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The Longest Bull Market In History & What Happens Next

“Barring a breathtaking plunge, the bull market in U.S. stocks on Aug. 22 will become the longest in history, and optimistic investors argue it has miles to go before it rests.”Sue Chang, MarketWatch

Depending on how you measure beginnings and endings, or what constitutes a bear market or the beginning of a bull market, makes the statement a bit subjective. However, there is little argument the current bull market has had an exceptionally long life-span.

But rather than a “siren’s song” luring investors into the market, maybe it should serve as a warning.

“Record levels” of anything are “records for a reason.”

It should be remembered that when records are broken that was the point where previous limits were reached.  Also, just as in horse racing, sprinting or car races, the difference between an old record and a new one are often measured in fractions of a second.

Therefore, when a “record level” is reached it is NOT THE BEGINNING, but rather an indication of the PEAK of a cycle. Records, while they are often broken, are often only breached by a small amount, rather than a great stretch. While the media has focused on record low unemployment, record stock market levels, and record confidence as signs of an ongoing economic recovery, history suggests caution. For investors, everything is always at its best at the end of a cycle rather than the beginning.

The chart below has been floating around the “web” in several forms as “evidence” that investors should just stay invested at all times and not worry about the downturns. When taken at “face value,” it certainly appears to be the case. (The chart is based up Shiller’s monthly data and is inflation-adjusted total returns.)

The problem is the entire chart is incredibly deceptive.

More importantly, for those saving and investing for their retirement, it’s dangerous.

Here is why.

The first problem is the most obvious, and a topic I have addressed many times in past missives, you must worry about corrections.

Most investors don’t start seriously saving for retirement until they are in their mid-40’s. This is because by the time they graduate college, land a job, get married, have kids and send them off to college, a real push toward saving for retirement is tough to do as incomes, while growing, haven’t reached their peak. This leaves most individuals with just 20 to 25 productive work years before retirement age to achieve investment goals. 

This is where the problem is. There are periods in history, where returns over a 20-year period have been close to zero or even negative.”

Currently, we are in one of those periods.

Lies, Damned Lies, And Statistics

Secondly, percentages are deceptive.

Back to the first chart above, while the mainstream media and bloggers love to talk about gains and losses in terms of percentages, it is not an apples to apples comparison.

Let’s look at the math.

Assume that an index goes from 1000 to 8000.

  • 1000 to 2000 = 100% return
  • 1000 to 3000 = 200% return
  • 1000 to 4000 = 300% return
  • 1000 to 8000 = 700% return

A 700% return is outstanding, so why worry about a 50% correction in the market when you just gained 700%?

Here is the problem with percentages.

A 50% correction does NOT leave you with a 650% gain.

A 50% correction is a subtraction of 4000 points which reduces your 700% gain to just 300%.

Then the problem now becomes the issue of having to regain those 4000 lost points just to break even.

Let’s look at the S&P 500 inflation-adjusted total return index in a different manner.

The first chart shows all of the measurement lines for all the previous bull and bear markets with the number of years required to get back to even.

What you should notice is that while the original chart above certainly makes it appear as if “bear markets” are no “big deal,” the reality is that in many cases bear markets wiped out essentially a substantial portion, if not all, of the the previous bull market advance. This is shown more clearly when we convert the percentage chart above into a point chart as shown below.

Here is another way to view the same data. The table and chart below overlays the point AND percentage of gain and loss for each bull and bear market period going back to 1900 (inflation-adjusted).

Again, the important thing to note is that while record “bull markets” are a great thing in the short-term, they are just one half of the full-market cycle. With regularity, the following decline has mostly erased the previous gain.

Broken Records

While the financial media is anticipating a new “record” being set for this “bull market,” here is something to think about.

  • Bull markets END when everything is as “good as it can get.”
  • Bear markets END when things simply can’t “get any worse.”

While everything is certainly firing on all cylinders in the market and economy currently, for investors this should be taken as a warning sign rather than an invitation to pile on additional risk.

In the near term, over the next several months, or even a year, markets could very likely continue their bullish trend as long as nothing upsets the balance of investor confidence and market liquidity.

This bull market will easily set a “new bull market record.”

