EDMOND — Oscar Wilde once said, “Experience is the name everyone gives to their mistakes.” If that is true, many people have gained a lot of investing experience during the past 10 to 20 years. In a previous column I discussed the significance of secular (i.e. long-term) bull and bear markets. Contrary to what you might think, secular bear markets don’t really trend down as much as they move sideways for long periods of time, with lots of mini bull and bear markets bouncing around in between.

Let’s look at a stock such as Walmart and see what takes place in a sideways market. (This is just an example and not a recommendation to buy or sell Walmart.) In the past 10 years, the stock has basically gone nowhere. However, during that time Walmart’s earnings almost tripled from $1.25 to $3.42 per share, growing at an impressive rate of 11.8 percent a year. This doesn’t look like a stagnant, failing company. In fact, it’s quite an impressive performance for a company whose sales are approaching half a trillion dollars. Its stock chart would lead you to believe otherwise.

The reason for this unexciting stock performance was valuation — the P/E (price/earnings) ratio — which declined from 45 to 13.7, or about a 12.4 percent decline a year. The stock price has not gone anywhere because much of the benefits from earnings growth were canceled out by a declining P/E ratio. Even though revenues more than doubled and earnings almost tripled, all of the return for shareholders of this terrific company came from dividends, which did not amount to much. This is exactly what we see in the broader stock market.

Let’s zero in on the last secular bear market the U.S. saw from 1966 to 1982. Overall stock market earnings grew about 6.6 percent a year, while P/E ratios declined 4.2 percent. Thus stock prices only went up about 2.2 percent a year. Of course there were lots of brief up and down cycles during that period, called cyclical bull and bear markets. That time period had five cyclical bull and five cyclical bear markets. Two forces worked against each other. The benefits of earnings growth are wiped out by P/E ratio contraction.

Secular bull and bear markets tend to last about 15 to 18 years on average. As I have written before, I think we are currently in a secular bear market that began in 2000 and probably has another six to eight years to go. We saw a similar trend in P/E ratios in the 1966 to 1982 period. Since 2000, P/E ratios declined from 30 to 19, a decline of 4.6 percent a year, while earnings grew 2.4 percent. This explains why in 2010 the stock market was pretty much where it was in 2000, despite 10 years of earnings growth.

Historically, though earnings growth fluctuates in the short term, it generally mirrors the growth of the economy, averaging about 5 percent a year. If P/E ratios never changed and always remained at an average of 15, we would not have bull or bear markets at all. Stock prices would simply go up or down with whatever earnings were. That is what would happen in a utopian world where people are completely rational and unemotional. Of course, there is no utopian world and people are not rational.

The change of P/E ratios from one extreme to the other through market and economic cycles is largely responsible for sideways and bull markets.  P/E ratios moving from low to high levels cause bull markets and P/E ratios moving from high to low cause the roller coaster ride of sideways markets.

Secular bear markets occurred when you had two conditions in place; a high starting P/E ratio and prolonged economic distress. Together they are a lethal combination. High P/E ratios reflect high investor expectations for the economy. Economic problems such as runaway inflation, recessions or severe deflation, declining or stagnating earnings, a credit crisis or a combination of these things destroy those high expectations. Instead of an above average economy, investors find themselves in an economy that is below average. Suddenly, a bear market has started. That is where we are today.

What about a cheerier subject — the bull market? We saw a great example of a secular bull market from 1982–2000. Earnings grew about 6.5 percent a year and P/E ratios rose from low levels of around 10 to the unprecedented level of 30, adding another 7.7 percent to earnings growth.  Add up the positive numbers and you get incredible compounded stock returns of 14.7 percent a year. Add dividends on top and you had even more incredible returns of 18.2 percent over almost two decades. No wonder everyone thought they were stock market geniuses in the late 1990s. Not anymore.

Mean reversion is a statistical term for things going back to what could be considered normal. Mean reversion is the Rodney Dangerfield of investing: It gets no respect. Mean reversion is as important to investing as the law of gravity is to physics. As long as humans come equipped with emotions like fear and greed, market cycles will persist and the pendulum will continue to swing from one extreme to the other. Prices never stop at the mean. They always overshoot on the way up and on the way down. When P/E ratios hit the extremes is when the next bull or bear cycle starts.

So what does this mean for investors today? It means that if we are in fact in a long-term bear market for the next several years, we are not likely to see major advances in stock prices even with improving earnings. I am often asked how stock prices can go down or stay flat even when company earnings are improving. It is because of P/E ratio contraction and it is important for investors to consider whether we are in a bull or bear market when considering their investment decisions.  

Short term, I think we’re in a brief bull market cycle. But we may be just whistling past the graveyard. Longer term, I think we’re still in a secular bear market with several more years to go. You’ll have to decide what you think. Thanks for reading.



NICK MASSEY is a financial adviser and owner of Householder Group Financial Advisors in Edmond. Massey can be reached at www.nickmassey.com. Securities offered through Securities Service Network Inc., member FINRA/SIPC.