Alpha Power Investing Newsletter

November 12, 2010

The Next Ten Years

There are three forces at work which will determine the course of investments over the next decade. They are powerful, unchangeable and predictable.

They are:
  1. Demographics
  2. The end of the 30-year bull market in bonds.
  3. The current valuation of the stock market.
Demographics

The boomer generation is retiring and will be arriving at retirement in increasing numbers over the next decade. As investors approach and enter retirement their behavior changes and their appetite for risk diminishes. This is caused by a rising concern about running out of money (and income) in old age. Thus, their demand for lower risk investments raises the demand for fixed-income investments. This is a force for lower interest rates and lower stock prices. Another 30%-40% bear market decline in the stock market will add fuel to the fire and accelerate boomer liquidation of stocks.

The Bond Market

Perhaps the greatest bond investor of our time is Bill Gross, the president of PIMCO, the largest fixed-income manager in the world. Gross has recently said that the long bull market in bonds, which began in 1981, is over. PIMCO management is now committed to a long-term shift in strategy, which involves using hedging strategies and a more global search for income opportunities.

There is now a hot debate about whether the bond market is in a "bubble" which will deflate with ugly consequences. While it is certainly true that money has been moving from stocks to bonds almost continuously over the past 20 months, I believe that concerns over the risk to bonds are overblown at this time.

I'd like you to take a look at the history of the 10-year Treasury yield (long-term interest rates):


Data courtesy of Professor Robert Shiller, Yale University, Department of Economics

Please note that abrupt shifts from low to high rates just don't occur anywhere. As you can see, the decade of the forties was a turning point, but even in the face of high wartime inflation, rates did not spike up.

Fixed-income commitments tend to be longer term and require a more persistent accumulation of contrary evidence to push investors into liquidation. The implication of this "ocean-liner" turning behavior is that today's yields will remain with us for years, with the usual variations around the mean. I look for a flat trading range market for bonds for at least the next five years.

Unfortunately, this, in turn, implies lower returns from traditional fixed-income securities. For thirty years investors have had the wind to their backs in bonds, and have enjoyed returns comparable to stocks (in long maturities). This virtuous force is over, or nearly so, as rates approach zero. The demand for fixed-income by the newly retiring baby boomers is just another nail in the coffin.

The Stock Market

The stock market goes through long cycles of accumulation and liquidation. These are called "secular" trends. Over the past 110 years, there have been three secular bull markets: 1921-1929, 1942-1968, 1982-2000. During secular bull markets, stocks, in the aggregate, move from deep undervaluation to strenuous overvaluation in an almost continuous year-by-year price rise. Corrections tend to be sharp and short-lived.

During secular bear markets (1900-1921, 1929-1942, 1968-1982) stocks undergo regular bull and bear cycles which tend to cancel each other out over time, resulting in a long-term go-nowhere market. During these lengthy periods of stagnation, stocks slowly move from overvalued to undervalued, setting up the next secular bull market. The chart below shows the inflation-adjusted price history of the S&P 500.


Data courtesy of Professor Robert Shiller, Yale University, Department of Economics

During secular bear markets, buy and hold investors pay a terrible price for their discipline as these periods can last 20 years or longer. A recent example of this is the Japanese market, which has been in a secular bear market for 20 years now.

Investment survival in a secular bear market means avoiding the stock market altogether during certain periods. Diversification may not help during these periods since, as often as not, the bond market is bearish also. In the 1900-1921 market and also in the 1968-1982 market, both stocks and bonds were savaged by inflation.

The main driving force behind long-term trends in the stock market is valuation. Are stocks cheap or expensive? The best answer to that question comes from the valuation method first developed by Graham and Dodd and recently popularized by Professor Robert Shiller at Yale. It's the price/earnings ratio computed over the average of ten-year earnings adjusted for inflation. The 130-year history of the market's valuation is depicted above in Chart #1.

With the Shiller PE currently above 21, it is clear that the market is in valuation territory associated with the onset of bear markets, not vice versa. It is also clear that all secular bull markets of the past century have begun with the Shiller PE at 10 or less. It would take an immediate market correction of 60% to get us to that level.

The most likely scenario for the future is a continuation of the bubble/bust, bubble/bust behavior of the past ten years. Over time, as earnings and dividends grow, the market will descend through "normal" into "cheap" valuation, even as stocks go nowhere.

Investors who are now expecting "normal returns" of 10% or more from their stock holdings over the next five to ten years must assume that stocks will get even more expensive over that timeframe. This, it seems to me, is an irrational hope.

We are now in a window of opportunity for the stock market caused by the presidential election cycle. The 15-month period beginning in the fourth quarter of the mid-term year has not been down since 1931. During this period, stocks have historically done very well, averaging a 25.5% appreciation plus dividends (Dow Industrials). The average daily gain of the stock market during this five-quarter period has been 7.5x greater than the average daily gain of all other months. Once this period has passed into history, the risk of the market rises substantially, particularly in 2013-14, the first two years of the next presidential term.

If you don't have a disciplined risk management system in place to cover your financial investments, it's time to get one. The bottom line is that today's investor is facing a set of circumstances that are even more challenging than those ten years ago.

If you are self-managing a 401(k) or 403(b) account, I recommend taking a look at www.401kwealthengine.com. The 401(k) FormulaTM offers an age-based tactical asset allocation strategy designed to manage the risks that lie ahead.

Sincerely,
Jerry Minton, Ph.D.
President
1-877-229-9400, Ext. 11


Disclosure: Past performance is not a guarantee of future performance.

© 2010 Alpha Investment Management Inc.

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