Nothing suggests a bull market has begun. Dream on Wall Street

SERIOUS MONEY:THE LATE Canadian-American economist John Kenneth Galbraith noted in 1977 that, "pessimism is a mark of superior intellect".

The uber-bulls on Wall Street beg to differ, and date the birth of a sustained multi-year upswing in stock prices to the cyclical advance in the major market indices that began during the spring of 2009. Is such optimism justified? Perhaps an examination of the early years of the three previous secular bull markets will shed some light on this matter.

It is important to appreciate that secular bull and bear markets have historically been precipitated by movements towards or away from price stability. Previous secular bear markets have alternated between inflationary and deflationary regimes; they have been characterised by a pronounced increase in economic volatility, with contractions in business activity both more frequent and of greater magnitude than those experienced in a more stable economic climate.

The sustained increase in uncertainty sees investors willing to pay fewer and fewer dollars for one unit of cycle-adjusted earnings as the secular bear progresses. By the time the unfavourable investment climate comes to an end, stocks are trading at a substantial discount to replacement cost.

Conversely, as the economy’s structural headwinds dissipate and the climate improves, investors become increasingly willing to pay more and more dollars for a unit of cycle-adjusted earnings, and at the peak, stocks are priced for “permanent prosperity”.

The first secular bull market of the past hundred years began in August 1921 and, in real terms, stock prices at the bottom were no higher than they had been half a century earlier. The major market averages reached their trough one month after a steep downturn in economic activity or the “forgotten depression”, induced by the seven-year old Federal Reserve in its attempt to eradicate post-war inflation, finally came to an end.

Investors valued the stock market at little more than five times cycle-adjusted earnings at the trough, and the dividend yield on offer was more than 7 per cent, which meant that investors could realistically hope to double their initial investment within a decade without any capital gains in real terms, so long as the increase in corporate distributions per share kept pace with inflation.

Forty months on and the major market averages had jumped by more than 60 per cent after inflation, and had not suffered a cyclical bear decline of more than 20 per

cent, despite the one-year recession that began in the summer of 1923. Meanwhile, trading volumes had surged almost 50 per cent, while the dividend yield was still inviting north of 5 per cent.

The second secular bull market began during the summer of 1949 following a ghastly period of almost 20 years that saw the number of dollars that investors were willing to pay for a unit of cycle-adjusted earnings sink to less than 10, while the dividend yield available to astute investors was north of 7 per cent just like 1921.

Investors endured a prolonged sideways market following the end of hostilities in 1945, but adjusted for inflation, the damage was much worse and stock prices were no higher at the bottom than levels first reached more than six decades earlier. Once again, the dividend yields on offer promised strong returns irrespective of potential capital gains.

Forty months on and the major market averages had jumped by more than 60 per cent after inflation once again, and had weathered the outbreak of the first proxy battle of the Cold War era – Korea – a military engagement that underlined relations between the Soviet Union and the United States during this period.

As for valuations, they were still more than reasonable with the major stock market averages trading on a multiple of 12 times cycle-adjusted earnings and a dividend yield close to 6 per cent.

The third secular bull market can be dated to August 1982, when the Federal Reserve’s war on inflation ended in victory, and the then-chairman, Paul Volcker, reversed course and announced an end to monetary targets.

The malaise of the previous decade and more saw the number of dollars that investors were willing to pay for a unit of cycle-adjusted earnings drop to less than seven times, while the dividend yield on high-quality stocks pushed north of 6 per cent.

Forty months on and one soft landing later saw the major stock market averages jump by more than 60 per cent, as trading volume exploded on the upside. Valuations remained inviting with stocks trading on less than 12 times cycle-adjusted and offering a dividend yield of almost 4 per cent.

Fast forward to today and not one of the conditions seen at previous secular bear market bottoms has been satisfied. From valuations to fundamentals, nothing suggests a secular bull market has begun. Dream on Wall Street.

[ charliefell.ie ]