by Richard Band | August 26, 2012 9:00 am
Feel the city breaking and everybody shaking,
And we’re stayin’ alive, stayin’ alive.
— The Bee-Gees (1977)
Twelve years and counting. Investors have waited a long time for the stock market to return to its irrepressible winning ways of 1982–2000. To be sure, the news since then hasn’t been all grim. We’ve enjoyed a pair of vigorous “cyclical” bull markets, from 2002 to 2007 and from 2009 to the present, both of which have generated worthwhile profits. But the truth remains: Despite those two recoveries, the Standard & Poor’s 500 index—the institutional benchmark for U.S. stocks—is still wallowing about 10% below where it stood in March 2000.
Happily, our Profitable Investing model portfolio, with its variable mix of stocks and bonds, has performed considerably better than the stock market alone during this period of secular (a fancy word for “long term”) stagnation. In fact, the dollar value of our Total Return Portfolio, including reinvested dividends and interest, achieved an all-time high in both March 2012.
However, I’ve got to level with you. This has been one long, tough slog — for me as much as you — and it’s probably not over yet. In this special report, I want to share with you my thoughts on when the next super bull market might arrive. (I’ll also suggest a few triggers to watch for.) As a final gesture, I’ll give you some pointers on how to stay alive financially, and keep your money growing, until the big bull bursts on the scene.
First, though, let’s consider why the market’s long-term trend really does matter for us as investors. Some interesting research from Ed Easterling of Crestmont Research sheds light on this question. Ed sums up his findings in the table below.
By Easterling’s reckoning, there have been eight completed secular bull/bear cycles since 1901. During long-term bull cycles, it’s rare for the market to drop more than 10% for a full calendar year. In fact, the Dow Jones Industrial Average (the index Easterling used for his calculations) has risen more than 10% in two-thirds of the years that comprise a secular bull market.
During a secular bear phase (such as we’ve experienced since 2000), the results look quite different. When the market’s long-term bias turns negative, sharp down years occur much more frequently. In secular bear periods, 37% of the years have shown a drop of more than 10%, and 30% of the years have administered a drubbing of more than 16%.
There are some crucial strategic lessons in these numbers. During a secular bull market, investors can afford to take a more relaxed view of stock valuations. Almost by definition, the standard valuation metrics will rise over the course of a long-term market uptrend. Thus, when considering stocks to buy, you don’t need to be ultra-finicky about price-earnings ratios, dividend yields and the like.
By the same token, timing your purchases isn’t much of an issue during a secular bull. Almost anytime is a good time to buy, because the market will eventually bail you out of most errors.
Secular bears call for a change of mindset. Uptrends within a secular bear phase are shorter. Downtrends are longer and steeper. To get ahead in this type of environment, you need to cultivate a fierce bargain-hunting attitude. You’ll also be wise to sharpen your timing skills. We’ll dig into the details later in this report.
At this point, you’re no doubt asking: “Well, Richard, when will the next long-term bull market lift off?” If it were already here, we could dispense with defensive tactics and buy stocks with both hands. But one obstacle still stands in the way of the big surge: Stock valuations haven’t yet reached the bargain levels typically seen at long-term market lows.
For many decades, analysts have relied on the price-earnings ratio as a basic tool for measuring values in the stock market (individual stocks as well as the market in the aggregate). However, the “earnings” (profits) part of the formula can fluctuate wildly in response to changing economic conditions. Thus, when you’re trying to assess the overall market’s valuation in a long-term context, it makes sense to take an average earnings figure over a period of, say, 10 years. Prof. Robert Shiller of Yale has championed this approach, comparing the price of the Standard & Poor’s 500 stock index with the 10-year average earnings of the companies that make up the index. Shiller also corrects the earnings for inflation.
The chart below shows Shiller’s “cyclically adjusted” (10-year) P/E ratio for the S&P index. As you’ll notice, the Shiller P/E has dropped considerably since 2000. Nonetheless, at more than 21X, it remains well above the single digits that characterized the major market lows of the past century.
Essentially, there are two paths the market could follow to the bargain basement. Prices could drop sharply; or prices could remain more or less flat while earnings continue to grow (increasing the denominator in the P/E ratio). The first course might lead rather quickly to a major low, perhaps as early as 2013. The latter route would likely take several more years, pushing out the ultimate turning point to maybe as late as 2019 or 2020.
I don’t have a strong sense, at the moment, whether this issue will resolve itself with a bang or a whimper. What I can tell you with some assurance, though, is that when the Shiller P/E dips below 10, we can look forward to double-digit returns in the stock market for many years to come. I hope to be there—with you—to celebrate those gains!
Besides valuation, a number of other gauges will help us know when conditions are ripe for the next superbull. Some of these indicators are of a “fundamental” nature—that is, they relate to economic events and trends. Others speak to investor psychology. Here are three of the more prominent signposts I’ll be watching for:
• Resolution to the entitlements crisis. The U.S. housing bust, which triggered the searing stock market wipeout of 2007–2009, is now pretty much behind us. American households have slashed debt (in many cases through bankruptcy and foreclosure) to a level that would ordinarily allow a fresh cycle of economic growth to begin.
Not so fast, though! The U.S. government — along with governments throughout the developed world — now faces a skyrocketing tab for Baby Boomer retirement benefits (pensions and healthcare). What’s more, this enormous bill is starting to fall due even before Uncle Sam has finished running up trillions in debt to “stimulate” us out of the 2008 financial crisis.
