As we continue to look for the best ways to invest, it is an opportune time to communicate again regarding the long term trends we see that help form our investment philosophy.
Short term, market moving events are extremely difficult to predict and capitalize on consistently. However, longer term trends are more apparent. There are two long term trends that are extremely important to us in making investment decisions at this time: the secular bear market, and the end of exponential growth. In this letter we will revisit the critical aspects of the secular bear market and how our investment strategy is guided by these points. In a future letter we will look at the end of exponential growth and its ramifications.
You may remember that in our 3rd Quarter letter of 2009 we wrote about the current secular bear market (if you’d like another copy of that letter just let us know). From that letter:
As a bit of background, a secular market cycle refers to a long market cycle, generally one that lasts for up to 20 years. Within these secular cycles are many ups and downs. When looked back on, secular bear markets are a long period of time in which, from beginning point to ending point, there was a negative change in stock prices, usually with a lot of volatility in between.
With the benefit of almost 3 years of new experience since writing last about this secular bear market it is clear that we are still solidly in the secular bear market. Ed Easterling, in his book Probable Outcomes, makes it clear that previous secular bear markets have not ended until stocks have a very low price to earnings ratio (PE ratio). When this happens it means that stocks are undervalued relative to the health of their business activities. So, where are we in this secular bear market?
Put simply, we are not yet in a situation where stocks are undervalued. Therefore, we are not ready to enter a long term bull market. The PE ratio for the S&P 500 currently sits at about 15, which is just about equal to the historical average PE ratio for the index. This means that stocks are currently at “fair value” (from the perspective of the historical PE ratio). The last secular bear market ended in 1981 with the S&P 500 at a PE ratio of about 7. For comparison, to get to that PE ratio now the S&P 500 would have to drop from its current level, at around 1,350, to 700 or so.
The other way to get a lower PE ratio is for earnings to grow and stock prices to stay stagnant. Neither this scenario, nor the one in which the S&P 500 loses about -50% are particularly appealing for a “buy and hold” stock investment strategy. Investing during a secular bear market is not the time to buy a narrow set of asset classes. In particular holding only, or even mostly stocks, is not likely to lead to successful investing.
The Importance of Diversification
We are in a time of large up and down swings in stock prices, where the endpoint is not higher than the beginning. These swings provide investment opportunities, and diversification provides more opportunities. Our goal in portfolio construction is to lessen the dramatic swings that can be expected over the years in a secular bear market, and to benefit from the opportunities that arise in uncertain, volatile times. This is why we have the enduring view that the best way to invest continues to be a conservative, diversified, balance of holdings; along with some active and/or alternative investment strategies.
Diversification of holdings allows for a degree of insulation from market shocks, as each asset class reacts differently. Additionally, diverse holdings can provide exposure to assets that show strong performance, even during a bear market for stocks. By way of example, below is the chart from our 3rd Quarter, 2009 letter showing asset class performance during the first decade of the current secular bear market.
Sol is president of Highlander Financial. He has over 20 years of experience in financial markets and managing businesses.