A Really Long-Term View of Stock Market History

For the last 80 years or so, stock market performance can be described in terms of alternating so-called secular bear and bull markets.  From 1929 to 1942, stocks declined significantly in the aftermath of 1929 crash and the Great Depression.  From 1942 to 1965, prices increased eight-fold.  This was followed by volatile but flat period to 1982.  After that, from 1982 to 2000, prices again went on a tear and increased twelve-fold.  And now, in 2011, the prices are at the level of 12 years ago.

The book “Unexpected Returns” by Ed Easterling tries to provide some explanations for this behavior.  According to the author, company earnings actually grow at a relatively constant rate and increase about three times during an average secular period (either bull or bear) of 16 years (bull markets tend to last longer than bear markets).  But it is the P/E ratio that drives the equity valuations.  During periods of declining interest rates, P/E ratios tend to expand, again by a factor of about three, from an average low of 8 to an average high of 25.  This, together with 3x earnings growth, results in prices increasing roughly ten-fold.  This happened in secular bull markets of 1942-1965 and 1982-2000.

On the other hand, rising inflation tends to compress P/E ratios again by that same factor of 3.  And 3x earnings growth simply means that stock prices are stagnant (with a lot of volatility in between), as was the case during secular bear market of 1965-1982 and is the case today.

There is no denying that we are currently in a secular bear market.  The question is, are we anywhere near its end?  Well, at its beginning in 2000, P/E ratio actually was abnormally high, at 40.  Today, it is about 13.   So we already had a “mandated” 3x compression in P/E.  However, we are still ways off away from an average P/E bottom of 8.  Also, while previous secular bear market had rising inflation, this time it actually declined slightly from the level in 2000.  An optimist may make a case that low inflation justifies higher P/E ratios and thus we should be close to the start of another secular bull.  A pessimist, on the other hand, will argue that prices must swing from that high P/E of 40 to below average.

Of course, no one knows if the next secular bull market is around the corner or if it is still a few years off.  In all likelihood, we won’t even recognize it until several years pass after its actual start.  But the prices tend to be mean-reversing and it is clear that equity valuations today are depressed.  So, it is important to have your portfolio ready for the coming rebound.  It is easy to be a stock investor during secular bull markets — all you have to do is buy an index fund and you would do just fine.  During secular bear markets, however, investors need to pick stocks with extra care.  But this is not mission impossible by any means — just ask Apple investors how they did in the last ten years.  I am here to help.