Market History: Secular Cycles & Fundamental Valuations - Part 5


Hello everyone! We've spent the past couple of weeks identifying bull and bear secular cycles over the past 90 years. We've examined how these cyclical markets were formed as macro-economic policies taken in response to prevailing economic and geo-political conditions often have long lasting ramifications over the next decade or so that can swing the economy from one extreme to the other. Periods of contraction would led to expansion to inflation and as cooling measures took shape, the economy would contract once again sometimes leading to deflation. Likewise, investors can swing from feeling euphoric to great fear as market tops and bottoms are often formed during these extreme sentiments. And so the boom and bust cycles continue from one extreme to the next.

We've seen how interest rates, foreign exchange rates, budget deficits, taxes, fiscal policies, wars and crisis of different kinds have also unfolded to bring about many trends and counter-trends in the markets.

Today, I am going to share with you how valuations have also historically trended in cycles. This will have important implications for investors as I will explain later. 

From the chart below, you can see market trailing PEs oscillate between a low of 6.64 to a high of around 24 for most part of history. Historical average is around 16. Market PEs generally rise during secular bull markets and fall during bear markets. We saw big spikes in market valuations (PEs over 40) over the last decade that quickly led to a crash in prices following the sky-high valuations for internet companies and the subsequent boom in energy and commodity prices.

Because of the cyclical nature of prices and the expansion and contraction phases of EPS due to business cycles, it is critical for investors to realise that buying equities at different market PE levels will produce varying returns, even if held over the long-term like 10 years. This will have an important implication for asset-allocations.

To illustrate this, I have produced another chart below overlaying the 10-year subsequent returns (annualised) following each year's recorded market PE. You can see initiating purchases of equities during high market PE levels are unattractive as the coming 10-year returns could even be negative (-1.38%). In contrast, buying at lower market PE levels could yield over 20% annualised returns in the subsequent 10 years!

Hence, despite the well-known fact that long-term average return for equity investments is an annualised 9.37% (between 1930 and 2010), the actual disparity in returns for equity investors can be huge. The critical consideration is your point of entry.

Equity markets can only advance strongly through a combination of higher earnings and a low starting market PE ratio.

Given our current market PE is at long-term average of about 16, and Q ratio (measure of market value over book value) is currently above 1.2 (over-valued) and that we are currently in the midst of a secular bear market which may likely mean slowing EPS growth, probability of mean reversion is high.

In conclusion, from a fundamentals perspective using market valuation analysis, we have now arrived at a similar outlook on the equity market in line with the secular bear market trend we have observed earlier from the charts. Equity investments are likely to produce relatively sluggish returns below the historical market norms for the coming 8-10 years - the remaining span of this secular bear market we are currently in.