Submitted by Lance Roberts via STA Wealth Management [12],
This morning, as I settled in to begin my morning research routine, I was greeted by an email containing a speech delivered at the University of California. The opening paragraph immediately grabbed my attention:
"The stock market has been advancing with only one significant setback throughout the decade...It has thus established a new record for the length of its rise, although it has not equaled the extent of the record advance of the 1920's: 450 percent from 1921-1929.
What does this phenomenal upward movement portend for investors and speculators in the future? There are various ways of approaching this question. To answer it, I shall divide the question into two parts. First, what indications are given us by past experience? Second, how relevant is past experience to the present situation and prospects?"
The issue of past experience, known as "recency or anchoring bias, [13]" is one of the primary factors that has the greatest effect on investor returns over time. As stated in the speech:
"However, in order to judge today's market level, it is desirable, perhaps essential, to have clear picture of its past behavior. Speculators often prosper through ignorance; it is a cliche that in a roaring bull market knowledge is superfluous and experience a handicap. But the typical experience of the speculator is one of temporary profit and ultimate loss."
The importance of that statement is that most individuals extrapolate past performance indefinitely into the future. This tendency is what leads investors to "buy high and sell low." This psychology is displayed in the following chart.
The two questions that must be answered are whether this is just a bull market or some sort of "new market" that will defy all previous experiences?
If this is just a bull market, then the term itself suggests that it is just the first half of a full-market cycle and that eventually a bear market will follow. The chart below shows the history of full market cycles going back to 1900.
Historically, full market cycles have finished when prices complete a "mean reverting" process by falling well below the long-term mean. Since the beginning of the secular bull market in the 1980's that full "mean reverting" process has not yet been completed due to the artificial interventions by Central Banks to prop up asset prices.
There is an argument to be made that this is could indeed be a "new market" given the continued interventions by global Central Banks in a direct effort to support asset prices. However, despite the coordinated efforts of Central Banks globally to keep asset prices inflated to support consumer confidence, there is plenty of historic evidence that suggest such attempts to manipulate markets are only temporary in nature.
Beijnath Ramraika and Prashant Trivedi [16]recently discussed this topic showing a chart of the rate of change for the S&P 500 index over a 75-month period which is the length of time of the current market advance from the financial crisis lows. I have reproduced the chart below with some modifications. I have used a 72-month rolling rate of change of the real, inflation-adjusted, return of the S&P 500 index from 1900 to present. I have also overlaid that with the actual real S&P 500 index (log-2 basis). This more clearly shows that from current peaks of the long-term rate of change in the index, forward market returns have become less desirable.
Their conclusion is simple:
"Clearly, the current rate of change is in extreme territory and is exceeded only by three other market up-moves: the roaring bull market of twenties leading into the Great Depression, the bull market of the fifties and the technology boom. Further, the trajectory of the up-move is similar to that of the market leading into the highs of 1929 and the highs in 1983.
We have had a market on potent steroids."
Such extreme movements in prices over a relatively short period, regardless of underlying circumstances, have all had similar outcomes. Consequently, investors should expect a similar outcome in the future. However, in the short-term psychology tends to overtake more logical thought processes as the "need for greed" keeps investors at the table long after the "cards have turned cold."
Valuations also provide similar evidence that the current market is most likely no different than previous bull market cycles. Sam Ro at Business Insider [18] recently posted the following bit of analysis:
"The forward price/earnings (PE) ratio — the price of the S&P 500 divided by the expected earnings of those S&P 500 companies — is probably the most popular way to measure value in the stock market.
In theory, it tells us if the market is cheap or expensive relative to some long-term average.
Unfortunately, it is horrible at signaling where the market will go in the near-term, like in the next year. This is not news."
Sam is correct. In the very short-term, valuations are a horrible market timing metric due to the psychological impact of investor behavior on the markets.
However, as shown in the series of charts below (compiled by my colleague Nan Lu), valuations can tell us much about what we should expect as investors over the longer term. The charts below are the total dividend reinvested returns of the inflation adjusted S&P 500 index.
Not surprisingly, the expected total inflation-adjusted returns from currently high levels of valuation have historically been disappointing relative to what investors had witnessed previously.
Importantly, the charts above DO NOT mean that EVERY year will be a low return. What history suggests is that forward returns will be much more volatile with periods of significant drawdowns that will comprise a total long-term return at lower levels. Unfortunately, most investors will not survive to see that outcome.
This was a point made within the speech:
"Now, what can past experience tell us about the validity and dependability of this rosy view as to the future of business and common stocks? Its verdict cannot be conclusive, because NO prediction, whether of a repetition of past patterns or of a complete break with past patterns, can be proved in advance to be right.
Nevertheless, past experience does have some things to say that are at least relevant to our problem. The first is that optimism and confidence have always accompanied bull markets; they have grown as the bull market advanced, and they had to grow, otherwise the bull market could not have continued to their dizzy levels; and [secondly] they have been replaced by distrust and pessimism when the bull markets of the past collapsed."
So, who was this mysterious speech giver? It was delivered by Benjamin Graham at the University of California, Los Angeles on December 7th, 1959. (The speech can be found here [23].)
As the evidence suggests, the current bull market is likely not a "new market" but just the first half of a full market cycle. Eventually, the cycle will complete itself as price goes through a mean reverting event. This is not a BEARISH prognostication but a simple reality. Nothing more. Nothing less.
In there near term, over the next several months or even couple of years, markets could very likely continue their bullish trend as long as nothing upsets the balance of investor confidence and market liquidity. However, of that there is no guarantee.
As Ben Graham concluded:
"'The more it changes, the more it's the same thing.' I have always thought this motto applied to the stock market better than anywhere else. Now the really important part of the proverb is the phrase, 'the more it changes.'
The economic world has changed radically and will change even more. Most people think now that the essential nature of the stock market has been undergoing a corresponding change. But if my cliche is sound, then the stock market will continue to be essentially what it always was in the past, a place where a big bull market is inevitably followed by a big bear market.
In other words, a place where today's free lunches are paid for doubly tomorrow. In the light of recent experience, I think the present level of the stock market is an extremely dangerous one."
