Intermediate- to Long-Term Stock Market Analysis
October 11, 2008
Stock Market Super-Cycles
Stock market super-cycles do seem to exist, and seem to have a duration of something like 35 years (although the first of the hypothetical cycles that's visible on the chart below appears to have lasted for at least 43 years, and may have run longer than that).
We are in a super-bear market that started in 2000 and that could run 10 more years until 2018.
The market indices could go a lot lower than they are now (e. g., to 400, in 2008 dollars, on the S&P 500 in 2018) without exceeding the bounds of a "normal" super-bear market. And if we are entering into a Depression, than 200 in 2008 dollars in 2018 wouldn't be implausible.
Although the total return on the popular market indices has gotten down to less than half what it was at their 2000 zeniths, the market indices were overextended in 2000 well beyond anything else ever seen in stock market history, and they have a long way to fall. I had thought that perhaps the high productivity levels and globalization we saw during the past seven years could support current market levels, but we have now learned that they were based upon deficit spending, and may be suspect.
If you buy-and-hold at the beginning of a "normal" super-bear market and stay the course until the end, you'll lose, after correcting for inflation and dividends) about 2/3rds of your initial investment.
There are ways to make money during a super-bear market. One way is to buy and hold a mutual fund that does much better than the S&P 500. (Hint: there aren't many of them.) Another is to buy at the bottoms of the intermediate, more-or-less cyclical bear markets and sell at the tops of the corresponding bull markets (easier said than done). Of course, another way is to to invest somewhere besides the U. S. stock markets.
Do Stock Market Super-Cycles
The answer to this question isn't entirely obvious, but I think the short answer is YES.
If we really want to be honest--and frankly, I really do want to be honest--then we have to decide whether stock-market super-cycles actually exist or whether they're a Rorschach pattern we project onto the stock market. The chart below shows why this might be in question.
Looking Back to 1871:
From 1871, when this plot of the S&P 500 begins, you can see the index dipping down to about the middle of its historic range, reaching it in, maybe, 1878. Then it comes up to the top of its range in about 1882, after which it hangs in there above the middle of its range until... what?... 1906? That's 24 years of more-or-less continuous bull market, dropping a little from 1882 to 1896 before it goes back up until 1906. From there, it fluctuates a bit until 1912. Around 1912, it drops off a cliff through World War I, and even falls a little further until 1921. So from 1878 to 1906, a period of 28 years, it's in a long super-bull market. From 1906 to 1921 it's in a super-bear market that lasts 15 years.
During the 8 years from 1921 to 1929, it's back in a super-bull market that ends with the Crash of '29. From 1929 to 1947 (18 years), it's in the super-bear-market-to-end-all-super-bear-markets.
Then in 1947, the S&P 500 starts back up, peaking 19 years later in 1966. From 1966, it falls for 16 years until the super-bear market bottom in August, 1982. From August, 1982, it rises for another 17½ years to March, 2000.
Now, for the past 8½ years we've been in another super-bear market. If this bear market behaves the way super-bear markets typically behave, we could see the start of another secular (super) bull market sometime between 2014 and 2018.
The notable exceptions to this pattern are the 28-year super-bull market from 1878 to 1906, and the 8-year super-bull market from 1921 to 1929. Otherwise, these super-semi-markets appear to last 16 to 18 years, with a full cycle lasting 32 to 36 years. The first super-cycle lasted 43 years, from 1878 to 1921. The second super-cycle endured 36 years, from 1921 to 1947. The third super-cycle stretched 35 years, from 1947 to 1982. The first half of the third super-cycle prevailed from August, 1982 to March, 2000, or 17½ years. Add another 17½ years to that and you're looking at 2018, or 10 more years of losses. Ugh!
Where are We Now, and What's Ahead?
I have no way to reconstruct and then extend this chart beyond 1997, but the S&P 500's intra-day peak of 1,553 on March 20, 2000, would have put the yellow curve in the plot at the top edge of the aqua border area in the above plot, and far above its historical upper trend line.
If you extend the historical upper trend line beyond where it ends in 2000 to the present time (in 2008), you're probably looking at a value for the S&P 500 upper trend line, in 1997 dollars (as I read it off the chart) of about 860 before correcting for inflation. The official inflation factor (though there's some suspicion that actual inflation would be higher if food and energy were factored in) is 1.36. This would put the upper edge of the S&P 500 range right now at 1,170 or about 1200, given my estimation inaccuracies. There's about a 4:1 ratio for the value of the upper trend line compared to the value of the lower trend line, so the lower trend line value for the S&P 500 right now would be about 300. Ouch! Let's hope it doesn't come to that. But note also that it usually does. If this super-bear market behaves true to form, the S&P 500 would fall to about 400 when it hits its super-bear market low in 2018. (The lower trend line will probably be around 400 by then, in 1997 dollars, rather than 300, because of the underlying growth of the economy and the payment of dividends between now and that future bottom.) In the meantime, as the above chart shows, there will be one or two hefty bull markets between now and that super-bear market bottom.
