The stock market is getting a little scary. Having climbed the proverbial “wall of worry,” will it fall off the cliff of complacency? The short answer is definitely yes — but probably not for a few years, if not longer.
Signs of complacency abound. CNBC’s Joe Kernan notes that a few months ago many strategists were telling investors to “wait for a pullback,” but now you seldom hear that. The parabolic rise of “glamour stocks” like TSLA, NFLX and LNKD is a sure sign of a toppy market. Yesterday’s Wall Street Journal is a cacophony of complacency. On page A-1: “Stocks Regain Broad Appeal: Mom-and-Pop Investors Are Back, but Some Say That Could Be Cause for Concern.” On page C-1: “New-Issue Flurry Hints at Trouble” and – even more alarming – “‘Long-Only’ Funds Trim Their Hedge.” (What would you expect after the hedgies missed the first 120% of the bull run?)
So how worried should we be? To put this bull market in historical context, we looked at the quarterly price of the S&P 500 since World War II to identify major bull and bear markets. This is an inexact process; others would slice and dice the data differently. See the Appendix for my chronological analysis. Two conclusions:
- The market is sufficiently frothy that we could get a material “pull-back” of 10-15% at any time. I have no insight about when that might occur. But the risk is non-trivial.
- Nevertheless the stock market is likely to grind higher over the next couple of years. History suggests we are still quite early in a secular bull market that has much further to run.
Lags and Lurches
Since the 19th century the stock market has alternated between lags and lurches – that is, between lengthy periods when stocks “do nothing” (1907 -1920, 1929-49, 1972-82, 2000-2011) and “secular bull markets” when stocks surge (1920s, 1949-72, 1982-2000).
Below I dissect the secular bull markets of 1949-72 and 1982-2000, but first we’ll outline a template of how the typical secular bull market evolves over time.
The Three Stages of a Secular Bull Market
At the start of Stage I, which follows many years of poor performance for equities, most investors hate stocks because they are “too risky.” Even when stocks post strong gains there is disbelief that the bull market is “for real.” (Sound familiar?) For example, in 1954 Congress held hearings on the dangers of stock market speculation because the S&P 500 had finally exceeded its 1929 high. In Stage I the upward move in stock prices is fairly smooth and strong as investors belatedly move back into stocks from other assets such as bonds, cash, commodities and (in the current cycle) hedge funds. In Stage II, after the “easy money” has been made stocks becomes more volatile and risky for various reasons – they are more expensive, the Fed is starting to tighten, and the risk of recession is higher. Stage III is characterized by a speculative blow-off as dumb money embraces a “cult of equities” and buys overpriced stocks on margin while regulators stand idly by, afraid to break up a great party that is pouring capital gains tax revenue into the U.S. Treasury.
We Are Still in Stage I of a New Secular Bull Market
Since March 30, 2009 the S&P 500 has climbed 122%. That sounds like a huge gain, but it is not that big compared to history. In Stage I of the 1949-72 secular bull market, stocks climbed 235%, and in Stage I of the 1982-2000 secular bull market they rose 190%. Also, in Stage III of the latter bull market—i.e., the 1990s–stocks rose 390%; even if they had stopped in Dec. 1996 when Alan Greenspan lamented “irrational exuberance” the gain would have been 142%.
Stocks probably won’t keep going “straight up” as they did this year. But keep in mind that, even if the Fed starts tapering soon, the yield on money funds will be close to zero for the next couple of years; by contrast, the yield of the S&P 500 – using the current price and estimated 2014 dividends – is 2.4%. Endowments and institutions that have been eschewing equities for years will lumber back into stocks. Though profit margins won’t rise much from current levels, profits can grind higher as the global economy improves. Another positive that Wall Street has ignored is that U.S. economic policy is likely to improve markedly once Obama is replaced by a less socialistic President.
One big risk is a melt-up. As we have noted before, Obamacare and other regulations are impeding hiring, which remains weak even though other economic indicators (such as ISM’s) are improving markedly. With the Fed focused on employment despite these regulatory headwinds, it could remain too loose for too long, creating a stock market bubble and then a crash. But it’s a little hard to believe the Fed is that stupid after missing both the tech and housing bubbles. But anything is possible in the city that produced Obamacare.
