Beware the Secular Bear

Study the past if you would define the future.’ — Confucius

Overnight the US market lost ground. Concerns over China and weaker earnings from Wal-Mart weighed it down.

The current conditions are a far cry from earlier this year when the US market was making new high after new high.

A few months ago the ASX was a sure bet to hit 6000 points. Today that target is out to much longer odds.

These daily gyrations are critical if you’re a day trader….deciding whether to go short or long. However, longer term passive investors need to stand back from the daily picture and take a panoramic view.

For over 140 years the US share market has been influenced by very long term cycles. The recent stalling in the US market could actually indicate a much steeper downward trend. This would complete a cycle that began back in 1981.

I know the Fed has made a pact with Wall Street to keep markets on the up and up forever. But there are forces at play far more powerful than a handful of academics who think they possess divine powers.

Tides rise. Tides fall. Expansion and contraction. Night followed by day. Sunshine and rain.

We all know life has its cycles and balancing forces. Yet when it comes to markets, the overwhelming story is always one of growth followed by more growth. 

When was the last time you can recall a mainstream analyst or economist issuing a dire warning about next year’s earnings or economic outlook? Rarely, if ever.

Yet we know from history that the global economy and financial markets do experience periods of contraction and out right depression.

These are not every day or even every year events, but they do happen.

These events happen because the system gets ahead of itself. Unearned growth and assets priced well above their true value need to be given the occasional reality check. This is the yin and yang of life.

However, central bankers have appointed themselves as the almighty controllers of the one-sided cycle. In central banker world this is a cycle that only ever expands and never contracts. Recessionary periods and market corrections in excess of 20% cannot and will not be tolerated. 

All forces — interest rate manipulation, ex-nihilo money, imprisonment for shorting the market, instructing institutions to act in a State-friendly manner, tortured statistics — are marshalled to ensure the one-sided cycle stays upright.

We don’t have to look too far into the past to define what happens to markets and economies under state control.

In 1989 the falling of the Berlin Wall revealed, for all the world to see, what the outcome is when States think they know better than the market.

Cuba is another case in point. 

When it comes to man versus markets, markets always win. Always.

And so it will be with the Fed’s manipulation of the US share market.

For fifteen years, the Fed has fought the contractionary forces of the US share market, with a variety of programs.

With the benefit of over 140-years of data, the markets have demonstrated repeated cycles. Cycles going from undervalued to overvalued and back to undervalued. This is the natural course of events.

These cycles — lasting up to four decades — are known as secular markets.

A Secular Bull Market is when the cycle is moving from undervalued to overvalued. 

A Secular Bear Market corrects the excesses of the Secular Bull and takes the market back into undervalued territory.

It’s a very long ‘two steps forward, one step back’ process.

The following chart identifies the various Secular Bear Markets patterns that have occurred in the US share market since 1875.

The P/E Ratio on the left hand scale shows how each Secular Bear market begins with a high price/earnings multiple — in excess of 20 times. An overvalued position that is the siren call that stirs the Secular Bear into action.

The Secular Bear market unleashes sufficient force over a number of years (ranging in duration from four to 20 years) to drive the P/E ratio into undervalued territory…less than 10 times.

The latest Secular Bear market (blue line) began in 2000.

At the peak of the dotcom euphoria, investors pushed the market’s P/E ratio to an unbelievable 47 times. Nearly double the highs reached during previous Secular Bull markets.

The tech wreck saw the exit of the Secular Bull and the entry of the Secular Bear.

The Secular Bear lost no time in driving the P/E ratio down…for three years it plunged headfirst into the 20 times range.

Then the Fed intervened. Dropping interest rates so low they created a housing frenzy funded in part by subprime lending. Encouraged by the Fed’s action, the share market once again pushed back against the Secular Bear and moved the market P/E ratio higher.

The Secular Bear went into hibernation for four years. The GFC was a result of the Secular Bear once again unleashing its fury in a very short space of time. The market’s PE ratio fell into mid-range level.

Again the Fed felt compelled to keep the one-sided cycle upright. For six years they’ve sidelined the Secular Bear market with a combination of zero interest rates and QE programmes.

Over the past 15 years, the level of intervention in markets — in the US, Japan, Europe and China — has been truly extraordinary. 

It has gone on for so long, no-one remembers how markets used to undertake genuine price discovery. There is an almost unquestioned belief in the central bankers’ ability to continue underwriting market valuations with their voodoo solutions. Buy-the-dip is Wall Street’s mantra.

The recent actions by Chinese officials to stem the losses in the Shanghai Composite index took State-sanctioned intervention to a whole new level. 

The Secular Bear market has a job to do. It will not rest until the task of driving the market’s P/E ratio much lower is achieved. 

Since 2000, the secular bear has made two attempts to complete its mission. The Fed has fought fire with fire. It’s managed to hold the Secular Bear at bay. 

This time is different by Professors Reinhart and Rogoff chronicles 800 years of financial folly. In every single case the market has the final word.

What makes policymakers, investment institutions and mainstream economists think this time will end any differently? Ego and self-interest.

Central bankers have enormous self-belief. Why else would they pursue these theoretical solutions? They truly believe they know what’s best for markets. The prospect of immortality awaits the first central banker who defies history. What an ego stroke that would be. 

In the case of Wall Street it is all about vested interest. Last year, the combined profits of Goldman Sachs, CitiGroup, JP Morgan and Bank of America exceeded US$200 billion.

The more money in motion — from share trading, IPOs, merger and acquisitions — the more Wall Street can clip the ticket. A full blown Secular Bear market would bring the profit machine to a grinding standstill. A downcast social mood would play havoc with their bottom line. Wall Street is all in favour of any intervention that keeps the party going…and the longer the better.

Mainstream economists are in it for pure self-interest. Government operates on the principle of ‘to get along, you must go along’. Be a good boy or girl and doors will open for you in Treasury, Finance, the chance to sit on Committees — that’s how the system works. You scratch my back and I’ll scratch yours.

The Fed needs all the favours it can get.

Never before has there been so much capital printed and used to stem the natural expansion and contraction cycle of the share market.

When you consider what’s a stake, you understand why central bankers act with elevated levels of desperation.

The US share market is valued at over US$20 trillion. A correction of 65% (which is what’s required to take the market down to a P/E ratio of 10 times) would wipe out US$13 trillion. The equivalent of nine months of US GDP.

A number of US pension funds would be insolvent. Government welfare commitments would increase significantly. Companies that financed share buyback schemes with cheap debt, find their balance sheets awash with red ink. Retirement dreams are either put on hold or completely shattered. The dominoes keep on falling right through all levels of society. 

This is what happens when a system is built on the lie. The Fed wants you to believe there is no need to be overly worried and that they can take nearly all risk out of the market. If there is a market wobble, wait awhile and you’ll soon be back to 100 cents in the dollar. So many people have bought into the lie that it takes more and more energy to keep the truth from being exposed.

When the Secular Bear decides enough is enough and shows the Fed who really is the boss, people are going to be shattered. When the truth is revealed it will be much like finding out your spouse has been cheating on you. 

Beware the Secular Bear. History tells us what the future holds for share investors. Take heed and look at taking precautionary action now.


Vern Gowdie,
Editor, The Daily Reckoning, Australia