And this assumes that this will be a "normal" super-bear market. If this were to play out like the Great Depression, the markets will fall below the lower trend line. It might fall as lo as, for example, S&P = 200.
This isn't good news. Although the markets have given up about half their peak dot.com gains, they're still far above their average long-term valuations. The downside risks would appear to me to exceed the upside opportunities.
Right now, at 900, the S&P would be 25% below its upper trend line, and would have to rise 33% to reach its upper trend line. At the same time, the mid-line of its "trend channel" would probably be at, or around 750.
The "super-bear-market" link below transfers you to a more-detailed discussion of super-bull markets and super-bear markets.
What this seems to me to be suggesting is that if you buy index funds at the beginning of a super-bear market and hold them for the next 16-18 years, you'll lose 2/3rds of the purchasing power of your money. Since 80% of all mutual funds don't do as well as the major index funds, the outlook for most investors would appear to be bleak. However, there are a few mutual funds that may outperform the markets sufficiently that you can make money with them even through the current super-bear market. That was the case during the 1966-1982 super-bear market when the Templeton Foreign Funds returned 14% a year. Funds like the Baron Partners Fund and the Bridgeway Aggressive Investors funds might qualify. Also, foreign funds, and particularly, Chinese funds starting from their present levels, might perform better than U. S. equities over the next 10 years. I hope to make money during the next 10 years, and hopefully, you can, too, but achieving it by buying and holding an S&P 500 index fund doesn't look promising to me if these super-cycle concepts prove prophetic.
The paragraphs below were written on October 11th, 2008, just after the October 10th intra-day low of about 840.
We're in a Super-Bear Market
We're clearly in a super-bear-market half-cycle that began in 2000 and is apt to last 6 to 10 more years. (Please note that the description of super-bill and super-bear markets to which this hyperlink points was written in 2002, with the latter portion prepared in the 1980's.) This should be followed by a super-bull market beginning in 2014 to 2018 that should last for something like 16 more years, peaking in the early-to-mid 2030's.
Buy-and-Hold Strategies Don't work in a Super-Bear Market
During a super-bear-market half-cycle, a buy-and-hold strategy, so dear to financial advisors, won't work, and will cost you dearly. To illustrate this, consider the fact that the S&P 500, which closed at 1,527 on March 24, 2000, didn't reach that level again until October 15, 2007, when it closed at 1,554. This doesn't include the inflationary erosion in purchasing power, nor does it include the dividends on the S&P 500 (which helped to offset the inflationary losses). On the other hand, there was a terrific bull market that ran from October 10, 2002, to October 15, 2007. You can make money during a super-bear market, but you have to sell at market tops (often during election years) and buy at market bottoms.
(One important observation about the past eight years is that in 2000, the S&P 500 average price-to-earnings, price-to-dividend and price-to-book ratios, as the "Falling Out of Bubble Territory: graph reveals, inflated well above any values ever seen before in the U. S. stock markets. Stocks had a long way to fall to reach fair value, and fall they did.)
While it's reassuring that stocks are falling out of bubble territory, you also have to remember that during a recession, earnings fall, and prices have to fall equally just to keep the same price-to-earnings ratio. Usually, though, stock prices fall faster than earnings, leading to severely impacted stock indices.
One approach is to move out of stocks at a super-bull-market top (typically during the election year), and buy back in 14-18 years later at a super-bear-market bottom (typically during the year halfway between presidential elections). Unfortunately, we'd have to have started that in 2000, and most of us probably didn't.
What's Going to Happen Next?
I'm sure I don't know, but my intuitive guess, for whatever it might be worth is that we'll soon have a "relief rally" but that the markets will then overshoot on the downside. But as the 2000-to-2007 bottom shows, the markets don't always overshoot. However, we're seeing a once-in-a-lifetime stock market right now, and it's hard to invest much conviction in forecasts of what's immediately ahead. The stock market decline over the past week (October 6-10, 2008) has rivaled the Crash of '87, albeit at a slower pace.
Will It Be a Decade or More Before We Can Make Back the Money We've Lost?