I don’t argue that the Boomer entitlements issue has to be fully resolved before a new secular uptrend can blast off. However, the broad outlines of a settlement should be visible—just as it was apparent to careful observers, after Ronald Reagan’s election in 1980, that America’s inflation problem (the major cause of the last secular bear market) was on its way to being tamed.
• Higher dividend-payout ratios. For the past decade, despite the ongoing stagnation in the stock market, many CEOs have resisted paying out a fair percentage of company profits in the form of dividends. Gradually, though, managements are relenting—even in the technology sector, where doling out dividends has often been viewed as a sign of weakness (revealing a “lack of growth opportunities”). Microsoft (NASDAQ:MSFT) gave in as early as 2003, but it took Cisco (NASDAQ:CSCO) until 2011 to get the message. Apple (NASDAQ:AAPL) finally caved after Steve Jobs, a fierce opponent of dividends, died in 2011.
Before the speculative craze of the late 1990s took hold, it was normal for large U.S. corporations to distribute 40%–50% of their operating profits to shareholders as dividends. Currently, that figure stands at about 33%. A payout ratio in the mid-40s (or higher) would signal that a majority of managements have converted to a shareholder-friendly mindset—a prerequisite to a new secular bull market in an era when retirees will dominate the investor universe.
• Changing of the guard. Admittedly, this is a somewhat subjective criterion. At almost every important market turning point, however, the strategies of the old era — and the people who promoted them most flamboyantly — are left thoroughly discredited. (Think of the real estate “heroes” of yesteryear.) Often, a major financial institution will fire a conspicuous leader of the old guard just as the market is preparing to write a brand-new chapter.
This time around, before the next mega-bull can arise, I think we’ll see the whole rapid-fire trading culture discredited, and the vastly overpaid hedge-fund community in particular. Watch for CNBC to shut down its hyperkinetic (and unbelievably superficial) Fast Money segment. Jim Cramer will be ushered off the air. One or more celebrity hedge-fund managers will close shop—followed, perhaps, by dozens or even hundreds of smaller fry if Congress finally gets around to closing the indefensible “carried interest” loophole, which allows hedgies to convert salary income into lightly taxed long-term capital gains.
As I said earlier in discussing the Shiller ratio, we don’t know when the tide will turn on this long period of market stagnation. It could be within the next year, or even seven or eight years from now. Until the ship’s whistle sounds, though, there are plenty of things we can do to preserve our wealth, and grow it. Following are three specific steps I advise you to take in the meantime:
• Focus single-mindedly on bargain hunting. During a secular bear trend, it’s not enough to buy “reasonable values.” You’ve got to look for, and wait for, fire sales. To accomplish this goal, you’ll want, first of all, to carry around in your head definite prices at which you’re willing to buy individual stocks, or the market in general.
For instance, I know I would be very interested in buying Apple at $477, halfway between its 2011 low and 2012 high. At that point, the stock would trade at only 9X estimated FY13 earnings, and a reasonable 2.2% dividend yield. Should the market appear to be forming a major bottom without taking AAPL that low, I would consider buying at a somewhat higher price, perhaps in the $510 to $540 range.
Patience constitutes the other half of the bargain-hunting process. AAPL today is trading nowhere near any of my target prices. I’m in no hurry, though. I’m crouching in the grass, looking all around and listening, like a great cat of the Serengeti. When the prey ambles by, my muscles will be tensed, ready to pounce.
• Shift your stance as prices shift. In a stagnant or declining market, it also makes sense to adjust your exposure to stocks more frequently. Wall Street’s paid apologists deride this tactic as “market timing.” However, the critics often assume that the only alternative to being 100% invested in stocks is to be 100% out. That’s not true.
You might decide, for example, that in a challenging secular climate, you’re willing to allocate 50%–65% of your portfolio to stocks. (As it happens, I’ve adopted that range as the working benchmark for our Profitable Investing model portfolio until the long-term fundamentals for equities improve.)
When economic and market conditions seem good enough to lift share prices for the next year or two, you could push your stock weighting toward the top end of the range. As the advance matures, or when it falters, you could drop to the lower end. The remainder of your portfolio would consist of bonds, cash and other assets that don’t closely follow the stock market’s ups and downs. As we speak, I’m recommending a below-normal equity allocation for the model portfolio, reflecting my concern that the cyclical uptrend dating back to March 2009 may be in its final innings.
• Emphasize current income. With capital gains often fleeting and unreliable in today’s environment, it’s essential to capture as much of your return as possible in the form of “cash on the barrelhead.” Dividends and interest, in other words. The challenge, of course, is that yields on most dividend-paying stocks (and virtually all bonds) have declined substantially over the past couple of years.
Still, if you choose carefully, buying stocks and bonds on pullbacks as I suggested earlier, you’ll be able to assemble a portfolio with a current yield well above what is available on money market funds or bank CDs. In the equity arena, for example, we’ve recently locked in a yield of well over 3% with Emerson Electric (NYSE:EMR), a blue chip industrial firm that has raised its dividend 55 years in a row. A timely June 21 buy signal in my Richard’s Journal blog allowed us to grab Procter & Gamble (NYSE:PG) at a 3.8% yield, just before news broke that activist investor Bill Ackman had accumulated $2 billion worth of the stock.
Stay in touch with the regular monthly issues of Profitable Investing and my online updates between newsletters. That’s where I’ll be fleshing out this three-step strategy in practical detail. By maintaining a bargain hunter’s focus, shifting your portfolio gradually between stocks and fixed income, and emphasizing current yield, I’m confident you and I can stay alive—and thrive—until the Big Bull romps again.
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