In his book Stock Cycles: Why Stocks Won’t Beat Money Markets over the Next 20 Years—written at the top of the dotcom bubble in the year 2000—Michael Alexander conducted a 200-year study of the S&P 500 and its precursors. He posited that US equities have alternated between secular bull and secular bear markets approximately every 15 to 20 years.
Below, we take a closer look at the definition of bull and bear markets, the conclusions of Alexander’s study, and what those conclusions could mean as we look ahead.
An Introduction to Bulls and Bears
What, you may ask, are secular bull and bear markets?
Generally speaking, a secular bull market is one in which the market is rising strongly over a long period of time, while a secular bear market is one in which the market goes sideways or down during the period.
By Alexander’s computations, secular bull markets, on average, have delivered 12% annualized real returns (after inflation) across 200 years of US market history, from 1800-2000.
In stark contrast, secular bear markets, on average, have delivered 0% real returns over the same time period. In other words, secular bear markets have tended to only keep pace with inflation.
If we average the real returns across all secular bull and bear market cycles, we arrive at the oft-cited long-term annualized real return of US equities: 6%. This means that over roughly 200 years of history, when we factor in the really good years, the really bad years, and inflation, we see that US stocks have tended to grow by approximately 6% each year.
What causes bull and bear markets?
But what is more fascinating about Alexander’s study is his claim that the causes of secular bull and bear market cycles alternate between the following four drivers:
Low real earnings growth → secular bear
High real earnings growth → secular bull
High inflation → secular bear
Disinflation → secular bull
While Alexander presents statistical evidence going back to the early 1800s, for illustrative purposes here we’ll start in the early 20th century:
1929-1949: A secular bear market driven by low real earnings growth. This was during the Great Depression, when real earnings growth was negative from October 1929 until November 1948.
1949-1965: A secular bull market driven by high real earnings growth. In the aftermath of WWII, while the rest of the world was rebuilding, the US was an unrivaled manufacturing powerhouse. The real earnings growth during this period was over 3% annualized.
1965-1982: A secular bear market driven by high inflation. During the 70s, there was an oil crisis and interest rates on bonds approached 20%. The Consumer Price Index rose at an annualized rate of 6.5% over those 18 years.
1982-2000: A secular bull market driven by disinflation. After then-Federal Reserve Chairman, Paul Volcker, squashed inflation by raising interest rates, both equities and bonds entered into powerful bull markets. The Consumer Price Index grew at a much more reasonable 3.1% during this time period.
Alexander published his book in 2000, thus, the 1982-2000 secular bull market was his final example. But from his framework and with the benefit of hindsight, we can perhaps extrapolate the following secular cycles:
2000-2009: A secular bear market driven by low real earnings growth. Recall that in both the dotcom bubble and the Great Financial Crisis, S&P 500 earnings completely vaporized. In March 2000, the S&P 500 real earnings stood at $76.30 per share and by March of 2009, they had fallen to $8.27.
2009-2021(?): A secular bull market driven by high real earnings growth. The annualized earnings growth from 2009 through 2020—even despite the pandemic-induced recession and global lockdown—was greater than 23%.
If Alexander’s framework is correct (and we believe it might be) the next cycle would be a secular bear market driven by high inflation—and that cycle may already be upon us.
Why We Believe We Are Entering a New Cycle
What reasons do we have to believe we may be entering or have already entered a secular bear market driven by high inflation? Here are a few:
1. Negative Expected Equity Returns
In 2000, when the US equity market was transitioning into a secular bear market driven by low real earnings growth, theSingle Greatest Predictor of Future Stock Market Returns was forecasting -1% annualized returns over the ensuing 10 years. The actual annualized return for U.S. equities from 2000-2010 ended up being -0.2%.
In 2009, when the US equity market was presumably exiting the aforementioned secular bear market and entering the most recent secular bull market, the Single Greatest Predictor of Future Stock Market Returns was forecasting returns of 15.8% annualized from 2009 to 2019. The market ended up delivering 16% annualized over that time period.
