Bulls and bears, secular or cyclical?
Bull markets are characterised by long periods of rising security prices punctuated by short sharp and usually muted declines. Bear markets normally begin with some external shock, a burst bubble, corporate malfeasance, rank speculation or excessive debt.
Afterwards, they oscillate violently as a result of investor optimism and despair. Eventually, these gyrations decline in magnitude much like a rubber ball bouncing into stasis.
Bears are typically associated with declines of 15 per cent or more, whilst bulls are characterised by a general rise in prices with moderated volatility. What is important is whether the market – bull or bear is secular or cyclical. Secular markets last from 15 to 20 years or more whilst cyclical markets coincide with the economic cycle of three to five years in duration.
Overlaying this is a seasonality to equity prices lasting from four to eight weeks occurring two or three times each year. (See Graphic A)
Secular markets are composed of a series of cyclical bull and bear periods roughly coinciding with the economic cycle. Even though investors may be faced with a secular bear market today, powerful cyclical bull markets do occur and can be quite profitable as shown by the green marked up cycle. (See Graphic B)
The point here is that the investor has to be in the game to profit from these rallies and that may require tolerating higher volatility levels in the short term. “Being in the game” may provide some other benefits for stock investors not considered in recent years.
A short history of secular bear markets
The US has suffered three great US secular bear markets (and four secular bull markets) in the 20th Century. (Graphic C) The first started in September 1906 and lasted until the end of 1920 (20th I) or about 14 years.
The real price decline from peak to trough was 70 per cent and was precipitated by both a liquidity crisis and rank speculation. The liquidity crisis was exacerbated by the occurrence of the San Francisco earthquake the previous April.
Reconstructing San Francisco required that capital, in the form of insurance payments and financial aid, shift from the east coast of the US to California. Money flooded into the stricken area draining US and foreign – primarily UK – gold reserves.
Unlike today, the world’s major currencies such as the British pound, German reichsmark, US dollar, and French franc were backed by gold. Since international trade was paid in gold, the drawdown in reserves meant that a limited amount of the metal was available for business or speculative ventures.
This then precluded a governments’ ability to exercise effective monetary policy. Ultimately, this event set up the New York financial crisis of 1907 so that the initial break came from the failed attempt in October to corner the market on the stock of the United Copper Company.
When this bid failed, banks that had lent money to the cornering scheme suffered runs that later spread to affiliated banks and trusts, leading a week later to the downfall of the Knickerbocker Trust Company – New York City’s third largest trust.
The collapse of Knickerbocker spread fear throughout the city’s trusts as regional banks withdrew reserves from New York City banks. Panic extended across the nation as vast numbers of people withdrew deposits from their regional banks.
The second secular bear market occurred in October 1929 and is generally known to have ushered in the Great Depression (20th II). Precipitated by binge spending on the part of the populace, malfeasance in boardrooms and rampant stock speculation the similarity to today’s economic condition is unsettling.
During that period, the market collapsed 83 per cent in real terms over 33 months in what was a relatively short and violent fall. From that point onwards prices rose generally although the market was punctuated by violent corrections. Sentiment drove the first cyclical recovery spawned by the euphoria of Franklin Roosevelt’s election as president.
The market peaked in 1937 and declined into mid 1942 in the longest cyclical bear market of the century. Nevertheless, the low set in 1932 held and after June 1942, when the US defeated the Japanese fleet in the battle of Midway Island, market conditions steadily improved and volatility moderated.
The third and final 20th Century secular bear market began in November 1968 and saw the final low in real terms in August 1982 (20th III) after declining 65 per cent over nearly fourteen years. A host of problems befell the US economy beginning in 1968. Civil, unrest was epidemic as both racial strife and protests against the war in Vietnam were daily occurrences.
The end of the war saw a consequent rise of inflation precipitated by the Johnson administration‘s Great Society programmes. President Nixon sought to bring inflation down through wage and price controls, which proved ineffective.
The US support for Israel in the 1973 Yom Kippur war spurred the Arab oil producing nations to institute an oil embargo, which fuelled more inflation leading to high unemployment. (See Graphic C)
Where are we now?
We believe we are currently in another secular bear market which started early in 2000 at the height of the tech market bubble. As with the secular bear market of 20th II (Great Depression), the Great Recession (21st I) may be similarly characterised by overspending by both public and private sectors, malfeasance such as with WorldCom and Enron, and rampant speculation in the real estate sector supported by over-leveraged investment banks such as Lehman and Bear Stearns.
Whereas the markets have resolved for the most part the private sector issues above, the markets’ current difficulties revolve around the over-extension of the public sectors of various governments.
The democratic process does not lend itself easily to the resolution of excessive government spending. The result has been that we at BIAS have refocused our efforts to provide safety to our clients by increasing the allocation of our portfolios to high grade corporate debt.
Similarly the intervention of central banks around the world in the money markets has forced interest rates in many countries, particularly in the US, to levels which we believe are unsustainable.
The historically low level of income available from fixed income securities requires that we look for greater sources of income. Where equities had previously been used primarily for growth, dividends yields are currently substantially higher for many blue chip stocks than are there bond yields.
The opportunity for the investor is not only higher income from stock dividends than available from bonds issued by the same companies, but the potential for good capital appreciation over the next three to five years.
We will continue to use bonds but primarily for risk control, not so much for income. Dividend paying blue ship stocks offers the best opportunity despite volatile equities markets; however, investors should not be passive in the current market environment. (See Graphic D)
Specifically, when investing in equity markets during secular bear periods investors must keep four important points in mind:
- Hold a large proportion of an equity portfolio in dividend paying blue chip stocks.
- Add stocks that will likely grow regardless of the economic cycle.
- Buy when there is blood in the streets.
- Remember to take profits.
This approach, while not yet fully embraced, is gaining traction. In fact, no less a person then Jeremy Siegel, the Russell E Palmer Professor of Finance as the Wharton School and the author of “Stocks for the Long Run” has admitted, when asked about his personal portfolio in a recent interview that:
“I have moved more into dividend-paying stocks. I like that sector more than ever. With interest rates so very low, there is no income in the bond market,…. They are going to be the new bonds that people are going to be seeking for income, because I don’t see bonds as being attractive for years and years and years1”.
1 As reported by Robert Huebscher of Advisor Perspectives 29 November 2011