But, as I said, “records are records” for a reason. As Ben Graham stated back in 1959:

“‘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 cliché 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.”

He is right, of course, things are little different now than they were then.

For every “bull market” there MUST be a “bear market.” 

While “passive indexing” sounds like a winning approach to “pace” the markets during the late stages of an advance, it is worth remembering “passive” approaches will also “pace” the decline.

Understanding that your investment returns are driven by actual dollar losses, and not percentages, is important in the comprehension of what a devastating effect corrections have on your financial outcome. So, before sticking your head in the sand and ignoring market risk based on an article touting “long-term investing always wins,” ask yourself who really benefits?

This time will not be “different.”

If the last two bear markets haven’t taught you this by now, I am not sure what will.

Maybe the third time will be the “charm.”

8-Measures Say A Crash Is Coming, Here’s How To Time It

Mark Hulbert recently penned a very good article discussing the “Eight Best Predictors Of The Stock Market,” to wit:

“The stock market’s return over the next decade is likely to be well below historical norms.

That is the unanimous conclusion of eight stock-market indicators with what I consider the most impressive track records over the past six decades. The only real difference between them is the extent of their bearishness.

To illustrate the bearish story told by each of these indicators, consider the projected 10-year returns to which these indicators’ current levels translate. The most bearish projection of any of them was that the S&P 500 would produce a 10-year total return of 3.9 percentage points annualized below inflation. The most bullish was 3.6 points above inflation.

The most accurate of the indicators I studied was created by the anonymous author of the blog Philosophical Economics. It is now as bearish as it was right before the 2008 financial crisis, projecting an inflation-adjusted S&P 500 total return of just 0.8 percentage point above inflation. Ten-year Treasuries can promise you that return with far less risk.”

Here is one of the eight indicators, a chart of Livermore’s Equity-Q Ratio which is essentially household’s equity allocation to net worth:

The other seven are as follows:

As Hulbert states:

“According to various tests of statistical significance, each of these indicators’ track records is significant at the 95% confidence level that statisticians often use when assessing whether a pattern is genuine.

However, the differences between the R-squared of the top four or five indicators I studied probably aren’t statistically significant, I was told by Prof. Shiller. That means you’re overreaching if you argue that you should pay more attention to, say, the average household equity allocation than the price/sales ratio.”

As I discussed in “Valuation Measures and Forward Returns:”

“No matter, how many valuation measures I use, the message remains the same. From current valuation levels, the expected rate of return for investors over the next decade will be low.”

This is shown in the chart below, courtesy of Michael Lebowitz, which shows the standard deviation from the long-term mean of the “Buffett Indicator,” or market capitalization to GDP, Tobin’s Q, and Shiller’s CAPE compared to forward real total returns over the next 10-years. Michael will go into more detail on this graph and what it means for asset allocation in the coming weeks.

The Problem With Valuation Measures

First, let me explain what “low forward returns” does and does not mean.

  • It does NOT mean the stock market will have annual rates of return of sub-3% each year over the next 10-years.
  • It DOES mean the stock market will have stellar gains in some years, a big crash somewhere in between, or several smaller ones, and the average return over the decade will be low. 

This is shown in the table and chart below which compares a 7% annual return (as often promised) to a series of positive returns with a loss, or two, along the way. (Note: the annual average return without the crashes is 7% annually also.)

From current valuation levels, two-percent forward rates of return are a real possibility. As shown, all it takes is a correction, or crash, along the way to make it a reality.

The problem with using valuation measures, as Mark Hulbert discusses, is that there can be a long period between a valuation warning and a market correction. This was a point made by Eddy Elfenbein from Crossing Wall Street:

“For the record, I’m a bit skeptical of these metrics. Sure, they’re interesting to look at, but I try to place them within a larger framework.

It’s not terribly hard to find a measure that shows an overvalued market and then use a long time period to show the market has performed below average during your defined overvalued period. That’s easy.

The difficulty is in timing the market.

Even if you know the market is overpriced, that doesn’t tell you much about how to invest today.”

He is correct.

So, if valuation measures tell you a problem is coming, but don’t tell you what to do, then Wall Street’s answer is simply to “do nothing.” After all, you will eventually recover the losses….right?