I hope not. I'm counting on that not happening. How will we do it? The opportunities right now are fabulous. To give a few examples, the Proshares Ultra Emerging Markets Fund (UUPIX) hit a high of $72 a share last October. As of Friday's close, it was running $8.59 a share!. Sooner or later, it will go back to those highs, more than 8-folding in the process! Since it's a mutual fund, it doesn't carry the risks of, e. g., put and call options. The only question is: how much lower will it go and when will it get there? (Will it go below zero? Will Proshares pay you to buy shares in it? Because of their leavening economies, the emerging markets will probably rebound more quickly and more surely than stock markets in the developed countries.) Individual stocks on which I placed small bets on Friday are in the alternative energy area. The bailout bill included a renewal and expansion of alternative energy credits. Solar energy credits were renewed for the next 8 years, and the $2,000 cap on the existing 30% credit was removed. Wind energy credits were renewed for only a year, but that's enough for now. In the meantime, one of my favorite solar photovoltaic stocks, Suntech (STP), has fallen from a high of $80 a share last fall to $21.90 a share at Friday's close. Suntech is the third largest photovoltaic company in the world, is the largest photovoltaic company in China, and, with a fair-value price projection of $70 a share, is projected to increase its sales by 50% in 2008. Of course, given a global financial crash and a second Great Depression, alternative energy markets and all the energy markets could be hit in the near-term, but surely, the long-term trend must be up, and rapidly so. But I only bought 100 shares on Friday, since we don't know how much deeper this trough will get. I also bought 20 shares of Vestas Wind Systems (VWSYF) at $54.50 a share (yesterday's closing price). Vestas is the world' leading manufacturer of wind turbines. It reached a peak price of $138 a share last June and was trading at at $132 a share at eh beginning of last month, but it's also been thrown out with the bath water like many another good company. Another good company is a Chinese steel company called General Steel, Inc. (GSI). GSI was trading at $14 a share at the beginning of September, after peaking at nearly $17 a share in late July. It closed on Friday at $3.24 a share, and I bought another 500 shares at that price.
The point of this is: even if the markets don't recover their precious highs until the middle of the next decade (and soar on to new highs), we should be able to recoup our losses by buying near a market bottom like this, and selling when the market hits an intermediate high. How will we know when to buy and when to sell? I'll be looking at sentiment indicators like the VIX and VXO, and monitoring market measures like up-down volume and moving averages. I'll also be listening to my investment newsletters such as Cabot's China and Emerging Markets newsletter. Right now, this newsletter is recommending 90% cash, with one previously purchased stock on HOLD. Of course, I'll be publishing to this website whatever I find.
November 9th Update:
Cabot's China and Emerging Markets Fund isin cash and has been in cash for several weeks now.
Talking Business: Swept Up by Insanity of Markets
Economix: How Cheap Are Stocks?
Economix: How Long Before the Market Bottoms?
Using the Proshares Ultra Emerging Markets mutual fund to recoup your bear-market losses.
After thinking about this, I've decided that for my own purposes, the Proshares Ultra Emerging Markets Fund (UUPIX) looks like the place for me to be when it comes time to surf a market recovery. This invests in emerging market countries which are expected to rebound better than developed countries. There is the currency exchange-rate risk if the dollar rises against third-world currencies, and conversely, currency exchange rates will act as a tailwind if the dollar falls against third-world currencies. What's so attractive about this is that it could constitute a relatively low-risk means of multiplying our current dollars by a factor of several, given even a partial recovery in the markets.
The other alternatives I've mentioned... Suntech (STP),
Vestas Wind Systems (VWSYF),
General Steel, Inc. (GSI),
the Proshares Ultra Nasdaq 100 Fund (QLD),
the Powershares Wilderhill Clean Energy Portfolio (PBW),
and the iShares Emerging Markets ETF (EEM)
don't readily give the kinds of manifold recovery potential that UUPIX affords. It's possible to boost gains with these other stocks and funds by using call options, but first, the risk goes up exponentially if you try to achieve more than something like a 2:1 leverage with call options, and second, in the highly unstable environment we're in now, options are a very dangerous gambit. Not only is it very risky, it's also (a) hard to find deep-in-the-money LEAPs, (b) it's hard to find call dates later than January, 2010 (only 15 months away), and (c) risk premiums seem to be uncommonly high right now.
So what should you do?
Well, since we don't know what the economy is going to do from here and how bad it's going to get, I would suggest making a token investment in UUPIX (the minimum is $250), and then waiting to see what happens next. (The worst thing that can happen to you is that you'll be able to buy UUPIX cheaper at a later date. And the absolute worst thing that can happen is that the world's economies collapse into chaos. But that's pretty far-fetched. The world's governments aren't going to let that happen.) Bear in mind that you have to buy when the "smart money" is selling (when there's "blood in the streets") and sell when the "smart money" is buying.
