While we often focus on the long-term return of stocks, the reality is that market growth is very uneven, not just due to volatility, but as markets go through long-term cycles called secular bull and bear markets. In the midst of a secular bull market - such as the one that exploded stock prices upwards from 1982 to 2000 - the optimal investment strategy is fairly straightforward - buy-and-hold, buy more on the dips, and dial up the leverage and risk exposure. In the midst of a secular bear market, though, buy-and-hold tends to merely produce the flat returns associated with the overall markets, and instead concentrated stock-picker portfolios, sector rotation, alternative investments, and tactical asset allocation become more effective. Using the wrong strategies in the wrong investment environment can produce poor results - just as many styles of active management generated little to no value and just became a cost drag in the 80s and 90s, so too does buy-and-hold now generate benchmark returns that may do little to achieve client goals. The ultimate key is to match the investment strategy to the market environment, given that such cycles can persist for 1-2 decades at a time. And notwithstanding the fact that a secular bear market has been underway for 12 years, it appears that the secular bear market still has a ways to go - which means its dominant investment strategies still have many more years to shine.
The inspiration for today's blog post was a recent discussion I had with another financial planner, who questioned the recent industry trend towards alternative investments and active management strategies. "It's just a fad," he said, "and will end with heartache as all investment fads do. I've watched it play out over and over again in my 30 year career."
"Not necessarily," I replied, "the secular market cycle in today's market environment is quite different than the one you witnessed for the first half of your career. And not all market cycles favor the same investment strategies."
Defining Secular Market Cycles
Secular stock market cycles are extended periods of time when markets deliver below-average or above-average returns. Often lasting for one or two decades, secular bull and bear markets become an important backdrop to the overall market environment; although shorter term, "cyclical" bull and bear markets (that might last 1-3 years) can both occur within a broader secular bull or bear environment, the secular market serves as an overriding tailwind or headwind that further enhances or reduces market returns.
As it turns out, not only do these bull and bear secular market cycles occur with amazing consistency throughout history, but they also occur in a predictable manner: bear market cycles begin once markets reach historically high P/E ratios, and continue until markets reach historical lows, at which point a secular bull market begins, carrying the markets higher and higher until valuation once again reaches a historical peak, and the cycle begins anew. A visualization of secular market cycles over the past century from Crestmont Research is shown below.
As the chart highlights, green sections are secular bull markets where prices rise nearly unabated for an extended period of time. Red sections, on the other hand, represent secular bear markets, where prices typically barely break even, or even finish lower, at the end of the phase. As indicated in the bottom area of the chart, the defining line between secular bull and bear market cycles is when valuation - not prices - make a peak or trough. Coincidentally, it's also notable that in reality, virtually all of the cumulative return for the past 100 years actually came in approximately half of those years - the secular bull market environments. During the other half of the century, markets merely treaded water while the economy and earnings grew, until valuations eventually reached a trough at the lower end of the range so a new bull market cycle could begin.
Secular Market Cycles And Investment Strategies
Because markets go through secular cycles with extended periods of above- or below-average returns over time, the investment strategies that will be most advantageous also shift over time.
In a secular bull market cycle, the optimal strategy is to buy and hold, and buy more on the dips. Returns can be further enhanced by dialing up leverage and/or "risk exposure" to generate even greater returns - given that there is little actual risk, as in secular bull markets any cyclical bear markets recover quickly to make new highs. In point of fact, the end phase of secular bull markets is often marked by a general market euphoria where stocks are seen as virtually riskless, equity exposure is at all-time highs, and margin and other investment leverage is high. As long as the secular bull market continues to persist, these strategies continue to be effective. Until the cycle turns.
When the secular bear market cycle begins, however, the optimal investment strategies shift significantly (and can impact other planning strategies as well). As the earlier chart illustrates, buy-and-hold in the midst of a secular bear market simply leaves the client with roughly the same amount of money one or two decades later (or even underwater after inflation), which may drastically fail to achieve the client's financial planning objectives. Accordingly, as I wrote in "Understanding Secular Bear Markets: Concerns and Strategies for Financial Planners" (FPA membership login required) in the March 2006 issue of the Journal of Financial Planning (with co-author Ken Solow), four strategies are typically popular in secular bear markets to combat the low return environment: concentrated stock-picker portfolios, sector rotation, alternative investments, and tactical asset allocation.
Notably, many of these secular bear market investment strategies haven't been very popular and successful since the 1970s - the last time the markets went through a major secular bear market, leading to the shutdown of many investment funds that couldn't effectively manage through the environment, with a huge boost to the few who did figure out how to survive and thrive (such as Warren Buffett and Peter Lynch). During the secular bull market of the 1980s and 1990s, the strategies were both unnecessary - as the rising tide of the expanding P/E multiples lifted all the investment boats - and generally just resulted in a cost drag for active management that couldn't produce much benefit (because the "benefit" in a secular bull market is dialing up risk and leverage, not actively managing it!).
Looking Back And Looking Forward
For advisors who have been in practice for many years, the reality is that their "early" years of the 1980s and 1990s occurred during a secular bull market, where buy-and-hold-and-buy-more-on-dips is a remarkably efficient and effective investment strategy, and it's nearly impossible for an active manager to shine without dialing up risk (which continues to work until the cycle turns, and it stops working). However, since the market valuation peak in 2000, a secular bear market has been underway, leading to a 12-year investment period where equities have made little or no progress since their year 2000 peak. While some markets have at least broken even or generated a slight positive return with dividends, the reality is that in the preceding 12 years leading up to 2000, the market exploded, with the S&P 500 price level alone rising from just over 300 to more than 1,500 (in addition to dividends) - a remarkable contrast to the fact that now the S&P 500 is still at its 1999 levels!
Given this reality, it should come as no surprise that investors have been seeking new investment approaches to replace the (predictable) failings of buy-and-hold in a secular bear market, and that advisors too feel the pressure to come to the table with better investment offerings, more alternatives, or some other way to generate the returns that clients need to achieve their financial planning goals. And as long as the secular bear market persists, continuing to invest as though it's a secular bull market will continue to result in unfavorable outcomes.
Of course, at some point in the future, the cycle will turn, as it always does, and a new secular bull market will begin. At that time, buy-and-hold-and-buy-more-on-dips will once again become a popular and effective strategy, and active managers will again struggle to add value short of just adding risk. However, history shows clearly and consistently that secular bull markets do not begin until markets regress not just to the average P/E ratio, but to the lows, suggesting that this secular bear market may still have many years left to play out, given a Shiller P/E ratio that is still in excess of 20 (new secular bull markets typically don't begin until the 6-10 P/E range!).
In fact, as Ed Easterling recently pointed out in an Advisor Perspectives commentary, the current Shiller P/E ratios on the stock market are actually still remarkably close to where secular bear markets normally begin, not end - the past 12 years of dismal returns have merely compressed valuations from nosebleed heights down to a level of "merely high". Which means as it stands now, secular bear market investment strategies may still have more than a decade of life remaining.
(Editor's Note: For those interested in reading more about secular bull and bear market cycles, I highly recommend the resources at Crestmont Research, including Ed Easterling's two books, "Unexpected Returns: Understanding Secular Stock Market Cycles" and his more recent "Probable Outcomes: Secular Stock Market Insights".)
So what do you think? Do you consider secular bull and bear markets as part of your investment approach with clients? Would you invest differently in a secular bull market compared to a secular bear? Should you?