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Thoughts from the Frontline

Somewhere Over the Rainbow

December 31, 2012

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            We are 13 years into a secular bear market in the United States. The Nasdaq is still down 40% from its high, and the Dow and S&P 500 are essentially flat. European and Japanese equities have generally fared worse.

            The average secular bear market in the US has been about 11 years, with the shortest to date being four years and the longest 20. Are we at the beginning of a new bull market or another seven years of famine? What sorts of returns should we expect over the coming years from US equities?

            Even if you have no investments in the stock market, this is an important question, in part because the pensions funded by state and local governments are heavily invested in US equities. In fact, they are often projecting returns in excess of 10% per year. How likely is that to happen? Who will make up the difference if it doesn’t? In nearly all states and jurisdictions, it is against the law to change the terms of a public pension plan once it is agreed upon.

            Even more important to you personally, what will happen to your taxes if the secular bear persists? On this final day of 2012, let’s take a look at the potential returns of the stock market over the next 7-10 years. In previous Thoughts from the Frontline and in my book Bull’s Eye Investing, I have written that stock market returns are a function of valuations (typically, price-to-earnings ratios). Secular bull markets are periods of rising valuations, while secular bear markets are periods of falling valuations. While stock market returns can vary widely over one-year, ten-year, or twenty-year periods, over the long term stock market earnings have tended to correlate very highly with GDP and inflation.

            Since GDP has tended to grow (at least until recently) at 3% per year, predicting long-term returns and secular bull and bear markets has been pretty straightforward. But recently several noteworthy analysts have presented research suggesting that GDP will not grow anywhere close to 3% over the coming decades. In today’s letter we look at the ramifications of slower GDP growth on equity returns. For most investors this is a very important topic, as the stock market tends to be the main driver of their investment returns.

So Who’s the Optimist Now?

            At the beginning of the last decade I wrote that the US economy would be lucky to grow at 2% for the entire decade. Even though I was called a “big bad bear” at the time, it turns out that I was an optimist. The economy grew at 1.7%. When asked about the present decade a few years ago, I cautiously said that we would be…

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david@msf1.com

Dec. 31, 2012, 1:14 p.m.

OK, so either a bout of inflation or deflation will ultimately kill the current secular bear and take the stock market down either way, to start the next era of the secular bull. Do I have this correct?
And, assuming that the money equation still holds, M*V=Q*P, and we all know that M has risen dramatically while price levels (P) have remained fairly stable, then either V or Q must have fallen dramatically as well (to keep the equation valid). If production (Q) is assumed to remain fairly constant going forward, then V is the variable to watch going forward (especially if the FED continues pumping more money into the equation). So, it would be very interesting to hear John Mauldin and others discuss the current and future state of V (velocity of money) going forward into the decade. There seems to be plenty of discussion about money supply (M), growth/output(Q), and price level(P), but not enough discussion about velocity of money (V). Any prognostications?

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