The word secular originates from a series of Latin words that mean an extended period of time or an era. It is actually closer to you than you might realize. On the back of the one-dollar bill, look below the pyramid on the left; the one with the strange eye above it. The term Novus ordo seclorum means a new order for the ages, a new American era. Seclorum is the word in that phrase that means ages or era. Thus, the term secular stock market cycles relates to extended periods, or eras, in the stock market.
For the stock market, secular cycles are generally qualified as either bull or bear cycles. Bull cycles are periods when stock market returns are good and bear cycles reflect periods of weakness.
That’s where agreement among secular stock market analysts and market pundits ends.
Too often, the concept of secular cycles is dismissed or misunderstood by investors because they are confronted with a lot of incorrect or contradictory information about these cycles. First impressions can be a powerful force. Adding to the confusion, there are at least three schools of thought about the causes or drivers of secular bulls and secular bears. The principles and theories within those schools are quite different.
This article seeks to help you to differentiate the various sources of secular stock market information and understand the basis of their positions. It will explore in detail key principles from the third school and conclude with a quantitative outlook for the stock market environment and expected future returns. This will show that secular cycles are mathematically-driven and not phenomena or coincidences. It will also highlight the need to focus on decade-long periods and not century-long average returns.
Keep in mind as we discuss secular stock market cycles, that these longer-term cycles are distinct from the short-term cyclical cycles that occur numerous times within secular periods. The shorter cyclical cycles are driven by emotion, events, funds flows, or any number of temporary factors. Secular cycles are extended periods of longer-term trends in the stock market.
The most commonly followed school identifies secular cycles based upon chart patterns or average length of past cycles. For example, extended periods that appear to be rising (e.g., the 1980s and ‘90s) are designated as secular bulls. Extended flat or declining periods are designated as secular bears. Alternatively, other analysts in this school define bulls and bears based upon years (e.g., 17 years for secular bears). This school has a wide range of explanations for the causes behind the cycles. They include economic conditions, major events, investor psychology, etc. to explain the phenomenon driving chart patterns or time periods. Ultimately, however, the designation of secular period under this approach can be fairly subjective or it relies upon an undefined force. This school not only has the largest following of observers; it also has the largest audience of skeptics.
The second school identifies secular cycles based upon the force of reversion. The members of this school believe that the market’s valuation level is naturally drawn back to its historical mean over time. The most common measure of valuation for this mean-reverting cycle is the price-earnings ratio (“P/E”). This school believes that the market exhibits a cyclical pattern whereby P/E rises toward relative highs, then is pulled downward and through a natural mean level. The mean is considered to be the all-weather level of fair value. Then the market often overshoots into relatively low levels before reverting back toward its natural level at the mean. As this process continues, according to this school, the result is a cycle of secular bulls and bears. Members of this school are reversion-to-the-meanists that can be identified by their underlying assumption that future market returns will be impacted by the reversion of market valuation to its historical mean.
The third school believes that secular stock market cycles are driven by fundamental principles of finance and economics. In particular, Crestmont Research develops analyses and graphics that identify the inflation rate as the primary driver of P/E over secular cycles. Secular cycles are the effect of these principles; they are not patterns or phenomenon that are explained by forces or events. These principles are not merely rules or criteria, they are essentially axioms for secular stock market cycles. Crestmont’s axioms will be the primary subject of this article.
- There are only three components of general stock market returns: earnings growth, dividend yield, and the change in P/E over the investment period.
- Earnings growth is closely correlated with and caused by economic growth.
- Dividend yield is significantly driven by the level of valuation (i.e., P/E) at the time of investment.
- The level and trend of P/E is driven by the inflation rate: low, stable inflation drives P/E higher; high inflation or deflation drives P/E lower.
First, there are three components to stock market returns: earnings growth, dividend yield, and the change in P/E over the investment period. Earnings growth and P/E change determine capital gains or losses. Dividend yield provides return in addition to any capital gains or losses. These three components determine the stock market’s (or any passive stock portfolio’s) total return.
Second, each of the three components has drivers rooted in finance or economics. Each of the three components can be estimated over longer-term investment horizons with reasonably accurate ranges based upon economic assumptions. Stock market returns are not random over longer-term periods. Although the general level of stock market return is challenging to predict over days, weeks, quarters, and a few years, the relative level of stock market return is often fairly predictable over periods of 5-10 years or longer.
Third, earnings growth is closely correlated with, and derived from, economic growth. Over complete business cycles, earnings growth for a market index like the S&P 500 Index will be slightly slower on a nominal basis than the overall economy (reflecting that larger, public companies generally have slightly slower average growth than the economy with its new start-ups and sometimes faster-growing small companies). Since the range of forecasts for future economic growth is relatively narrow, earnings growth can be estimated within a relatively narrow range.