Happy days are here again, but investors should be ready to sell on further strength

SERIOUS MONEY:Stock prices reached a bottom last March, but they are now entering expensive territory, writes CHARLIE FELL.

THE FIRST two weeks of August 1982 marked the end of the secular bear market in US stocks that commenced towards the end of the 1960s. Businesses and households were struggling in the face of the third economic downturn in less than a decade and the harshest since the 1930s. Equity investors had become an endangered species by the summer of 1982 as the stock market had previously lurched from one false dawn to another and rewarded buy-and-hold investors with negative real returns since 1968.

Dexy's Midnight Runners, the British soul group inadvertently captured the mood of investors at that time in the year's biggest hit single, Come on Eileen, which reached number one in the charts exactly 27 years ago. Kevin Rowland, who penned the song, wrote: "These people down here wear beaten down eyes. Sunk in smoke dried faces they're so resigned to what their fate is, but not us, no not us, we are far too young and clever."

The words could well be used to describe not only the generation of long-suffering equity investors down on Wall Street but also an emerging new breed that would go on to enjoy the greatest secular bull market in US history as the SP 500 climbed from just 100 in August 1982 to more than 1,500 during the spring of 2000.

More than a quarter of a century later, and following a greater than 50 per cent advance in stock prices from their devilish intra-day low of 666 registered in early March, most investors have been taken by surprise and are questioning whether now is an appropriate time to increase equity allocations.

Investors’ concern has rapidly turned to restless agitation as the Great Recession appears to be running out of steam, while the short-term technical picture has turned decidedly positive.

The 200-day moving average of stock prices has turned upward, the 50-day moving average has crossed the 200-day moving average on the upside and Dow Theory has confirmed the bullish signal emanating from the market’s recent action. Meanwhile, relative sector performance indicates that a cyclical bull rally is indeed under way. The birth of a secular bull however, is a different matter altogether. The savage decline in stock prices through 2008 to the bottom in early spring of this year saw valuation multiples drop below their long-term average for the first time in a generation, but the blistering advance in recent months has seen stocks enter expensive territory once again.

The overvaluation is modest as equities on 16½ times trend earnings are trading at close to fair value, but such a valuation picture is highly unusual in the context of a protracted secular bear market such as now.

Stock markets look for any reason to trade at cheap valuations during the latter years of secular bears. Indeed, the price/earnings multiple on trend earnings dropped below 16 times in 1938, bottomed on a single-digit multiple and did not exceed that level until 1955.

Similarly, the multiple fell below its long-term mean in 1973, bottomed at eight times trend earnings and remained below average until 1987.

The current incarnation troughed at 11 times earnings and has seen just nine of 112 months register below-average valuations. This strongly suggests that investors are confident not only that a normal V-shaped economic recovery is in the offing, but also that a return to the economic and financial stability that characterised the Great Moderation is assured. This appears to be a tad optimistic to say the least.

The annals of history reveal that a full investment cycle, including both secular bull and bear, spans roughly three decades. Thirty-year real price returns smooth stock market movements across the cycle and serve as a good indicator of the exuberance or pessimism reflected in current prices.

The 30-year annualised real price return through the past six decades has ranged from approximately zero at secular market bottoms to more than 5 per cent at secular peaks.

The current reading is 4 per cent or 1½ percentage points above the historical average, which demonstrates how powerful the previous secular bull truly was and that the market is not even close to the irrational pessimism that is so typical of a secular bottom.

Historical data also reveal that the duration of the secular bear should it have come to an end in March would be unusually brief. The median of the eight previous structural downturns over the past two centuries is 15 years and the current nine years would be the shortest since the eight-year affair from 1853 to 1861.

It would appear that the current incarnation could easily run for another six years or more and potentially see real prices revisit the lows of March at some stage in the future.

Indeed, such an outcome would see long-term real price returns drop to zero and valuation multiples to levels consistent with the bottom of previous secular bears.

Stock prices have rebounded sharply from the market lows recorded in March, and technical indicators combined with bottom-up evidence suggest that the second downdraft in prices of the current secular bear is now complete. A cyclical bull has commenced, but the eradication of cheap valuations means that investors should reduce weightings into further strength.

Happy days are here again for now, but the chances that current price action reflects the birth of a new secular bull is remote.

Unlike the secular bottom of 1982 when Come on Eileen topped the charts, stock prices won’t “hum this tune forever”.