Wednesday, November 16, 2011

Secular bear market investing

Last week, David Rosenberg (via Pragmatic Capitalism) stated that "we’re just 4 years into a depression that will likely last 7-10 years". Ken Rogoff, interviewed by CFA Magazine, said that the current slowdown that began in 2008 is likely to take 6-10 years for a recovery to take hold.

This is a secular bear
This confirms my views from August that I expect a stock market bottom about the end of this decade. This is a secular bear market characterized by flat returns and investors need to re-orient their investment policy and portfolio strategy accordingly.

To recap my first point about a secular bear market, equity valuations are not especially attractive right now. The chart below from VectorGrader (chart is theirs, annotations are mine) shows the market cap to GDP of US equities from 1950. I use market cap to GDP as a proxy for the market Price to Sales ratio. Many investors look at P/E ratios, but P/Es can be volatile since P/E = P/(Sales x Net Margin) and net margins can be volatile depending on where you are in the economic cycle, but Price to Sales is a far more stable ratio for evaluating long-term market valuations.

Note how the bull phases, or secular bulls, coincided with expansion of the market cap to GDP ratio. The equity market then topped out went sideways and entered a secular bear market, which coincided with a corrective phase in the market cap to GDP ratio, until that "valuation" metric returned to more realistic levels.

Similarly, this chart from Naufall Sanaullah of Shadow Capitalism tells a similar story. The chart shows the require amount of work to buy the SPX as a measure of the differential between the returns to labor and capital. Just like the Market Cap to GDP chart, this relationship remains stretched in favor of equity.
Using a rough eyeball estimate of both charts suggests a valuation bottom some time around the end of this decade given the current trajectory of adjustments. These conclusions are in accordance with the views of David Rosenberg and Ken Rogoff.
Using pruning shears in a snowstorm and a snow shovel in July
Even though I am trained as a quant, I have always thought myself to be an investment strategist first and a quant second. There are different tools for different seasons. Otherwise, you can get caught and wind up holding pruning shears in a February snowstorm or holding a snow shovel in the heat of July.

In secular bull markets, such as the one we experienced in the 1980's and 1990's, buy-and-hold was a great strategy for portfolio construction. Stocks went up. To control risk, you just added some bonds to control volatility and voila, a portfolio that balanced risk and return. To raise expected returns, you raise the equity weight at the cost of greater risk. To lower risk, you raise the bond weight at the cost of lower expected returns.

During secular bear markets characterized by flat returns, buy and hold investors are likely to see flat but volatile returns. Raising the equity component in a balanced portfolio just raises volatility, but does not significantly increase returns. Under these conditions, investors need to use dynamic asset allocation techniques such as the Asset Inflation-Deflation Trend Model to capture the swings of a flat market.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.


Tiho said...

"Under these conditions, investors need to use dynamic asset allocation techniques such as the Asset Inflation-Deflation Trend Model to capture the swings of a flat market."

Why? Why not just buy and hold commodities. When stocks are in a secular bear market commodities are in a secular bull market.

Cam Hui, CFA said...

While commodities were in a secular bull in the last US secular bear (1970's), that experience was not repeated in Japan in the 1990's in JPY terms.

In an environment where the markets go risk-on (commmodity bullish) and risk-off (commodity bearish), the market action for commodities is likely to be very choppy and not necessarily better than stocks.

Tiho said...

Commodities are priced in US Dollars. What's that got to do with Japan? Japan runs on its own cycle, away from US Stocks and Commodities traded in Chiacgo in US Dollars.

Cam Hui, CFA said...

Sorry, I don't get it. So what if commodities are priced in USD?

In a risk off environment, commodities get sold.

During the first Japanese Lost Decade of the 1990's, commodities were not in a bull market no matter what currency you price them in. So the US 1970's experience of the stock secular bear/commodity bull was likely a coincidence.

Tiho said...

I can see that "you don't get it". Haven't you heard that the risk on risk off phenomenon is a recent Media Phrase that consensus bloggers drop around.

Did you know that commodities and stocks moved in opposite directions during 1970s/80s/90s... do some history study!

Risk on risk off might last for awhile, but nothing correlates forever. Eventually commodities will go up and stocks will not follow anymore...

Than the new phrase will be invented. It will be called "Commodity Bubble".

Cam Hui, CFA said...


You sound like a gold bug. In that case, I refer you to the following:

Tiho said...

I'm not a Gold Bug. I'm a Commodity Bug until the bubble pops, than I will be an Equity Bug when the new secular bull market starts. So I guess you can call me a Money Bug, because I always try be on the right side of the bull market!