Monday, February 18, 2013

A reply to the Ritholz secular bear question

I haven't had the time, but I had been meaning to write a reply to Barry Ritholz's posts last week where he indicated that he believed that the secular bear market that began in 2000 was in the process of ending (see Explaining My Position on Secular Bear Markets). His caveat was:
I DO NOT KNOW IF ITS OVER. It could be, but I suspect it is not. I do think that it is in the process of coming to an end, and that’s why I used the baseball metaphor of in the 7th inning.

Note: “Coming to an end” does not mean over. I erroneously assumed most people would understand what “in the 7th inning” meant — to those folks overseas, an American game of baseball has 9 innings. The 7th inning means its late in the game, but there are still a few innings left to be played.
I would tend to agree with his assertion that we are much closer to the end than the beginning of this secular bear, but I don't think that it's over for a couple of reasons:
  1. Valuations: Stock market valuations have not declined sufficiently to levels where secular bulls have historically begun; and
  2. Demographic effects on fund flows: The Baby Boomers are just starting to retire and take money out of stocks. Who are they going to sell to?

A long term look at stock market valuation
My favorite long-term valuation metric is Market Cap to GDP (via VectorGrader) as a rough proxy for the aggregate Price to Sales for the stock market. Market Cap to GDP, shown on the top panel, remains elevated relative to its own history. Secular bulls have historically begun when this measure has been depressed. In addition, note how falling Market Cap to GDP ratios have corresponded to secular bear markets, which have shown up as sideways markets.

The above chart of Market Cap to GDP only goes back to 1950, in which we have only had one episode of a secular bear, or sideways market. Barry Ritholz also showed, in a separate post from his secular bear post, a much longer history of this ratio that goes back to 1925 from Bianco Research. Market Cap to GDP remains highly elevated relative to its own history. That's one reason why I don't believe that a secular bull can start from current levels.

Indeed, Warren Buffett uses a similar ratio of Market Cap to GNP as a valuation measure for stocks. Cullen Roche at Pragmatic Capitalism pointed out that this metric has risen to levels that could only be called  overvalued:
For the first time since the recovery began, Warren Buffett’s favorite valuation metric has breached the 100% level. That, of course, is the Wilshire 5,000 total market cap index relative to GNP. See the chart below for historical reference.

I only point this out because it’s a rather unusual occurrence and the recent move has been fairly sizable. It happened during the stock market bubble of the late 90′s, but then occurred again just briefly during the 2006-2007 period when the valuation broke the 100% range in Q3 2006 and stayed above that range for about a year. We all know what followed the 2007 peak in stock prices.

Demographic headwinds for stocks
Another reason for the continuation of a secular bear, or sideways stock market, is the outlook for fund flows. Simply put, stock prices rise when there are more buyers than sellers. So what happens when Baby Boomers in retirement or nearing retirement withdraw money from stocks? Can their children and grandchildren support stock prices at these price and valuation levels?

I wrote about this topic in 2011 (see A stock market bottom at the end of this decade) and cited two demographic studies by the San Francisco Fed and by Geanakoplos et al.  The conclusions of these studies were that the projected inflection point where the fund flows of the Echo Boomers into stocks start to overwhelm the fund flows of their parents the Baby Boomers is somewhere between 2017 and 2021.

Until then, we will have to live with the ups and downs of a sideways and range bound stock market. Investors should therefore expect that the risk-on/risk-off environment should continue until the end of this decade.

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.

1 comment:

Anonymous said...

the destruction of a currency doesn't come along as often as the other things being measured on the chart.

but one shouldn't become comfortable that it won't happen just because it hasn't for a couple hundred years or whatever. because it does, and just as surely as the other phenomena on the charts. it just takes longer.