Research & Advice

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Cyclical Bull in a Secular Bear

Thursday, September 3, 2009

 

  • Up 46% and 52%, respectively over the 120 days from the March 9 bottom through their highs on August 27, the Dow Jones Industrial Average (DJIA) and S&P 500 have not gained this much, this quickly, since the 1930s. Clearly the pace of the advance must moderate.

  • This leveling off of the stock market’s ascent as the economy is recovering is nothing new. The good new is that after the end of recessions, the stock market has risen in nine of ten cases both six months later and twelve months later

  • All through 2003-2007 we argued that the stock market’s rally was merely a cyclical bull in a secular bear. We are taking the same position now as we did then – that we have the opportunity to take advantage of a “monster rally”, but that a new secular bull market has not yet begun.

  • The only strategy that works during a long-term bear market, is the strategy that Berkshire Money Management client’s have had the luxury to participate in over the better part of the last decade.

 

A Moderating Market Advance

 

Up 46% and 52%, respectively over the 120 days from the March 9th bottom through their highs on August 27, the Dow Jones Industrial Average (DJIA) and S&P 500 have not gained this much, this quickly, since the 1930s. Clearly the pace of the advance must moderate. However, the good news is that the breadth has been bullish (the ratio of positively advancing shares relative to shares declining in price has been positive and wide). The stock market is correctly pricing in our March 31, 2009 comments that “there are some tentative signs that the economy is trying to stabilize.  There is still a lot of healing to be had, but the brunt of the decline, as experienced in Q4 2008 and Q1 2009, is behind us” as well as our July 1, 2009 comments that “the recession will be over by the end of Summer. “

Clearly the stock market cannot maintain the pace of its advance. Still, even despite the impressive run up of stock prices, it would be logical to expect that stock market’s advance would moderate for economic reasons. US Gross Domestic Product (GDP) growth is currently tracking at about a 2.5% rate for this quarter, and we forecast a 2%-ish rate for next quarter. Much of this growth is due to an inventory rebound necessitated by companies severely reducing their stockpiles to below sales rates. However, for some quarters thereafter economic growth will likely recede to something still positive, but more flat.

This leveling off of the stock market’s ascent as the economy is recovering is nothing new. The good new is that after the end of recessions, the stock market has risen in nine of ten cases both six months later and twelve months later (the exception was 2001, as the stock market continued to fall in 2002 as the Tech Bubble popped). With the power of hindsight (and revised economic numbers), we know that the S&P 500’s respective average gains six and twelve months after recessions have 9% and 14%. That pattern illustrates a slowing stock market rally as the economy improves. And that is certainly a reduced pace compared the respective six and twelve month gains of 24% and 32% from the market lows that occur during recession.

 

Those “phases” of stock market advances are illustrated in the below chart. Considering the chart of “Historical Performance of DJIA Around Waterfall Decline” it is expected that the “Recession End” has technically occurred. But even if we are too optimistic and the recovery doesn’t officially begin for a few moths, the point is the same – the cyclical bull market, while slowing, remains intact.

 

 

 

Cyclical Bull in a Secular Bear

 

When we started Berkshire Money Management in 2001, we declared that we were in a secular (aka “long-term”) bear market. And then in October 2002 we went from a huge cash position to a huge allocation of equity investments. Still, all through 2003-2007 we argued that the stock market’s rally was merely a cyclical bull in a secular bear. We are taking the same position now as we did then – that we have the opportunity to take advantage of a “monster rally”, but that a new secular bull market has not yet begun.

The crash of March 2009 is still very recent, so there are still some investors that will listen to our point of view. However, from 2003-2007 we were largely derided in both cases by critics. It was the consensus that the bull rally was not cyclical, but rather secular (and, thus, no secular bear existed). But now, eight years after we incorporated Berkshire Money Management, the stock market is down about twenty five percent (clients of Berkshire Money Management have stunningly happier memories as they pertain to investment returns).

So now it seems as if, lo and behold, we were in a secular bear market. So while we are happy to have some recognition regarding getting that market call right, the discussion misses the point. In a secular bull market (think 1982-1999), an investor can make money with a buy-and-hold-almost-forever strategy. But study the chart below. It is a chart of the S&P 500 between 1966 and 1982 (the last secular bear market). That type of a buy-and-hold strategy during that period (especially considering the inflation rate of that time) would have proven to be a painful investment philosophy.

 

Bottom Line: The only strategy that would have worked during any period of long-term bear market, is the strategy that Berkshire Money Management client’s have had the luxury to participate in over the better part of the last decade – a risk management strategy that includes buy-and-hold, but cuts the holding period from decades to years.

The only way we know of for most investors to make money in bear markets is to be long (i.e. hold equity) during those huge trading swings up (like 2003-2007 and now), and then get out. Thus, one must have an “exit strategy” to survive. Our exit strategy in 2001 was to sell everything but small-cap value stocks and real estate investment trusts (REITs). Our exit strategy in late-2007 was to begin reducing equity allocations and start increasing our short positions (i.e. bet that the stock market would go down) by way of investing in FDIC-insured Absolute Return Certificates of Deposit that had the opportunity to gain in value as the stock market declined (for example, if the S&P 500 went down ten percent, then that investment would gain ten percent).

We’ll write more about our anticipated exit strategy in future commentaries.