The cover story in yesterday’s USA Today Money section speculated that investors’ reduction in their common stock holdings could be a market malady that lasts for years. It prompted me to re-visit a study I did for our 24th Annual Mission/Marathon Investment Conference in April 2007.
At the time, we posed the question as to which was the relevant trend: the four-year market rise from the early 2003 low or the sharp 6% decline that had just preceded the conference. We differentiated clearly between our advice to speculators and to investors. Acknowledging that we had just added 20% to our still low equity holdings–an addition that was strategic, not long-term in our view–we anticipated that momentum was still a powerful positive. While we believed the four-year rally was likely to climb still higher, the predominant advice was caution aimed at longer-term investors. In today’s market, we are largely agnostic on the short-term trend. We remain cautious, however, about the long-term picture for many of the same reasons we identified in 2007.
Over the past two centuries, stock prices have moved consistently in long cycles between strong performance and weak performance. Such cycles have averaged about a decade and a half apiece, with significant variation. Long strong cycles invariably end in investor euphoria and great expectations. Conversely, long weak cycles end with investors fearful and swearing off equity ownership. The current negative investor outlook profiled in yesterday’s USA Today article led several TV talking heads to counter that those absent investors will likely miss out on great returns in the years ahead. I would argue that a more comprehensive review of past long weak cycles indicates that cautious investors may well be rewarded rather than penalized over the next few years, although they will undoubtedly stay cautious far too long.
In 2007 we examined the three long weak cycles of the twentieth century, not simply as a history lesson. Our intent was to evaluate whether there were some characteristics we could employ to determine whether the current long weak cycle was likely to continue. The analysis of three years ago is still relevant today.
Each of the following graphs shows a simplified progression of stock prices from the beginning of each cycle to the end. While the precise patterns unfolded differently in each cycle, there were some common characteristics.
In two of three profiled cycles, stock prices rose above the cycle’s starting point after the initial decline. In all three instances, the final low was below the starting point 13 to 16 years later.
In each cycle, volume dropped significantly from the beginning of the cycles and from the intracycle highs to the sequential lows, sometimes down to small fractions of earlier volume levels.
The initial declines in each cycle failed to wipe out investor enthusiasm. Investors’ desires to own stock were not eliminated for a significant number of years until after the second or subsequent major declines.
In every instance, the long weak cycle ended after well more than a decade with extremely cheap valuations– high dividends, very low price-to-earnings ratios and very low price-to-book values – even though those valuations had been expensive at some point within the cycle following the initial decline. By the end of each cycle investors had largely given up and did not want to own stocks.
Another instructive example of investor behavior is seen in the following graph from Ned Davis Research, an excellent data source.
The current weak cycle, which began in 2000, looks very similar to the cycle that began in the late-1960s, albeit with grander dimensions. The initial price declines in each instance put huge dents in the value of individual investors’ equity holdings. The rallies that began in 1970 and 2003 rekindled enthusiasm for stock ownership, but not to the same degree seen at the initial highs. Behavior subsequent to those rallies differs somewhat from the 1970s to the present.
The 1973-74 declines so discouraged investors that there was tepid enthusiasm for the 1975-76 and subsequent rallies, despite prices returning essentially to former highs. In the current cycle, even after suffering through the two biggest bear markets since the Great Depression of the 1930s, investors have quickly brought equity holdings back toward their prior peak. The strength in equities over the two decades leading to the turn of the century built such tremendous confidence in stocks that the need to own them will not easily be extinguished. While the anecdotal examples of investor fear cited in USA Today’s article indicate a tendency to retreat from equities, the Ned Davis graph clearly shows current equity holdings well above the historic mean. Most investors certainly have not abandoned hope for common stocks.
Additional evidence exists as well to indicate that markets remain firmly in the grip of the long weak cycle that began near the turn of the century. If a new long strong cycle indeed began at the March 2009 low, the weak cycle will have been much shorter than the two-century average and far shorter than any of the 20th century’s weak cycles. That the weak cycle is finished is especially unlikely because the preceding strong cycle was the strongest in history, combining both its duration and the extent of the market’s advance. The resulting excesses were the largest ever.
Even more convincing, never did stocks become cheap by standard measures of valuation. Even at the depths of the declines in 2002-03 or 2008-09, at best, valuations approximated long-term norms. They never approached the cheap valuations that ended all prior long weak cycles.
None of these factors would preclude even a substantial move higher, especially in an era of government stimulus and seemingly never-ending quantitative easing. Intermittent rallies notwithstanding, however, the ultimate end to this long weak cycle probably lies some years in the future, with stock valuations at give-away levels and most investors not wanting to play anymore.
Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.