Beware the Stock Bear!
Adam Hamilton February 20, 2015 2970 Words
The US stock marketsí latest record highs have left traders exceedingly euphoric and complacent. They are utterly convinced this stock bull will power higher for years to come. But their enthusiasm is very misplaced. In real inflation-adjusted terms, the US stock markets only just regained breakeven levels 15 years after the last secular bull peaked. Now the secular stock bear ever since is overdue for a new cyclical bear.
The flagship benchmark index for tracking the US stock markets is the mighty S&P 500, often shortened to SPX. The whole financial world literally revolves around this dominant index, with most global equity markets and even some major commodities markets like oil usually mirroring it. American stock traders can directly trade the SPX through a handful of gargantuan ETFs including the leading SPY S&P 500 ETF.
As a broad-based market-capitalization-weighted index comprised of 500 of Americaís biggest and best companies, for all intents and purposes the S&P 500 effectively is the US stock markets. So new SPX record highs are widely-celebrated events, stoking great bullishness among investors and speculators. They were super-excited to see this leading index close over 2100 for the first time ever just this week.
If you follow the financial mediaís breathless euphoric coverage of new SPX record highs, youíd think things have never been better for investors. They are interpreted as a glorious harbinger of years more of rallying to come, trumping any global economic or geopolitical risks. But unfortunately this popular perspective is dangerously misleading. When necessarily adjusted for inflation, todayís records are pathetic.
Inflation is the rise in general price levels driven by central-bank money printing. When central banks expand money supplies faster than their underlying economies, relatively more money chases and bids up the prices on relatively less goods and services. As this monetary inflation makes everything grow more expensive over time, the value of each dollar dwindles. And this includes dollars invested in US stocks.
The last secular bull peaked back in March 2000, when the SPX soared to the then-staggering level of 1527. Back then the Federal Reserveís narrow and broad M1 and MZM money supplies were running around $1109b and $4463b. But after epic money printing led by uber-inflationists Alan Greenspan, Ben Bernanke, and Janet Yellen, the Fedís vast money-supply expansion in the 15 years since is unrivaled.
As of their latest reads at the end of last month, M1 and MZM have skyrocketed 2.6x and 2.9x to about $2933b and $13,054b respectively. So since the last secular US stock-market record high, the supply of US dollars has nearly tripled. While it is true the underlying US economy also grew much over that span, the money-supply growth dwarfed it. US GDP merely advanced by about 1.7x during those years.
With the Fedís money printing far outpacing economic growth, prices have relentlessly risen over the past 15 years. And we all know it, as the costs of the goods and services we need to live life keep on climbing. The most popular measure of inflation is the US governmentís Consumer Price Index, which is widely accepted by Wall Street even though this inflation read is lowballed for political and fiscal reasons.
The government actively manipulates the CPI to perpetuate the myth of low inflation because the truth has such a broad and detrimental impact. If true inflation was reported, these lofty stock markets would be radically lower. Americans would believe our economy was far worse, and would kick politicians out of office. The vast welfare payments indexed to inflation, along with interest payments on Treasuries, would soar.
This would threaten to bankrupt the entire US government! So it literally canít afford to report an honest inflation read. But even though the CPI is a farce, its lowballing makes it a super-conservative metric. Since the last secular stock bull peaked in March 2000, the CPI has climbed 37.2%. The Fed has devalued our currency so much that it takes at least $1.37 today to equal the purchasing power of $1.00 15 years ago.
Thus comparing nominal (not adjusted for inflation) stock-market levels over long periods of time is very misleading. Thanks to the Fedís relentless money printing, a dollar invested in stocks today is worth a lot less than a dollar invested in the past. So adjusting for inflation is essential for any long-term price comparison. When the SPX is rendered in todayís dollars using even the lowballed CPI, things look far different.
This weekís S&P 500 record high of 2100 was 37.5% above March 2000ís 1527. That is nearly identical to the 37.2% increase in general price levels as fudged by the US government. So in real terms, the US stock markets just returned to breakeven for the first time in 14.9 years! Let that sink in. For a whopping decade and a half now, the US stock markets have been dead flat at best. Stock investing has returned nothing!
This is incredibly damning. Our fleeting human lifespans limit us to about 40 years of investing time, from the ages of 25 to 65. American stock investors who listened to Wall Streetís perpetual advice to stay fully invested in stocks since the last secular bull peaked just threw away 15 of those 40 years! To lose 3/8ths of oneís entire investing lifespan is sickening, and crippling for those nearing retirement age.
Sadly Wall Street always claims stocks will rise indefinitely no matter how overvalued, overextended, toppy, and euphoric the stock markets happen to be. Wall Streetís livelihood is heavily dependent on investors remaining fully invested in the stock markets, so it can skim its hefty percentage-of-assets-under-management cut. So Wall Street had no problem lying to investors back as the last secular bull peaked.