Anatomy of the Secular Bull Market of 1949-72
Stage I Q2 1949 to Q1 1957 Stocks rise fairly smoothly, from very low valuations, as the U.S. economy expands and the much-feared return of the Great Depression does not happen. In this period recessions were shallow and inflation low. Nevertheless, individual investors gravitated toward stocks as a “hedge against inflation.” Market rises for 33 quarters, up 235%.
Stage II Q2 1958 to Q2 1966 Market becomes much more choppy. It declines 15.6% in the 1957 recession, then surges for four years to decidedly lofty valuations, before a severe sell-off in the spring of 1962. It then rises 69% before Fed tightening causes a recession scare in 1966.
Stage III Q3 1966 to Q4 1972 The bull market became quite speculative, with lots of excitement about high-tech stocks, diversified “conglomerates,” (a truly dumb corporate innovation from the decade that brought us the Vietnam War) and, in 1972, the “nifty fifty” “one decision growth stocks” such as McDonalds, Pfizer, Disney etc. The party ended sadly in 1973 when inflation soared and the “Arab Oil Embargo” started in the autumn of that year.
Anatomy of the Secular Bull Market of 1982-2000
Stage I Q2 1982 to Q3 1987 Stocks surge as inflation and interest rates decline. Individuals remain skeptical and can afford to do so because real interest rates offered by bonds and money market funds remain high. Market rises for 22 quarters, up 190%.
Stage 2 Q4 1987 to Q3 1990. Stocks become much more volatile. They decline 30% in the 1987 crash, rise 45% between Q4 1987 and Q2 1990, then decline 14.5% in the 1990-91 recession brought on by Saddam Hussein’s invasion of Kuwait.
Stage 3 Q3 1990 to Q1 2000 Over 39 quarters the market rises 390%. This phase started slow because of a “jobless recovery” from the 1990-91 recession. But stocks surged in the second half of the decade, with five straight years of 20%+ gains (1995-99) as productivity growth picked up, GDP accelerated, and investors embraced “new economy” Internet stocks. All was not rosy. The 1997-98 Asian Financial Crisis raised the specter of global deflation and caused a U.S. financial panic in the autumn of 1998. The Fed eased in response to both the Asian financial crisis and the risk to IT systems posed “Y2K.” This liquidity fueled the final speculative surge in 1999-2000, which Greenspan did little to discourage via higher margin requirements.
Appendix: Stock Market History since 1949 (based on quarter-end prices)
Q2 1949 to Q1 1957 Secular bull market begins; market rises for 33 quarters, up 235%.
Then market drops 15.6% in a pretty severe recession in 1957.
Q4 1957 to Q4 1961 A post-recession surge. Market rises for 17 quarters, up 79%.
Then market plunges 23.5% because of over-valuation in first half of 1962
Q2 1962 to Q4 1965. Market rises for 5 quarters, up 69%.
Market drops 17% in 1966 on Fed tightening, recession fear
Q3 1966 to Q4 1968. Market rises for 10 quarters, up 36%.
Market drops 30% in 1969 malaise and 1970 recession
Q2 1970 to Q4 1972. Market rises 11 quarters, up 62% as economy recovers from recession. Nifty fifty blow-off in 1972.
Market drops 46% in 1973-74 on severe inflation, “Arab oil embargo,” and recession–a disaster for financial assets, particularly growth stocks, such as the “nifty fifty.”
Q3 1974 to Q4 1976 Market rises 10 quarters, up 69%
Choppy market and then back to back recessions (1980 and 1981-82); market does little for five years.
Q2 1982 to Q3 1987 New secular bull market begins. Market rises for 22 quarters, up 190%, on disinflation, rising PEs and profits.
Then, market crash in autumn of 1987 on fears of Fed tightening, plunging dollar; market down 23%
Q4 1987 to Q2 1990 Market rises 11 quarters, up 45% as economy remains fairly strong despite stock market crash.
Then, recession in 1990-91; market falls 14.5%
Q3 1990 to Q1 2000 stocks rise 39 quarters, up 390%, amidst strong economic growth and tech bubble. Brief plunge in 1998 Asian crisis but recovery as Fed eases policy.
Severe bear market after tech bubble; stocks down 45.6%
Q3 2002 to Q3 2007 stocks rise 21 quarters up 87%
Financial crisis; stocks decline 47.7%
Q1 2009 to Q3 2013 New secular bull market begins. Stocks rise 19 quarters up 120% as economy recovers, short term interest rates go to zero.
Copyright Thomas Doerflinger 2013. All Rights Reserved.