Bulls are in danger of succumbing to groupthink

SERIOUS MONEY:STOCK PRICES have almost doubled since reaching their nadir more than two years ago and valuations are clearly in nosebleed territory once again.

Those of a bullish persuasion dismiss such inconveniences, however, and the hard-core even likens the advance to the increase in equity values from the autumn of 1982 through 1984, a run which heralded the birth of a new secular bull market that persisted until the collapse of the technology bubble more than a decade ago.

The mantra from the perennial bulls continues to grow in tempo as stock prices move higher and, one by one, the bears succumb to groupthink. The climate in which the downbeat find themselves resembles the atmosphere in George Orwell’s dystopian novel Nineteen Eighty-Four, where those of a different opinion stood accused of “thoughtcrime” and “simply disappeared”.

However, 2011 is not 1984 and the notion that a new secular bull market is under way is bunkum.

The secular advance in equity values that followed the multi-decade low in real stock prices on August 12th, 1982, appears to be similar to the stock market trough of two years ago when viewed through the prism of economic and financial events. At the time, the economy was deep in the throes of the deepest recession since the 1930s and the banking system was on the verge of collapse due to mounting charges arising from loans to poor creditors in the developing world.

The impending doom reached fever-pitch upon the default of Mexico in the autumn, but a meltdown of the world’s financial system was avoided through a significant easing of monetary policy, alongside the decision to allow the ailing banks to record the dubious debt at book value rather than distressed market prices.

The climate becomes eerily similar to the recent crisis once the words “developing world” are replaced with “low-income households” and “Mexico” with “Lehman Brothers”. The stock market responded enthusiastically and registered price gains of more than 60 per cent by the autumn of 1984. However, unlike the recent advance, the outsized gains in stock prices did not see valuations jump to dangerous levels.

Stock prices still traded on a multiple of just nine times trend earnings in 1984, which left plenty of room for further gains.

Fast-forward to today and the stock market sells for more than 20 times trend earnings, a level consistent with the end of a secular bull and not its beginning. Indeed, it took 13 years for stock prices to reach valuation levels comparable to today following the secular trough in 1982.

The reason stock prices remained cheap in 1984 is because the long secular bear that stretched from the latter half of the 1960s to the autumn of 1982 saw the major market averages bottom in real terms at levels that were no higher than the market peak of 1929. As a result, stock prices traded on a multiple of less than seven times trend earnings.

In contrast, the recent bear market, albeit severe for equity investors, saw stock prices return to levels reached only a short time earlier in the mid-1990s. Given the excesses were so large during the technology bubble, market valuations of 12 times trend earnings at the trough were several multiple points higher than the comparable figure in 1982.

Market valuation is not the only pillar that invalidates the notion that a secular bull market began in earnest during the spring of 2009. Analysis of the stock market’s trading volume suggests that, despite the near-doubling of prices, the current rally is nothing more than an outsized cyclical advance in an ongoing secular bear.

The historical evidence indicates that secular bear markets end not only on extremely undemanding valuations but also listless trading volume, as selling pressure is exhausted. Furthermore, the reversal in stock market fortunes induce professional investors to return. Buying pressure continues to build momentum as the new bull’s price action validates its credentials.

Trading volume expanded off the 1982 low and continued to increase as stock prices moved higher. Indeed, the 90-day moving average of daily trading volume jumped 60 per cent in the three months that followed the market’s trough and was more than 70 per cent higher in the autumn of 1984 as compared with the volume that was registered at the secular low two years previously.

Today, that typical historical pattern does not hold. The 90-day moving average of daily trading volume did expand dramatically off the low, but began to wane within three months and is currently more than a third below the volume seen at the low in prices in the spring of 2009. Thus the current advance in the major market averages does not resemble a secular bull.

Those of a bullish persuasion clearly have the upper hand at present, as stock prices continue higher. The propaganda is in danger of becoming groupthink. However, the bulls’ arguments are less than convincing and comparisons with previous secular bulls dispel the notion that “Ignorance is Strength”.

charliefell.com