Are we in a short-term cyclical bull market, one that is already long in the tooth and coming to an end? Or are we in the early years of a secular bull market, one that might last a decade or more?
The answer could have a significant impact on how your portfolios perform during the next few years. A few examples, definitions and some data points will help provide some context for this discussion.
Markets regularly go through long phases — bullish, bearish and sideways — lasting anywhere from years to decades. The 20th century saw three secular bull markets: The first lasted from 1921 to 1929, when the Dow Jones Industrial Average gained 367 percent. After World War II, the next bull market lasted about 20 years, more or less from 1946 to 1966. It is a somewhat subjective determination. The Dow had gains of about 350 percent during that stretch. The most recent bull market began in 1982, with the Dow starting at about 1,000, and ending in 2000 at 11,750 — a whopping gain of more than 1,000 percent.
In between were secular bear markets: 1966 to 1982, when the Dow went nowhere in nominal terms, but after inflation it lost about 75 percent of its value. We had another bear market starting in about 2000 and ending in 2013.
Long secular bull markets occur for a specific reason: waves of industrial, technological and economic progress make their way into employees’ wages, consumers’ pockets and corporate profits. Improving standards of living are reflected in the psychology of an era. Not surprisingly, markets do well, as investors become willing to pay more for a dollar of earnings as the cycle progresses. Multiple expansion, in the form of rising price-to-earnings ratios, drives returns even more than rising profits.
Let’s use 1982 to 2000 as an example. The widespread adoption of many technologies, including software, semiconductors, mobile, networking, storage and biotech, fed into each other. The economy expanded, there was record low unemployment, strong wage gains and high corporate profits. As you would imagine, U.S. stocks did very well. Now think about the many long-lasting positive elements that drove the postwar period: interstate highways, suburbanization, automobiles, electronics, commercial airlines. That 1946-1966 era was one of huge growth.
But bull markets tend to get ahead of themselves, especially as they age. They end up pulling years of future returns into the present. Hence, the subsequent bear market can be thought of as a refractory period, working off valuation excesses over time.
What does this look like in actual markets? According to an analysis by the fund company Fidelity Investments:
The average secular bull market lasted 21.2 years and produced a total return of 17.2 percent in nominal terms and 15.9 percent in real terms. The market’s P/E more or less doubled, from 10.1 at the start to 20.5 at the end.
The average secular bear market lasted 14.5 years and had a nominal total return of 1 percent and a real return of –2.3 percent. The market’s P/E compressed by an average of nine points, from 20.5 at the start to 11.3 at the end.
The psychology underlying bull and bear markets is why P/E ratios expand during bull markets and contract during bears. Declining P/Es during bear markets reflect investors’ fears. They become less willing to pay the same price for each dollar of earnings. This is why judging secular moves by price alone fails to fully capture just what is going on.
Historically, this suggests an extended period of range bound trading as the highest probability long-term scenario in my view. I expect vicious rallies, and wicked sell-offs to occur — over shorter term cycles — within the larger timeline. Active management and capital preservation are going to be the key methods of outperformance.
In 2013, markets broke out, implying the start of a new bull market. The Dow’s P/E has averaged 16 during the past three years, in the middle of the range during secular bull markets. We discussed last year the divide between the veteran market strategists, technicians and traders who were either in the secular bull or bear camps. I remain in the secular bull camp, and will share what would make me change that view in a future column.
One final thought: These things are always terribly clear in hindsight; in real time, they are more challenging to discern. It is easy to say 1982 to 2000 was a secular bull market, but read the commentary at the time. It was hardly definitive while it was happening.