Wall Street doesnít want investors to know that stock markets are forever cyclical. They donít just rally forever, as secular bulls inevitably yield to subsequent secular bears. And one was brewing back in early 2000, as the small fraction of contrarians including me warned about. I pounded the table about the extreme risks in those wildly-overvalued stock markets, and urged investors to shift to alternative assets.
And that bold contrarian call has proved utterly brilliant. Alternative investments are led by gold, which tends to move contrary to the stock markets. Over that exact 14.9-year span between the March 2000 SPX high and this weekís latest one, gold blasted 324.2% higher compared to the SPXís miserable little 37.5% gain. Investors willing to prudently fight the crowd and sell stocks high to buy gold low multiplied their wealth.
But sadly that was only a small minority of contrarians, as the great majority believed Wall Streetís silly stocks-rally-forever hype to stay fully invested through a secular bear. Secular bears are not plunges, but long sideways grinds. And thatís exactly whatís happened over the past 15 years as I warned about back in the early 2000s. The US stock markets have been stuck in a giant trading range ever since then.
This is readily apparent above. In nominal terms, the SPX traded between roughly 750 to 1500 until early 2013. Thatís when the Fed decided to brazenly and recklessly goose the topping stock markets though extreme money printing. Its third quantitative-easing campaign launched back in late 2012 was wildly unprecedented in being totally open-ended. It emboldened stock traders to aggressively buy high.
QE3 was not only open-ended, but the Fed kept promising it would be quick to ramp up its epic inflation if the stock markets sold off. All this jawboning convinced investors and speculators to flood into the US stock markets regardless of the overvalued fundamentals, overextended technicals, and exceedingly euphoric sentiment. So the SPX started flying, bursting above its nominal resistance to levitate higher.
But in real inflation-adjusted terms, even the Fedís mind-boggling QE3 stock-market distortions couldnít break the SPX free from its secular bear! With this flagship index now merely regaining its levels seen at the end of the last secular bull, the secular-bear consolidation of the past 15 years is very much alive and well. The SPXís real trading range as seen through the lens of the CPI is roughly 1000 to 2000.
And we are just over the top of it today, which ought to give the legions of complacent and euphoric stock traders serious pause. The long sideways grinds of secular bears are formed by an alternating series of cyclical bears and bulls. The former cut stock prices in half, then the latter double them again. This pattern continues until stocksí underlying corporate earnings grow enough to make stocks cheap again.
The critical question investors need to be asking themselves today is whether or not this secular bear is over. It inarguably exists, the charts donít lie, despite Wall Street steadfastly denying its existence for 15 entire years now. If this secular bear is not yet over, then the SPX is now almost certainly on the verge of rolling over into a new cyclical bear that will again cut it in half. That will be devastating for investors.
After 15 years of earning nothing in real terms, US stock investors are finally back to breakeven. And many are nearing retirement age after such a long miserable grind. To see their wealth sliced in half again over the next couple years would shatter the dreams of many if not most. If this secular bear isnít over, the critical decision time is now since todayís lofty stock markets are a fantastic selling opportunity.
Contrary to Wall Streetís perma-bullish assertions, the stock markets are forever cyclical. They move in great third-of-a-century cycles driven by valuations. The first halves of these are secular bulls, where stock investing grows in favor until stocks are bid up to fundamentally-absurd price levels. The second halves are secular bears, where stocks drift sideways until corporate earnings grow enough to restore real value.
Like the preceding secular bulls, secular bears tend to last for 17 years each. And throughout history their average duration is pretty tight. Todayís is only 14.9 years old, which implies another couple years left. And after the SPX more than tripled since March 2009, largely thanks to the Fedís gross distortions from QE3 and its associated jawboning, another cyclical bear over the next couple years makes lots of sense.
And valuations support this. All the euphoria in these stock markets has left stocks very overvalued by all historical standards. All 500 elite companies in the S&P 500 now sport average trailing-twelve-month price-to-earnings ratios of 26.0x in simple terms. If their individual P/Es are weighted by their market capitalizations, that merely drops to 24.1x. The historical average for the US stock markets is around 14x.
Half of that 14x fair-value level at 7x is cheap, which is where secular stock bears tend to end. And 21x is expensive historically, while double fair value at 28x is formally dangerous bubble territory. The US stock markets arenít far away from that today, which is exceedingly ominous. At such lofty valuations, the odds are very high that the secular stock bear since early 2000 is far from over despite the recent records.
Zooming out this CPI-inflation-adjusted S&P 500 data again, the great secular bull and bear cycles are readily evident. The last secular bear lasted 16.5 years straddling the 1970s, and saw the SPX rally modestly in nominal terms while falling precipitously in real terms. That secular bear didnít end until the elite S&P 500 stocks traded well under 7x earnings in the early 1980s. Only then was a new secular bull born.
