How to Invest in a Secular Bear Market

This Secular Bear Market piece is a companion to Volatility Risk: Volatility is Not Risk, both responses to Chuck Carnevale's Seeking Alpha article entitled Why the Stock 'Market' is Like No Other Market.

In that article, attempting to illustrate what he views as the absurd psychology of the stock market, Carnevale describes a scene at an imaginary Walmart where the manager announces on the PA system that all items in the store are now selling at a 10% discount, only to have everyone run from the store in a panic.

The manager quickly wises up and runs out to the parking lot to let everyone know that prices are now 10% higher instead of 10% lower. Everyone rushes back into the store.

For Carnevale, such reactions makes no sense, especially if one is a long term investor. For long term investors, it's the earnings of the underlying businesses that matter most. That and valuation, which is simply the ratio of how much you pay for those earnings. Obviously, the less you pay the better.

And yet the irrational reactions dominate.

Carnevale's approach is simple but sound:

"In the long run earnings determine market price. In the short run, the two can become temporarily disconnected, however, inevitably price will return to its earnings justified level. Therefore, when trying to determine the future value or movement of a stock or a market, it's wise to measure valuation relative to earnings. Again, at the end of the day, this is what matters most."

What is a 'Normal' P/E?

To illustrate his point, Carnevale provides a 15 year chart showing S&P 500 stock market valuation in relationship to annual earnings. It really is a cool chart and it illustrates nicely the extreme overvaluation of the late 1990s and the moderate overvaluation in the 2006-2008 period.

My only quibble is the use of 17.5 as the Normal P/E Ratio. Yes, I understand that may well have been the average P/E Ratio for the entire period. Elsewhere, Carnevale uses 15 as the long, long term average P/E ratio for the market. Again, I don't doubt that the figure is factually accurate.

My issue is that a normal or average ratio is not the same as a typical ratio and although there is a definite long term correlation between the level of earnings and the price the market trades at, the market can trade significantly below its long term P/E average just as it can trade significantly above its long term P/E average.

So I would be more interested in seeing the same chart but over a much longer time frame because, while I'm in agreement with the gist of Carnevale's article, the fact is that the stock market moves in long term secular bull and secular bear market cycles with each cycle often lasting a decade or longer.

Secular Bulls and Secular Bears

I've linked to this secular bull and bear market table before, but it's a powerful reminder of how the market functions over the truly long term.

Example: The S&P 500 average annual gain for the secular bull market of the 1982-2000 period was 14.8%. The average annual gain for the secular bear market that preceded that period (1966-1982) was -1.5%!

A secular bull market typically begins from a very low P/E level which then steadily expands over multiple years until the market is overvalued and finally unable to rise any more. Then the process is reversed as a secular bear market takes hold and, earnings be damned, the primary characteristic is an ever decreasing P/E multiple.

Consider this century's first "lost decade" - corporate earnings increased and yet the S&P 500 declined from the final close of 1999 to the final close of 2009 by nearly 25%. From a pure valuation perspective, the first 10 years of this century has been a roller coaster ride to nowhere.

How to Invest in a Secular Bear Market

I'm not predicting a major crash, but history does suggest we have a lot lower to go with P/E ratios before we find the foundation for the next long term sustainable secular bull market.

Corporate earnings likely will continue to improve and expand, but beware any investment philosophy that depends on a stable (or expanding) P/E ratio during a secular bear market.

If you must invest in the market as a whole, the time to do so is during a secular bull market, not a secular bear market. In a secular bull market, when both earnings and P/E ratios are expanding, any old kind of lazy index or mutual fund investing will work out just fine.

But what about the other half of the time? How do you invest during long term bear markets when the market is either going down or, at best, nowhere?

It's actually very simple: investing in individual, high quality, dividend paying and dividend growing companies (as long as they're not way overvalued) is a sound strategy for all time periods, but it's essential during secular bear markets.

Or, as I argued elsewhere, the chief benefit of a bear market is that it teaches you to invest as though every market is a bear market.

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