Current Thinking About Secular Bear Markets


Most Pinnacle Advisory Group clients are familiar with our view of secular (or very long-term) market cycles. My partner, Michael Kitces, and I first published a paper on secular bear markets in the Journal of Financial Planning in 2006, where we predicted correctly that stock prices were likely to deliver much less than average returns for years to come. In my 2009 book, Buy and Hold is Dead (AGAIN): The Case for Active Portfolio Management in Dangerous Markets, I reviewed in some detail the rationale for why stock prices can disappoint investors ‘on average’ for decades. (In fact, the “(AGAIN)” in the book title referred to the fact that we’re currently laboring through the fourth secular bear market since the 1900’s.)

Recently several writers have weighed in on the subject of whether the current secular bear market is over – which would mean that clients could expect decades of above average stock market returns going forward.

Unfortunately, like everything else in finance, the definition of a secular market cycle appears to differ from analyst to analyst. For some, secular bear markets occur when stock prices spin sideways for decades and market peaks and troughs are roughly the same over the years. As stock prices go from 750 to 1500 to 750 to 1500, no wealth is being created, except for those who buy at the troughs and sell at the peaks. These analysts define secular market cycles based on market prices. For them, a secular bear implies that the market will make new lows at each successive price trough, confirming that there is no clear uptrend in prices over time. For others, a secular bear implies that, on average, the returns of stocks for long periods of time will be equal to or less than the returns of bonds or cash. Such a result is so different from what we would expect from studying long-term average comparative returns that it would be considered evidence of a secular bear. On the other hand, if stocks deliver less than expected returns, but are still expected to outperform bonds and cash, then some analysts would claim that we are in a secular bull market.

Indeed, one of our most respected analysts, Tony Boeckh, President of Boeckh Investments and the author of the Boeckh Investment Letter, has persuasively argued that:

  1. Stocks are unlikely to exceed the March of 2009 low, implying that we are in a new long-term uptrend in prices.
  2. Stocks are highly likely to outperform cash and bonds over the next decade.

His view is that the secular bear market is therefore over and the new secular bull market has begun. While both of Boeckh’s points may be accurate, our own analysis of likely stock market returns going forward makes it difficult to raise investor expectations by claiming the new secular bull market has arrived.

2022-Normalized-EarningsWith the help of Sauro Locatelli, Pinnacle’s quantitative analyst, we have plotted the normalized or ten-year average earnings of the S&P 500 Index. Averaging, or normalizing, the earnings over a ten-year period removes the cyclicality of earnings data and makes it easier to arrive at an earnings figure that isn’t distorted by the current market environment. Current S&P 500 Index normalized earnings are $59.41 per share. The chart on the right shows how the earnings would grow over the next decade at different rates of growth. Discerning readers will note that if earnings grow at a negative -2% between now and 2022, the normalized earnings number still increases from $59.41 to $78.08 over the next decade. This anomaly occurs because earnings were so devastated during the 2000 – 2002 bear market that as we roll the clock forward and the prior earnings data is no longer counted, the average of the rolling ten-year data increases even though future earnings are actually falling. If we achieve average rates of earnings growth over the next decade of 6% per year, then future earnings are likely to be in the $107 – $119 per share range.

The next important question is what multiple of earnings investors are likely to pay in the future. The earnings multiple is determined by many factors, but investors tend to pay more for earnings when they are confident about the future, when they think inflation is under control, and when they believe that economic growth is likely to be supportive of corporate profitability. The long-term average PE multiple, depending on what time frame you use to measure, is about 18X normalized earnings. Many believe that PE multiples are notoriously mean reverting, meaning that investors continually migrate from being overly enthusiastic about the prospects for future stock prices, to overly negative about the prospects for future prices. Therefore, if the current multiple is higher than average, then the likelihood is that the multiple would fall over time and revert to the mean. Secular bears would claim that the multiple is more likely to revert to a number much less than the mean, as it always has in the past. In fact, secular low multiples have always been less than 10. Based on today’s S&P 500 price of 1450 and current normalized earnings of approximately $60 per share, the current PE-10 is 24X earnings – much higher than the historical average.

SP500-Ten-Year-2022The chart above tells us how to put these data together to make our forecast. If we assume that the PE-10 multiple regresses to the mean over the next ten years and investors are willing to pay 18X earnings, and if we assume that earnings grow at their historical average rate of 6%, then the ten-year annualized total return for the stock market — including dividends reinvested — would be 4.1% annually. If investors continue to pay historically high multiples for earnings in the future at 24X earnings, then the annualized total return for stocks would be 7.1%. Of course, if earnings growth were to be less than average because of slower than average economic growth, lower investor expectations for returns, or higher inflation, then the multiple and the earnings could be lower, creating a forecast of even lower stock market returns in the future.

The implications of a continuing secular bear market remain the same as they have since this current secular bear began in 2000. First, active management is a necessary component of trying to drive excess returns above the lower than average forecasted returns for the stock market, and so Pinnacle’s tactical asset allocation strategy should remain relevant for years to come. Second, clients need to plan for lower than expected returns in terms of forecasted returns on investment, the amount of spending and savings they need to achieve their goals, and their overall expectations for portfolio volatility. Unfortunately, for clients who might consider waiting this out in cash or bonds, we believe that Tony Boeckh is probably right. While stock returns are likely to be lower than average, they are likely to beat the returns of both cash and bonds over the next decade. Therefore, the best strategy is to remain globally diversified in a portfolio where you can live with the implied volatility of your portfolio policy.

As always, please consult with your Pinnacle Wealth Manager to be sure that your portfolio policy, and your expectations for future investment results, is appropriate.

Ken Solow
About Ken Solow
Kenneth R. Solow, CFP®, CLU, ChFC is a founding partner and serves as the Investment Committee Chair of Pinnacle Advisory Group, Inc. As a founding partner, he is responsible for the direction and management of Pinnacle’s investment analysts, as well as the philosophy, tactics, and trading strategy for over a billion dollars in assets. Solow is nationally known for his views on active portfolio management, and his 2009 book, Buy and Hold is Dead (Again): The Case for Active Portfolio Management in Dangerous Markets, is considered the definitive work on Tactical Asset Allocation. Solow appears regularly at events sponsored by the Financial Planning Association, National Association of Financial Planners, the Investment Management Consultants Association, and the AICPA, and has been published in The Journal of Financial Planning, Smart Money, Financial Planning Magazine, The Baltimore Sun, the Globe & Mail, and the Wall Street Journal.