The strength of the stock market rally seems surprising in light of ongoing weakness in consumer spending and housing. The strength is not unusual, however. And it’s not an indication that we’re in a great new bull market.
In our opinion, the economy’s fundamentals and the market’s valuation still suggest that we’re in the middle of a long bear market. We still have trouble seeing how the economy is going to go right back to 3%-4% sustainable growth in the face of our massive debt, increased consumer saving, debt reduction, overcapacity, tighter lending standards, high unemployment, and housing weakness. And we don’t see how corporations will quickly generate the record-high profit margins that produced the previous market high without cutting so many more employees that they will kill the economy in the process.
Regardless of which economic outlook you favour, though, don’t fall into the trap of thinking that the market’s recent rally is confirmation that we’re in a new bull market.
As John Mauldin observes, rallies like this one are par for the course in long-term bear markets.
Mauldin argues that we’re still in a long-term bear that will take the market’s valuation much lower than it was at the March low before everything finally turns around. Based on the market’s behaviour after previous bull market peaks, this argument is persuasive.
After the last three major bull markets–1900s, 1920s, and 1960s–the market went through nearly two decades of consolidation before a great new bull market began again. Valuations also got almost as extreme on the downside as they had on the upside. (See Robert Shiller’s chart below)
Right now, we’re 10 years into this bear market–about a decade less than the usual long-term bear market. Valuations dropped from record highs in 2000 to modestly undervalued in March 2009, and they’re now back to 10%-15% overvalued again.
Is it possible that we’ve entered a Great New Bull Market? Anything’s possible. But the economic fundamentals and valuations make this seem unlikely.
Check out the charts from Ed Easterling at Crestmont Research in Mauldin’s excerpt below. Note the magnitude of the bear-market rallies in the first chart, and the long-term decline in the market’s PE ratio in the second chart (line at the bottom).
Yesterday my good friend Ed Easterling dropped by… He had a chart that I asked him to get to me for your perusal. The last secular bear market was 1966-82. He charted the ups and down in that market and noted the percentage rises and falls. It was as volatile then as it is now. There were some breathtaking ups and downs. With every rise, pundits declared the end of the bear market, only to have the market fall dramatically again. Take a few moments to gaze at the chart:
What drives the volatility? My contention is that bull and bear cycles should be seen in terms of valuation instead of price. Markets go from high valuations to low valuations and back to high. It is an age-old story. We have done about half the work we need to do to get back to low valuations. These cycles average of 17 years. We are less than 10 years into this one.
I believe we are going to lower valuations in terms of price-to-earnings ratios. This can be done by the market going sideways and earnings rising, or the market dropping, or some combination. Look at the graph below, and notice the slow and steady drop in P/E ratios (bottom chart) and the very volatile markets that accompanied that fall. I agree with Ed; we should not be surprised at today’s volatile markets. And we should expect more volatility and large price movements. Both up and down. (Some of the best charts anywhere are at www.crestmontresearch.com.)
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