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Protect Your Capital from the Market Cycle

Nov 14, 2017

37

The weather is seasonal.

Moods can change.

Traffic conditions vary.

Everything it seems is subject to variation and transformation...everything except investment markets.

Investment analysts and commentators - in the main - always predict a better year ahead. Even with the US market hitting one record high after another, the thought of a severe correction is never seriously entertained...at least not in public.

We know markets operate on a cyclical basis. Yet this basic premise is forgotten or dismissed (out of self-interest, arrogance or stupidity) when assessing the future prospects of markets. It is always onwards and upwards. But even a cursory look at market charts shows you this is not the case.

Unfortunately, the higher (or lower) a market goes, the greater the expectation for the continuation of that trend.

Over the long term, to survive and prosper in the business of investing, you must understand the cyclical nature of markets.

John Hussman, of Hussman Funds, is one person with a demonstrable record of market cycles.

In last Friday's Markets & Money, I included this extract from Hussman's most recent newsletter:

    '"Market valuations, on these measures, presently approach or exceed the 1929 and 2000 extremes, placing U.S. equity market valuations at the most offensive levels in history. Indeed, with median valuations on these measures now more than 2.7 times their historical norms, there is strong reason to expect a market loss on the order of -63% over the completion of the current market cycle..."

    'The most offensive valuation levels in history are expected to deliver a market lossof 63%.'

John Hussman has an excellent track record in picking market tops.

Another US firm that has an equally impressive record is GMO.

GMO has long been making seven-year forecasts - for a number of asset classes - with an uncanny level of accuracy.

The following table is the firm's latest forecast for expected returns over the next seven years.


GMO predicts investors with exposure to large cap stocks in the US face the prospect of losing - on average - 4.1% every year for the next seven years.

If GMO's forecast is reasonably accurate, then, in dollar terms, that means $100,000 today will be worth $74,500 in 2024.

GMO does not use a crystal ball to arrive at these numbers. It's a simple matter of reversion to the mean.

Markets have been functioning - through good times and bad - for nearly 150 years.

There's a whole body of data available on the mathematics behind the human emotions that drive markets to extremes - in both directions.

Eventually we calm down and rational thinking restores some order to market thinking and pricing - this is the mean.

The fact that GMO calculates it'll take a period of sustained losses to restore balance is an indication of the euphoria that exists in the US share market.

Expecting that euphoric pricing to continue indefinitely is sheer lunacy...it never has, and it never will.

Understanding secular markets

In my book, How Much Bull Can Investors Bear? I devote a whole chapter to the long-term cycles known as 'secular markets'.

Understanding the long-term patterns that influence market pricing can assist you in deciding whether to over- or under-weight your exposure to the share market.

This is an edited extract from a chapter titled: 'Secular Markets - An Inconvenient Truth':

    'Even if you're not the investing type, you should be familiar with "bull" and "bear" markets.

    'The mental image created is a bull raging ahead, while the bear claws the market down.

    'But very few people, even those in the investment industry, are familiar with, or admit to knowing about, the terms Secular Bull and Secular Bear markets.

    'In my 30 years in the investment business, I've never heard or seen these terms mentioned in any industry presentation or research.

    'We know from share market charts that, over the very long term (100-plus years), the market's positive (bullish) periods have certainly outweighed the negative (bearish) ones.

    'Progress has been made with a pattern of "two steps forward and one step back". The very long 100-year term trend is why there's no disputing the statement: "In the long term shares go up".

    'There is just one small problem with this established belief - investors don't have 100-year timeframes. The majority of people have investment horizons that stretch between 20 to 40 years. Therefore, if you happen to be in the "one step back" period of the market's progressive dance, it's unlikely you are going to experience any significant uplift from the share market.

    'When viewed over a 20- to 40-year timeframe, the share market is not always the clear winner you are led to believe it is.

    'This is an inconvenient fact the investment industry is either ignorant of, or chooses to ignore.

    'The investment industry's relevance is heavily tied to the fortunes of the share market. Therefore, all marketing efforts are built around reinforcing the belief that, in the long term, shares go up. Selective data is used to validate the marketing message. It's this "cherry picked" data that enables the industry to perpetuate the myth.

    'The following graphs show you how the promoters can manipulate the message.

    'The first graph is the movement of the Australian share market (All Ordinaries index) from 1983 to September 2011. This graph, like the CommSec graph in Chapter One, shows the market's 15-fold increase over a 25-year period.

    'The trajectory wasn't always smooth. The investment industry uses the bumps in the road - 1987 crash, mid-1990s Asian crisis, and 2000 "tech wreck" - to highlight the resilience of the share market, and to add credence to their claim of the share market always recovering to post new highs.

    'To the average investor, this certainly appears to validate and reinforce the belief that, in the long term, markets go up.
    'The second chart (below) is an extended version of the above chart.

    'The difference is the next chart goes back to 1970. You can see the 13-year period prior to 1983 was a vastly different experience for share market investors. There was no 15-fold increase; in fact, there was barely any increase at all.

    'This rather dire period in the market's history is conveniently airbrushed out of the industry's marketing efforts. Every share market graph I've seen from the industry starts in the early 1980s.
    'These two distinct periods in the history of the share market are known as Secular Bear and Secular Bull markets.

    'Secular is another way of saying "long-term trend".

    'For example, if we look at the 1982-2007 period, there's a clear long-term rising trend - known as a Secular Bull market.

    'Falling inflation rates, rising levels of debt-fuelled consumption, falling interest rates, baby boomers' consumption, low oil prices and the introduction of technology all drove this trend of higher share prices.

    'However, the rising trend was not without its hiccups. There were short-term bear markets - the most notable setbacks being the 1987 "crash" and the 2000 "tech wreck".

    'In broad terms, the All Ords' progress during the Secular Bull market can be best described as "three steps forward and one step back".

    'A close inspection of the 1970-82 Secular Bear market (the Secular Bear market actually commenced in the late 1960s) shows the market also had times when it moved in an upward (bullish) trend, only to surrender those temporary gains to the negative trend.

    'Unlike the progressive dance of the Secular Bull market, the Secular Bear market's movement is more regressive - "one step back, one step forward and one step back".

    'No real positive momentum is achieved.'

In the midst of a long-term cycle, it's easy to forget that nothing lasts forever.

The warning signals are being sounded on this extended period of excess and manipulation.

We're on the cusp of a seasonal change in market conditions...clear blue sunny skies are going to give way to a very long and very bleak winter.

Please note: This article was first published in Markets and Money on 13 November, 2017.

Vern Gowdie is a contributing editor to Money Morning - Australia's biggest circulation daily financial email. Vern has been involved in financial planning since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia's Top 50 financial planners. His previous firm, Gowdie Financial Planning, was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser (IFA) magazine as one of the top 5 financial planning firms in Australia. Vern has been writing his 'Big Picture' column for regional newspapers since 2005 and has been a commentator on financial matters for Prime Radio talkback. His contrarian views often place him at odds with the financial planning profession.

Disclaimer: The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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