The subsequent secular bull was massive, and lasted 17.6 years into the early 2000s. But it left the SPX deep in super-dangerous bubble territory at 43.8x earnings. As I warned about nearly 15 years ago, that virtually assured we were in for a miserable 17-year secular bear. And that proved to be true of course. Just like in the 1970s, the SPX ground sideways on balance through a series of cyclical bears and bulls.
The US stock markets only broke out of this secular trading range in early 2013 thanks to the extreme distortions of the Fedís QE3 debt-monetization campaign. And even with the SPXís incredible artificial levitation of the last couple years, it still remains trapped at the same conservative inflation-adjusted levels it saw at the last secular bullís peak. The new record highs traders are lauding are a Fed-conjured illusion!
The stock marketsí next couple years totally hinge on whether the secular bear of the past 15 years is over yet or not. With euphoric stock traders bidding the SPX up to near-bubble valuations in recent years thanks to the Fedís implied backstopping, stock-price levels are far too high to argue for the end of the secular bear. They support just the opposite, that it is alive and well so a brutal new cyclical bear is looming.
The only other option was this secular stock bear ended back in early 2009, so we are now in a middle-aged secular bull. Wall Street advances this argument all the time, since it helps convince Americans to buy stocks and stay invested to generate massive asset-management fees. But unfortunately the March 2009 bottom looks far more like the end of a cyclical bear within a secular bear than the secular bear itself.
Remember that secular bears are valuation phenomena, and they tend to last for 17 years each. Back in March 2009, the market-capitalization-weighted-average trailing-twelve-month P/E ratio of the S&P 500 stocks merely slumped to 11.6x earnings. That is a whopping 2/3rds higher than the 7x levels seen at the ends of secular bears! 11.6x is much closer to 14x fair value than the cheap 7x secular-bear-slaying levels.
In addition, at that point the secular bear was only 9 years old. Thatís not enough time for any secular bear to do its full valuation and sentiment work, as itís just over half their normal duration. If that March 2009 low had happened at 15 or 16 years into a secular bear, I could understand making the case that it ended the bear. But certainly not at 9 years and near-fair-valued stock markets, thatís too far of a stretch.
And if this latest secular bear didnít give up its ghost and usher in a new secular bull in March 2009, then it certainly isnít over today either. And the stock markets only just regaining the last secular-bull-topping levels in real terms, and challenging bubble valuations, is strong if not ironclad evidence this secular bear is alive and well. That means another cyclical bear is looming which will cut stock prices in half again.
Stock valuations were the key in the early 2000s, and they remain the key today. Valuations drive those great third-of-a-century stock-market cycles. If the stock markets were trading at 12x trailing earnings today, a resurgent secular bear would be a minor concern. But way up at todayís lofty 24x, itís a very serious one. This is especially true with the Fed transitioning from the QE era to the next rate-hike cycle.
Before the Fed launched QE3 in late 2012, the US stock markets had looked very toppy for over a year. Without the Fedís extreme money printing, the SPX probably wouldíve peaked around 1500. But the euphoria resulting from that unprecedented open-ended QE3 campaign catapulted the SPX far higher to 2100. But after ending QE3ís new buying in late October, the Fed has effectively abandoned the stock markets.
With the Fedís quantitative-easing era finally and decisively over, itís hard to imagine the QE-driven stock-market levitation continuing in its absence. And on top of that, the coming Fed rate hikes will just hammer these lofty overvalued stock markets. They will erode corporate earnings on multiple fronts, leaving stocks looking more expensive. Capital will also migrate out of stocks into alternative investments.
So instead of being a bullish harbinger to be celebrated, the recent Fed-conjured record highs in the S&P 500 are exceedingly bearish. They portend a major topping within an ongoing secular bear. And that means the mighty mid-secular-bear cyclical bull of the past 6 years is almost certainly on the verge of rolling over into a brutal new cyclical bear. And that will cut stock prices in half, slaughtering the naive.
Thus itís essential for all investors to cultivate a studied contrarian perspective. Contrarians thrived in the last 15 years while stock investors earned nothing on balance, and we will multiply our wealth again in the next cyclical bear. Our market-cycle studies at Zeal have forged us into hardened contrarians. We fight the groupthink crowd to buy low in popular fear, then later sell high in universal greed. You ought to join us.
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The bottom line is the latest stock-market record highs widely celebrated as a bullish omen are anything but. They merely returned the flagship S&P 500 back to levels seen 15 years earlier in real terms. The stock markets are still very much trapped in the long secular-bear sideways grind. And that secular bear is likely far from over since general-stock valuations remain so high, actually challenging bubble territory.
An alive-and-well secular bear means these lofty stock markets are almost certainly topping before rolling over into their next cyclical bear. These vicious beasts slice stock prices in half, so they are very dangerous and not to be trifled with. Prudent investors need to trade with market cycles to protect and multiply their wealth. And with a new cyclical bear looming, alternative investments led by gold will shine again.
Adam Hamilton, CPA February 20, 2015 Subscribe at www.zealllc.com/subscribe.htm