Is a secular bear market upon us?
Some market watchers think so. They say advisers should prepare clients for a long period of choppy market returns that will include significant declines as well as shorter-term rallies.
These pessimists say the numbers just don't add up for investors who expect to achieve historical returns on stocks over the 10- to 20-year period that typically defines a secular bear market.
Contraction of price-earnings ratios could cause stock market returns to shrink, regardless of corporate earnings, these bears say.
Most bull-market phases end with a market P/E of 25, said Ed Easterling, president of Crestmont Holdings LLC, a Dallas-based investment firm. He is also president of Crestmont Research, which produces research on market trends.
And most bull phases begin with market P/Es under 10, according to Crestmont Research.
The last bull phase ended in 1999 with an unusually high P/E of 42, but the P/E of the S&P 500 stocks remains relatively high at around 20, said Mr. Easterling, who is author of the book, "Unexpected Returns: Understanding Secular Stock Market Cycles" (Cypress House, 2005), which outlined the case for this being a secular bear market.
Even if multiples hold up, with dividend yields on U.S. stocks at about 2%, and earnings growth of about 6% per year, "you're looking at 8% or 9% market returns," said Ron Surz, head of PPCA Inc. in San Clemente, Calif., a market research and consulting firm.
That's one of the more positive scenarios from bear-market believers.
Earnings growth actually averages around 4% off of a market peak, said Robert Arnott, chairman of Research Affiliates LLC in Pasadena, Calif., a developer of indexes.
Add in the 2% dividend yield and you get a nominal return in the vicinity of 5% to 7%, which might persist over the next 10 to 15 years, Mr. Arnott said.
"That's not bad," he said, but investors and advisers who are planning for more — and many are — could come up short.
Mr. Arnott co-authored a January 2002 article in the Journal of Portfolio Management, "What Risk Premium Is 'Normal'?", which warned of low market returns.
But if P/E ratios contract, which looks likely based on past market cycles, expect less than 6% nominal stock market returns, Mr. Easterling said.
"Most secular bear [markets return] less than that," he said.
Advisers should be using 6% as an average return in developing retirement plans, Mr. Easterling added. "And they should maybe look at a 3% or 4%" average return, he said.
John Hussman, portfolio manager of the Hussman Strategic Growth Fund and the Hussman Strategic Total Return Fund, has also been a prominent bear. Both valuations and corporate profit margins remain at historically high levels, said Mr. Hussman, who is also chairman of Hussman Econometrics Advisors Inc. of Ellicott City, Md., the adviser to the Hussman funds.
Over the next decade, annual returns will probably range from between -1% and 8%, with a 3% to 5% outcome most likely, he said.
"We'll continue to have some difficulty here," he said.
Not everyone buys into the secular bear market theory, of course. And even bears say the recent sell- off caused market sentiment — which is traditionally seen as a contrarian indicator — to go to extreme bullish levels.
"We have indicators as oversold and washed out as they were in the crash of '87," said Robert Kargenian, founder of TABR Capital Management LLC in Orange, Calif.
"One thing the market has in its favor is that a lot of folks are thinking about throwing in the towel," Mr. Arnott said. But "most investors [still] have too much in stocks," given the rough road ahead, he said.
HOW LONG?
Assuming the market is in a long-term bearish period, how long will it last?
"History suggests bear phases can span 15 to 20 years," Mr. Arnott said. "There's no assurance we'll see that this time around, but it would be unsurprising."
The market's been in a prolonged down period since the end of 1999, bearish observers say.
But P/E valuations are what matter, Mr. Easterling said, and "unfortunately, we spent a good portion of [the last seven years] getting P/Es from irrational [levels] to just the rational, so it's not almost over."
U.S. stocks compounded at 17% per year through the 1980s and 1990s — almost double historical averages, Mr. Easterling said.
"It takes more than a few years of flat and choppy markets to put valuations into perspective," he said.
Don't be fooled by new highs, either.
In real terms, the S&P 500 and Dow Jones industrial indexes have not made new highs since 2000, Mr. Arnott said. "That's a sign of a bear market rally," he said.
"New highs happened in 1973, too, and then we had the worst decline" of that bear-market phase, Mr. Easterling said.
Bear phases have in the past been characterized by increased volatility.
"We've seen great rallies and great declines," during these periods, Mr. Easterling said.
"Rallies in bear markets can be up by as much as 15% to 20% off the low," Mr. Kargenian added.
Veteran brokers say the current period looks a lot like the 1970s, with a lot of volatility for equities without much headway.
"It looks eerily similar," said Carl Busch, an Oklahoma City-based rep with World Financial Group Inc. of Dallas, Texas, and a 40-year industry veteran.
"We've seen this movie before," said an A.G. Edwards broker who entered the industry in the 1960s and asked not to be identified.
But most brokers and investors don't understand the shift that has occurred, this rep said.
Mr. Easterling agrees, saying he still speaks to brokers who insist they're going to buy quality stocks and hold them through thick or thin.
These advisers have become complacent about risk, he said. With falling P/Es and rising volatility, "it will be a frustrating period," Mr. Easterling said.
Dan Jamieson can be reached at djamieson@crain.com.
