Market Memo: A new secular bull market in equities?

As we live through yet another aftershock of the Great Lehman Brothers’ Earthquake of 2008, it is probably a good time to step back and ponder the long-term direction of the equity market. Has the rally off the March 2009 lows on the S&P 500 simply been a bounce in a long-term (“secular”) bear market which eventually will revisit or even take out those lows, or are we rather in a choppy and always worrying long-term up move that will later be declared the beginning of one of the great secular bull markets of the 21st century. Only in hindsight will we know. But as we first wrote in the dreary days of August 2011, we believe we may very well be in a “new secular bull market … that will take out the previous double top in the S&P 500 (1,550) sometime late in 2012 or 2013.”

Here are a few thoughts to ponder why we believe this to be our best base case:

1. Secular bull markets begin in bad conditions, not good ones. In the last 100 years, we’ve experienced at least two great secular bulls, the run from 1932 through 1965 that took the Dow up by a factor of 11 times, and the run from 1974 through 2000 that took the Dow up nearly 10 times.  Both of these runs began in conditions similar to today’s: a banking crisis, a deleveraging environment, and even a seemingly “anti-capitalism” occupant in the White House (FDR, Jimmy Carter starting in ’76, and now Obama). Why is this? By definition, secular bull markets, ones that take the market up by several multiples of itself over the next 20 to 30 years, have to start in grim conditions. These are the very conditions that spawn the move. Markets discount the current consensus and reality; future prices reflect the marginal change off that. So when things are great, stock prices generally reflect this, and have less room to run.  At the same time, when conditions are favorable, it’s harder at the margin to improve, so the rate of positive change is low.
   
   Given this, the current mess we’re in can, ironically, be looked at as a positive. As we move forward, banks will likely experience much improved fundamentals (albeit off dismal levels), such as loan growth and declining credit losses; households will slow the rate of deleveraging and even begin to borrow again; and, if history is any guide, the political pendulum of the country will likely swing back towards the middle or even the right, which would reignite the animal spirits of the country’s capitalist entrepreneurs—all good for equities.
2. The “Twin Peaks” of the S&P 500 are more scale-able today than when we first tried in March 2000. Another unspoken belief of most market strategists is that, whatever happens in the near term, sometime 12 to 24 months down the line we will be confronting the technically important twin peaks of the S&P 500 from 2000 and 2007, when the market index stood at roughly 1,550, and we will experience insurmountable selling pressure at that level.  We agree it will take time, maybe many months, to crack 1,550, but we see much better fundamentals in place today than we had the previous two tries.
   
   Owning the S&P 500 is in some ways a call on owning U.S. GDP, or even global GDP.  Think what that means today versus the last two times we tried this! In March 2000, U.S. GDP was under $10 trillion, and global GDP was $42 trillion; today, those figures are $15 trillion, and $83 trillion, respectively!  Similarly, on a price-to-earnings (P/E) basis, today’s market is trading at under 12 times our estimate of 2012 earnings, compared to 27 times in 2000 and 17 times in 2007.  And the U.S. and world economy is coming off of a depressed, cyclically low level, rather than an inflated, cyclically high level.  These are all ingredients for a breakthrough, not a breakdown.
3. While aftershocks often occur after a category 10 earthquake, a second category 10 earthquake rarely does. We’ve written in the past about earthquakes and recurring aftershocks, so I won’t belabor this point. But a key reason why we see Greece III, occurring right now, as another aftershock and not another earthquake is that thanks to the first earthquake (Lehman), investors have already priced in a pretty bad outcome and have battened down their hatches, even while the ambulance drivers in the form of the world’s central banks are already standing on the scene with emergency plans ready to be implemented.
   
   This is simply not the formula for a systemic market meltdown. Think about it. Who do you know that will be surprised to learn that Greece has left the euro and defaulted on its debts? In fact, the far bigger surprise would be that they don’t leave the euro, an event that could happen and which would probably carry us closer to the double top at 1,550 even sooner than we are forecasting.
4. Investment flows and positioning suggest there is a wall of money to move into equities and drive markets higher. Over the last four years since the market cracked, the flows of retail investors out of stocks and into bonds have been historic. The Investment Company Institute estimates that outflows from domestic equity funds have totaled nearly $500 billion since April 2007, while inflows into bond funds have totaled nearly $1 trillion—a $1.5 trillion swing.  Institutional investors, thought to be steadier hands, are actually holding nearly the lowest level of equity assets in their portfolios in the last 20 years. And cash assets in the banking and mutual fund system, at nearly $4 trillion, are at an all-time high. Although these numbers could all get worse before they get better, for sure, at some point (maybe when we pierce through 1,550 and a buying panic ensues?), they will reverse, and when they do, look out!
5. Valuations are compelling. With stocks today trading at less than 12 times earnings, and 10-year government bonds sporting a whopping sub-1.8% yield, clearly a significant amount of bad news on stocks and good news on bonds is in asset prices.  Once the news flow begins to turn modestly in the opposite direction, look out! Although bonds are generally safe instruments, the 25-year bull market in bonds that we’ve just come through may have too many investors inured to the possibility of losses in their bond portfolios, so once again, if and when losses start to occur, look out! In fact, off today’s rates, a rise in the 10-year yield to 5%, more consistent with a 3% inflation environment, would produce a stunning 25% drop in Treasury bond prices in a fairly short time. Oops!

Remember that successful investing entails perseverance though times of trial, endeavoring always to buy low and sell high. We believe we are at an interim low right here, and encourage investors who are not yet overweight equities to consider using this correction to position themselves for a coming secular bull market.