October 25, 2008, Update
The two key questions are: How
much farther will this market fall, and when will it hit its cyclic bear market
The good news is that the stock market is now running well below its long-term trend line, so the market is sizably under-priced by historic standards. What we don't know is how severe or protracted this bear market will ultimately be. Here is an article comparing the U. S. stock market with the Japanese market that has been falling for the past nineteen years: Will US Have Its Own "Lost Decade"?. (Before this article goads us all into committing hari-kari, I would observe that the Japanese stock market was terribly overpriced in terms of its P/E ratio when it began its descent in 1990.)
Are we headed for inflation or deflation?
Right now, the answer is clear enough: we're seeing deflation. Costs of everything at the commodities level are dropping. In the case of gasoline, this has shown up at the pump. In the case of food, it might take a little longer, but presumably, it's coming. Prices of raw materials such as copper and silver have been falling sharply.
Kevin Depew has written this article concerning inflation versus deflation: Five Things Podcast, The Transcript: Hyperinflation vs. Deflation. Among the changes he cites that are showing up are a switch from discretionary purchases to necessities such as food, from upscale stores like Starbucks to discount chains like Walmart and Costco, and the reappearance of layaway sales in which you save up the money before you buy an item rather than buying it on credit. Of course, this reduces profits for credit-card, and loan sharks, and leads to reduced employment in the credit-card industry. One service to which I subscribe draws a parallel to the Japanese government pumping out yen when the Japanese market tanked in 1990, and yet, failing to stem a deflationary tide. The reason is because banks are afraid to lend when companies and individuals may go bankrupt, and consumers are afraid to borrow because of job insecurities.
Living high on borrowed money
For the past seven years, the economy has prospered as consumers and government agencies ran up ever- higher debt. This Ponzi scheme had to end, and end it did. Now these loans will have to be paid back, and then (some are saying) money will have to be saved before we can fund a new run-up in the stock markets. Note, though, that there is cash sitting on the sidelines, waiting for an auspicious moment to put money back into the exchanges. Most of my money is sitting in the bleachers, in cash. The question is: how much money is warming the benches? One difference this time around is that for the first time, there's a lot of investment capital tied up in 401k's and IRA's that in 2002-2003 would still have been in professionally managed pension funds. Investment advisors are recommending that their clients don't sell their equities because it's so hard to time the markets, and because, sooner or later, the markets revert to their historic trend lines of 7% per annum real growth.
So far the S&P 500 hasn't fallen below the low it established on October 10th, when I began writing about this.
It's been two weeks to the day since I prepared the "October 11, 2008, Intermediate- to Long-Term Stock Market Analysis." The S&P 500 had closed on the preceding day (Friday, October 10th) at 899.22, with an intraday low that day of 838.9, which is the lowest the S&P 500 has hit during this bear market, and its lowest value since it dipped to 843.71 on March 31st, 2003. (It was working its way back up from its cyclical 2002-2003 bear market bottom of 768,67 that it registered on October 10, 2002.)
For whatever it may mean, the S&P 500 hasn't yet penetrated its October 10 low. Its low-water mark yesterday (Friday) was 852.85, and it closed yesterday at 876.77 (a new closing low in this bear market).
Note, though, that I mentioned two weeks ago that the Proshares Emerging Markets Fund, which peaked at $72 a share last year had closed at $8.59 a share on October 10th. As of yesterday, the 24th, it was had fallen further to $5.42 a share... less than 1/12th of its peak value. QLD, the Proshares Ultra QQQ (NASDAQ 100) Exchange-Traded Fund, peaking at $122 a share last fall, fell to $28.58 after getting as low as $25.54 during the day. That's approaching a 5:1 ratio on a fund that isn't going to go away. Par Dorsey, Morningstar's Director of Equity Research, explains that hedge fund and mutual fund redemptions are forcing these organizations to liquidate massively without respect to the quality of the underlying stocks or companies. In the case of hedge fund liquidations, this may involve banks selling blindly with no regard for the quality of the funds' holdings. The babies are being thrown out with the bathwater.
But the economy continues to spiral downward.
In the meantime, more and more layoffs are being announced, with, I'm sure, consumer confidence falling and fear of layoffs rising. With 70% of the economy having depended upon consumer spending, reductions in consumer spending feed on themselves, tending to spawn a vicious circle.
It's going to require retooling and capital investment to bring manufacturing back to American shores
Another complication is the fact that our corporations have outsourced much of our manufacturing, and have closed down their factories and either sold their manufacturing equipment or shipped it overseas. Bringing back U. S. jobs to the U. S. will require retooling and capital reinvesting, and investment capital is in short supply right now.. Many displaced clerical workers found jobs in our now-contracting financial services industry.