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Monday, January 25, 2010

What Happens to the Market in the Next Leg Down?

This week, the stock market correction began and with it a resumption of the secular bear market. We focus on price and volume, earnings and growth, when we discuss stock valuations and their trend cycles; however, we frequently overlook or conflate the changing ingredients of the economy with market action, which can cause these movements to occur for different reasons. Recognizing the asset's changing environment, through macroeconomics, provides additional context for making correct investment decisions.

The swift collapse of stock prices this week was not supposed to happen – if you listened to the experts. This was earnings season, with many companies beating the consensus estimates, healthcare reform was a win-win for the insurance industry. The Obama / Pelosi / Reid troika of socialist madness was stopped in its tracks following the humiliating loss of the late Ted Kennedy's Senatorial seat in the bluest of blue states – Massachusetts, (I'm convinced JFK and his poltergeist siblings paid BHO a White House visit in his dreams, Wednesday night), to Scott Brown, and green shoots are growing slowly, but surely, everywhere. So, what went wrong?

First, some background information. The two previous secular bear markets, using the S&P 500 Index, occurred from 1929-1949 and 1966-1982, lasting 21 and 17 years, and returning an average 2.34% and 3.64%, respectively. Many technicians believe the current secular bear market began in 2000. If true, an average length of 19 years, plus or minus 4 years, suggests this explains the "lost decade" of 2000 to 2010, and 2015, could be the earliest before the next secular bull market begins, establishing new market highs.

Prior to the secular 1929-1949 bear market, America spent two decades transforming itself into a manufacturing economy and away from an agrarian one. Our entry into World War I gave a terrific boost in accelerating modernization and production, pushing outward this young nation's supply / demand curve. After the war, and for the bulk of the 1920's, vast amounts of European and Latin American bonds were sold to ever growing prosperous Americans. Combine these two factors with a red hot real estate and a stock market requiring 10% margin, when the party ended, it really ended. Bonds defaulted, real estate collapsed, consumption could not absorbed production, and stocks became virtually worthless overnight.

Before the secular bear market, Charles Lindbergh crossed the Atlantic Ocean in a fabric covered, single-seat, single-engine "Ryan NYP" high wing monoplane and silent movies were the latest in cinema entertainment. As the 1950 secular bull market found its legs, the US Air Force was flying combat missions in Lockheed P-80 Shooting Star subsonic jet fighters. Gene Kelly and Frank Sinatra were singing and dancing, in Technicolor, in MGM's musical "On the Town". A generation of people and technology had past between the two bulls.

The 1950s ushered in the suburbs, television, Disneyland (DIS), union jobs, a growing middle class, rock 'n roll and Elvis, interstate highways, the photo copy, air conditioning, transcontinental passenger flights, a litany of consumer products, and a loss of fear of investing in stocks. Urban centers grew; wages rose, the space race developed, the national debt was reduced, and America led the world in education and technology.

The 1960s saw our wealth and prosperity change, challenging our culture and priorities at home and abroad. Expensive domestic programs and an expensive foreign war led to spending beyond our income. The baby boomer explosion required an expansion of the nation's infrastructure, while the world recovered from World War II by building new manufacturing infrastructures.

Resources were more in demand, globally levitating prices. Inexperienced laborers and rising wages reduced productivity. The Dow Jones Industrial Average reached 1,000 in 1966 and traded between 500 and 1,000 until 1982. Abandoning the gold standard, two oil shocks, a falling dollar, and 15% home mortgages created stagflation and inflation and provided the ingredients for the next secular bear market. Forming beneath the surface at this time, however, were advances in aeronautical and metallurgical engineering, miniaturization and solid-state circuitry, and computer science; the foundation of the information-based and digital-based economy we enjoy today, and in large measure, the basis for the previous secular bull market.

Paul Volcker, as the Federal Reserve Board Chairman, at the start of the 1980s, hiked short-term interest rates above 20%, to break the back of inflation. This bitter medicine drove thousands of credit-dependent businesses out of existence and pushed unemployment to 11%. This allowed a 26 year secular bull market in treasury obligations to begin, followed by the 1982 bull market. Ronald Reagan replaced Keynesian economics for Supply-Side economics.

Deregulation became a top industrial priority, unions were broken, marginal tax rates were lowered, and deficit spending was pursued by government. Usury laws were abolished, Defense spending increased, the personal computer was born, and productivity flourished. Wall Street took off, just in time to accommodate the conversion, by businesses; from defined benefit retirement plans to define contribution plans for their workers, and the mutual fund industry smartly induced metamorphosis to grab a share of the young Investment Retirement Account and 401k market.

In 1996, concerns were raised. Irrational exuberance was sounded; however, the boom overcame caution and prudence in the stock market by investors averaging 15%, annually. Y2K drove sales and purchases, alike, and the cold war was a fading memory. On Friday, March 10, 2000, NASDAQ closed at 5,049. Friday, January 22, 2010, NASDAQ closed at 2,205.

What caused the secular bear market, this time? The short answer is we are valuing 20th century assets in the 21st century. We are servicing and deleveraging 20th century debt levels with 21st century cash flow. Again, our production exceeded our consumption. Stagnant income in a global economy and declining national wealth restricts our ability to manage outstanding liabilities and the interest expense it generates. This bear market shall be with us until these imbalances are cured, that requires time.

But, the better question is; what happens next? Since last March, investors have enjoyed a vacation from investment terror, however, the disease which pushed our financial system to the brink is still inside our economy, and will continue mutating during the next leg down, so that the last cure is rendered ineffective even as we profit from one more cyclical bull market in the future.

How does one manage risk, preserve wealth, and seek alpha returns for the duration of this secular bear? I am advocating gold and precious metals today, commodities and natural resources tomorrow, and later; energy, utilities, and info-communication companies, for long-term investors. I believe we will witness a new phenomenon this decade that will invent the existence of deflation and inflation, side-by-side. Prior to the 1970's stagnation and inflation could not exist simultaneously, or so we thought. Paper assets, and several currencies will wreak havoc on portfolio returns, losing their value and becoming out-of-favor, for all, save the nimblest of traders.

Only time will rectify the excesses accumulated from the last bull market, thus prolonging pockets of deflation, while seeds for inflation are sowed into every corner of our economy, waiting to ignite. But, these seeds are different from the last bout of inflation we experienced; therefore, correctly identifying them becomes the intermediate and long-term investor's test.

That will be covered in the future.

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