A Smidgen of Dividends
Corporate dividends are a by product of a companies profitability. As a company makes a profit it pays
out a small portion of that profit to its shareholders. Now, while dividends aren’t directly affected by
the economy they do tend to play an important roll in the financial markets.
All during history whenever the financial markets were in a secular bear market period investors tended
to leave speculative investing for the safety of good quality companies that paid a solid dividend. You
have probably noticed that during the recent past companies with the poorest fundamentals have
rallied the strongest while blue chip, dividend yielding, companies have lagged significantly in
performance.
Every time in previous history when the financial markets found an inflection point from which to
change from a secular BEAR market to a secular BULL market dividend yields were around 5% on
average. As of the recent close the dividend on the S&P 500 was around 1.6%.
Dividend Yield = Price / Annual Dividend
In order for the dividend yield to rise to a level from which market inflection points tend to occur one of
two things have to happen; a) stocks prices remain stagnant while annual dividends are increased; or
b) annual dividends are stagnant while stock prices decline.
A Cup of Earnings
Continuing with valuation concerns is the earnings yield of stocks. We have written and talked a lot in
the past about the Price to Earnings (P/E) valuations of the financial markets. At historical turning
points in the markets the P/E ratio has generally been around 7 times earnings for starting a new
secular BULL market trend and around 23 times earnings for beginning a new secular BEAR market
trend.
Currently the P/E valuation on the S&P 500 is around 23 on a GAAP adjusted basis – down from 42
times earnings at the market peak in March of 2000.
Another way to look at valuations is the Earnings Yield of stocks which is simply the inverse of the P/E
ratio;
Earnings Yield = Annual Earnings / Price
The earnings yield is an excellent way to look at valuations in the financial markets because basically,
it's the amount of earnings you buy for every dollar worth of stock. Therefore, the higher the earnings
yield the better value of the financial markets.
Of course, as you would now suspect, the earnings yield of the market reached a peak around 1974
whereas currently the earnings yield of the markets are still at historic lows. Another way to look at
this is that in 1974 investors were willing to pay $1 for $14 dollars worth of earnings and today we are
willing to accept the same level of investment risk and pay that same $1 for only $3 dollars worth of
earnings…doesn’t seem like a very good bargain when you look at it that way.
Again, there are two ways to correct this imbalance; a) stock prices remain stagnant for a long period
of time as earnings continue to increase; or b) stock prices decline while earnings remain stagnant or
rise. As in the case of both the dividend yield and the earnings yield the prognosis for substantial gains
from these current levels in the markets are somewhat suspect.
Preheat the Oven
We can also talk about the trade deficit between the beginning of the last secular bull market and now
as well as employment, commodity prices and others. But all of the ingredients point to the same
thing in terms of the answer we are seeking; we will get a cake, but since the recipe is different this
time…what kind of cake will it most likely be?
Will it be another secular bull market or are we entering a secular bear market…only time will tell – but
one thing is fairly certain, if history does indeed repeat itself, the next decade or so of the stock market
will most certainly be different than the last.
Gary Clemmons
Owner / Senior Portfolio Manager
Texas Brokerage Asset Management
407-C, West Baker Road
Baytown Texas 77521
(281) 427-8000 - office
(281) 428-2796 - fax
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