Alpha Power Investing Newsletter

June 14, 2010

The Big Picture

The stock market has been on the rebound for over two years now and the data shows that mutual fund investors are finally becoming less anxious and beginning to move into equity funds. Contrary to popular opinion, this is not good news. I say this for two reasons: first, because we are in a "secular" bear market; and second, because the end to it is nowhere in sight.

The expressions "secular bear market" and "secular bull market" refer to conditions that are longer term than the "normal" three to five year cyclical ups and downs of the stock market. A secular bear market is an extended period of time, sometimes as long as 20 years, where the market's value at the end point is close to the value at the beginning point. The last completed secular bear market began in the mid-sixties and ended in 1982.

The chart below shows the secular bear and bull cycles since 1900. The chart displays the values of the S&P 500 Index, but does not include the reinvestment of dividends, and is not adjusted for inflation.

In this example, from Crestmont Research, secular cycles are correlated with PE ratios to show the long-term effects of high and low valuations. The PE ratio used here is price divided by the ten-year average earnings - often called the Shiller PE (after Professor Robert Shiller of Yale) or the PE10. As you can see, there is no secular bull market that has begun with PE's above 15. When the Shiller PE drops to 10 or below, the risk in the market has been pretty thoroughly wrung out and a secular bull cycle is at hand.

With the Shiller PE at 24 today, we are nowhere close to the valuation conditions that would ignite a new bull market. In fact, the market is currently in the valuation range associated with the onset of a secular bear market.

The relationship between PE ratios and long-term returns can easily be seen in the chart below which plots rolling ten-year total returns of the S&P 500 against starting PE ratios since 1900.

The recent decade-long drought was precipitated by record high PE's in the late 90's, but even after ten years, the Shiller PE has not dropped to levels which historically have kicked off a new secular bull market. The most reasonable conclusion to be drawn from this is that the secular bear market will continue until valuations decline to bargain levels.

The last secular bear market may look mild on the long-term charts, but up close it was a scary affair. This chart shows the behavior of the Dow Jones Industrial Average over 16 years.

By 1981, most investors had thrown in the towel or become dedicated market timers as a result of the go-nowhere 16-year rollercoaster ride. Yet, throughout the long torturous affair, corporate earnings kept growing at about 6% a year, dividends increased until, at last, stocks were dirt-cheap and ready to enter the next long-term bull market. The chart above is not adjusted for inflation. At the end of 1981, the real value of the market had dropped by about 50% since 1965.

Ten years ago Ed Easterling of Crestmont Research wrote "Unexpected Returns", a book which predicted a decade or more of sub-par returns for the market. I urge investors who want to learn more about long-term determinants of stock market returns to take a look at his new book, "Probable Outcomes" (, which lays out the probable direction of the market over the next decade. Along the way, readers get a good lesson in market history, economics, and investment theory.

Assuming that we are in a continuing secular bear market (which means a substantial decline in stock prices in the not so distant future) and also knowing that the market can sustain high valuations for years (as it has done for the past 15 years), the only course of action for investors who want to extract gains from the market without losing them back later on, is to employ some kind of tactical discipline. The best measure of a tactical discipline is how it has coped with the two bear markets of the early 21st century.

One tactical strategy that has managed to avoid almost all of the damage from 2000-02 and 2008, is based on the "annual forecasting cycle" which "skews" returns into the November through May period over the long-term. For the 11 ¼-year period ending March 31, 2011, the Alpha Mid-Cap Power Index has captured 98.5% of the S&P 500's up-market returns, while avoiding 74% of the market's declining periods. The index is constructed by owning the S&P MidCap 400 Index from November through May, and the Barclays Capital Intermediate Treasury Index for the remaining months of the year. Here is the cumulative record over two severe bear markets:

To read more about this strategy, go to our website by clicking on the following link Alpha Mid-Cap Power Index Managed Account.

If you would like to discuss any of our investment programs, please call me at 1-877-229-9400.

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

Past performance is not a guarantee of future performance.

© 2011 Alpha Investment Management, Inc.
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