However, getting back to even and actually reaching your financial goals are two entirely different things as we discussed recently in “Crashes Matter.”

There is an important point to be made here. The old axioms of “time in the market” and the “power of compounding” are true, but they are only true as long as the principal value is not destroyed along the way. The destruction of the principal destroys both “time” and “the magic of compounding.”

Or more simply put – “getting back to even” is not the same as “growing.”

Is there a solution?

Linking Fundamentals To Technicals

I have often discussed an important point in reference to our portfolio management process:

“Fundamentals tell us ‘what’ to buy or sell, technicals tell us the ‘when.'”

Fundamentals are a long-term view on an investment. From these fundamental underpinnings, we can assess and assign a “valuation” to an investment to determine whether it is over or undervalued. Of course, in the famous words of Warren Buffett:

“Price is what you pay. Value is what you get.” 

In the financial markets, however, psychology can drive prices farther, and further, than logic would dictate. But such is the nature of every stage of a bull market cycle where the “momentum” chase, or rather the physical manifestation of “greed,” comes to life. This is also the point where statements such as “this time is different,” “fundamentals have changed,” or a variety of other excuses, are used to justify rampant speculation in the markets.

Despite the detachment from valuations, as markets continue to escalate higher, the fundamental warnings are readily dismissed in exchange for any data point which supports the bullish bias.

Eventually, it has always come to a rather ignominious ending.

But why does it have to be one or the other?

Currently, the Equity Q-ratio, as graphed above, is at levels that have historically denoted very poor future returns for investors. In other words, if you went to cash today, it is quite likely that over the next 10-years the value of your portfolio would be roughly the same. 

However, before that “mean reverting event” occurs the market will most likely continue to advance. So, there you are, sitting on the sidelines waiting for the crash.

“Damn it, I am missing out. I should have just stayed in.” 

The feeling of “missing out” can be overpowering as the momentum driven market rises. Like gravity, the more the market rises, the greater the pull to “jump back in” becomes. Eventually, and typically near the peak of the market cycle, investors capitulate to the pressure.

Understanding that price is a reflection of short-term market psychology, the trend of prices can give us some clue as to the direction of the market. As the old saying goes:

“The trend is your friend, until it isn’t.” 

While the Equity Q-ratio implies low forward returns, technical analysis can give us the “timing” as to when “psychology” has begun to align with the underlying “fundamentals.”.

In the chart below we have added vertical “gold” bars which denote when negative price changes warrant reducing equity risk in portfolios. (The chart uses quarterly data and triggers a signal when the 6-month moving average crosses the 2-year moving average.)

Since 1951, this “equity reduction” signal has only occurred 17-times. Yes, since these are long-term quarterly moving averages, investors would not have necessarily “top ticked” and sold at the peak, nor would they have bought the absolute bottoms. However, they would have succeeded in avoiding much of the capital destruction of the declines and garnered most of the gains.

The last time the Equity-Q ratio was above 40% was during the late 2015/2016 correction and the technical signal warned that a reduction of risk was warranted.

The mistake most investors make is not getting “back in” when the signal reverses. The value of technical analysis is providing a glimpse into the “stampede of the herd.” When the psychology is overwhelmingly bullish, investors should be primarily allocated towards equity risk. When its not, equity risk should be greatly reduced.

Unfortunately, investors tend to not heed signals at market peaks because the belief is that stocks can only go up from here. At bottoms, investors fail to “buy” as the overriding belief is the market is heading towards zero.

In a recent post, It’s Not Too Early To Be Late, Michael Lebowitz showed the historical pain investors suffered by exiting a raging bull market too early. However, he also showed that those who exited markets three years prior to peaks, when valuations were similar to today’s, profited in the long-run.

While technical analysis can provide timely and useful information for investors, it is our “behavioral issues” which lead to underperformance over time.

Currently, with the Equity Q-ratio pushing the 3rd highest level in history, investors should be very concerned about forward returns. However, with the technical trends currently “bullish,” equity exposure should remain near target levels for now.

That is until the trend changes.

When the next long-term technical “sell signal” is registered, investors should consider heeding the warnings.

Yes, even with this, you may still “leave the party” a little early.

But such is always better than getting trapped in rush for the exits when the cops arrive.