At the most recent US equity market peak in December 2021, the Single Greatest Predictor of Future Stock Market Returns was forecasting slightly negative annualized returns for US equities over the next 10 years (i.e., from 2022-2032). That is, at current levels, there does not appear to be much sustainable upside for US equities over the next decade. The lack of sustainable upside seems much more likely to be associated with an impending secular bear market rather than with the continuation of the preceding secular bull market.
2. The Last Shall Be First
Research has shown that assets that have strongly underperformed over the intermediate past (e.g., 5 years or more), tend to outperform going forward.
So, let’s ask ourselves: “which assets have underperformed over the last decade?” Precisely the ones we would expect to outperform in a high-inflation environment—namely, energy stocks, materials stocks, commodities, etc.
Indeed, since the bottom of the COVID selloff on March 24th, 2020, energy stocks have delivered the highest total return of any of the 10 S&P 500 sectors.
3. Actual High Inflation
It goes without saying that in order for us to be in a secular bear market driven by high inflation, we should actually be observing high inflation!
And we are. It’s the talk of the town. High inflation is showing up in the official statistics (7% year-over-year CPI in December 2021), as well as anecdotally. It’s caused the Federal Reserve to pivot from its stance of inflation being “transitory” to forecasting multiple rate hikes in 2022.
In addition to these solid pieces of evidence, we also have data from how assets are behaving relative to one another and the implications are sobering.
The Correlation Regime Seems to Have Shifted
Over the time period from 1965 to 1982, when the US equity market was in a secular bear market driven by high inflation, the correlation between monthly equity and US government bond returns was positive, at approximately 0.35. This means that if equities were up in any given month, bonds tended to be up as well, and vice versa.
From 1982 until the top of the dotcom bubble on March 24th, 2000, during which time the market was in a secular bull cycle driven by disinflation, the correlation between monthly equity and US government bond returns remained positive (at approximately 0.33, i.e., little changed from the prior bear market cycle).
From the top of the dotcom bubble (March 24th, 2000) to the bottom of the COVID panic (March 24th, 2020), the correlation between monthly equity and US government bond returns was negative (at approximately -0.31). This period encompassed both a secular bear market and a secular bull market, each driven by the trajectory of real earnings growth.
A negative correlation between equity and bonds is ideal because it provides diversification. When one is up, the other tends to be down and vice versa. This lends stability to a portfolio.
Since the bottom of the COVID panic through year-end 2021, however, the correlation between monthly equity and US government bond returns has again been positive, at approximately 0.25—quite close to the level that prevailed before the year 2000.
A positive correlation means that a portfolio of only stocks and bonds is NOT well diversified as they both tend to move in the same direction at the same time.
Why This Should Matter to You
The weight of the evidence suggests we recently exited a secular bull market driven by high real earnings growth and have entered a secular bear market driven by high inflation.
Future expected stock returns are at very low levels last seen at the top of the dotcom bubble. Assets that one would expect to outperform during inflationary secular regimes have begun outperforming. And inflation itself is outright high—year-over-year inflation in December 2021 was higher than the annualized inflation from 1965-1982.
Moreover, and perhaps most tellingly, correlations between stocks and bonds have become positive. This is the same type of behavior observed during previous secular periods driven by inflationary concerns (e.g., 1965-1982 and 1982-2000).
The takeaway is that while investors have become highly conditioned to buy any dips in the US stock market, now may not be the time to be overly aggressive in light of the warning signs the stock market and the macroeconomic environment are giving us.
Further, to achieve real diversification in a macro portfolio, one might have to look beyond just stocks and bonds and consider alternative asset classes such as commodities, real estate, and digital assets such as cryptocurrency.
Here at Allio, we select assets for our portfolios based on an analysis of the prevailing macroeconomic conditions. As we believe US stocks and bonds are facing significant headwinds in the intermediate- to long-term, our portfolios are highly diversified and contain exposure to other asset classes such as:
Emerging markets, which may offer greater potential for growth
Commodities, which may provide a hedge against inflation
Gold, which is uncorrelated with equities and tends to perform well when equities perform poorly
Equity REITs, which benefit from rising rents and tend to do well during periods of inflation even with rising interest rates
Cryptocurrency, which may act as a hedge against inflation while also providing an engine for growth