Frequently Asked Questions

Cast in varying forms, this has been a very active question over the past year. Addressing it was a primary reason for writing Probable Outcomes. The book not only answers the question, but also builds the proof, quantifies the range of outcomes for this secular bear, and describes the implications for a variety of investors.

But if you don’t have time for the book or if you just want the answer and not the proof, here’s the summary. No, a secular bull has not started and is not near. Actually, the current level of P/E (relatively high–see “The P/E Report” on this website) is closer to secular bear starting levels than it is to the end or even the midpoint.

The level and trend of P/E drives the long-term secular cycles, but technically it is only “involved with” short-term cyclical cycles.

To qualify as a “secular” cycle, P/E must grind higher or lower over an extended period, specifically due to an adverse trend in the inflation rate. The result is an extended era–or secular period–when P/E has a significant effect on stock prices.

When P/E becomes misaligned with fundamental principles (e.g., in financial crises, sudden crashes, or euphoric bubbles), the move into misalignment is short-term or cyclical and the restoration to general alignment is also cyclical.  Cyclical moves occur fairly quickly once emotional forces dissipate. The recent 2008 decline and 2009/2010 recovery are classic examples of cyclical bear and cyclical bull cycles.

Here are 12 rules of secular stock market cycles:

1. Secular cycles are driven by the inflation rate (deflation, price stability, and higher inflation).
2. Secular bulls occur when P/E starts low and ends high over an extended period.
3. Secular bears occur when P/E starts high and ends low over an extended period.
4. Cyclical bulls and bears are interim periods of directional swings within secular periods.
5. Cyclical cycles are driven by market psychology, illiquidity, or other generally temporary condition(s).
6. Time is irrelevant to the length of secular stock market cycles.
7. Secular bulls require a doubling or tripling of P/E.
8. Secular bears occur as P/E stalls and falls by one-third to two-thirds or more.
9. When real economic growth is near 3%, there is a natural floor for P/E between 5 and 10, a natural ceiling around the mid-20s, and a typical average in the mid-teens.
10. If economic growth shifts upward or downward for the foreseeable future, the natural range of P/E likewise moves upward or downward.
11. Inflation drives P/Es relative position within the range; economic growth drives the level of the range.
12. The stock market is not consistently predictable over months, quarters, or periods of a few years. The stock market is, however, quite predictable over periods approaching a decade or longer, based upon starting P/E.

For example, assume the market crashes in half today, pulling P/E toward 10 but without a change in the outlook for inflation or deflation. Then market psychology or illiquidity remains mired in crisis for a week or a year or longer. The downdraft is a cyclical bear.  Once conditions calm, much like a tightly wound spring waiting for freedom, the market will recover to a higher level based upon price stability. The upswing is a cyclical bull. The key point is that the upswing restores the market to a high P/E.  Once that happens, even though P/E spent time near 10, it is no longer positioned for a secular bull. A secular bull cannot start from high P/Es–a secular bull requires a doubling or tripling of P/E over time.

To further illustrate, a secular bull occurs following a case of the financial flu–after the economy has slipped progressively into deflation or inflation from a condition of price stability.  The progressive worsening of conditions under deflation and inflation will have pushed P/E toward 10–or certainly well below average.  Then, as a result of improving conditions (which historically have required years and often decades), P/E progressively rises. As it doubles or triples over five, ten, or twenty years, the multiplier effect compounds earnings growth and delivers long runs of positive years and above-average returns.

Many people mistakenly assume (or hope) that P/E touching base below average–even if it quickly recovers–enables a secular bull era. It’s not so simple. The missing prerequisite is that P/E must be positioned to double or triple in order to produce a secular bull.

The Crestmont Matrix shows that long-term average returns represent the combination of below-average and above-average decades.  Further, the periods are primarily driven by the starting P/E.  As a result, the Crestmont Matrix helps investors know to invest differently today than they invested in the 1980s and ‘90s.  Investors must take action to plan for lower returns from traditional buy-and-hold stock and bond market investments.  Investors can take a more diversified and active-management approach of “rowing” across extensive periods of volatility rather than passively “sailing” with the momentum of a secular bull market.  Early recognition and planning enables investors to adjust expectations and strategy.

The Crestmont Stock Market Matrix presents the returns from the stock market, using the S&P 500 Index, for all combinations of periods from 1900 to present.  Each colored square and number in the field of the graph reflects a period driven by a starting year from the left axis and an ending year from the top axis.  The number in the square is the compounded annual return across the period; the color of the square indicates the magnitude of return.

First, the Crestmont Stock Market Matrix should be viewed from a distance, much like a Magic Eye image which reveals its picture as you stare at the whole at once.  The Crestmont Matrix reveals a heat map of returns that tells the story of calm blue average returns over the long-term–even as the long-term encompasses dramatic periods of a decade or longer along the horizon that reflect significant surges of well above-average returns punctuated by extended periods of stall resulting in well below-average returns.

Second, stock market returns are not random; they occur across extended periods driven by the trend in the price/earnings ratio (P/E).  The numbers within the graph are presented in black and white.  Black numbers reflect an increase in P/E over the period, while white numbers correspond to a decreasing P/E.  Note that green periods generally reflect black numbers and red periods reflect white numbers.

Third, the Crestmont Matrix delivers complementary views of history to emphasize that the current period is not unique.  Although the current era includes seemingly dramatic events and revolutionary technology, a walk down the right margin reveals that similar leaps in technology have occurred during almost every decade in the past century.  Likewise, a walk across the economic measures on the bottom of the chart similarly reveals a common long-term trend that generally continues today.  Neither the major events nor economic measures of today suggest that the current period and future decades will be different from the past.  Stock market history repeats itself, with slightly different rhymes.  The lessons of history are good indications for what is needed to be successful in the future.

Finally, the version of the Crestmont Matrix that presents real returns, excluding the effects of inflation, better reflects the purchasing power of returns from investments.  Periods with high inflation overstate the value of returns.  Conversely, breaking even in the stock market during a period of deflation can provide greater purchasing power than positive returns that don’t keep up with inflation.

One of Crestmont’s most recognized presentations is the Stock Market Matrix, the multicolored mosaic of investment returns over the past century. The Stock Market Matrix was one of Crestmont’s first research initiatives. In the summer of 2001, the objective was to determine whether the stock market had completed its retreat from recent highs and would soon return to new territory, or whether the pullback was far from complete. In a discussion with an experienced investor, debate raged about long-term returns in the stock market and whether the trend had made its way back to the level that would allow average returns in the future. The crux of the discussion focused on the returns that are typically presented–the long-term return series of seventy-five years or more that is often used by investors and investment advisors.

Some of the most popular presentations of long-term stock market returns arbitrarily start in the 1920s and determine the returns through the present. The first question was whether that starting date is reasonable or whether it distorts the analysis.  If the starting level in the stock market is the high in 1929, the returns are quite different than if the starting level is the low that occurred after the crash in 1929. An analysis of returns that is dependent on a single starting point may produce invalid information.

After many long hours, a detailed presentation was developed. Rather than start at one date in the distant past, multiple starting points at the beginning of every decade were chosen.  The result was eleven sets of analyses laid out for consideration. Almost conclusively, they reflected that the market remained overvalued to various degrees. The astute investor, however, identified another vulnerability when he asked, “But isn’t the analysis still subject to single-point risk? What if the start of every decade distorts the results for some reason?”

In response to the challenge, the Crestmont Stock Market Matrix was developed as a method to present every annual return scenario since 1900. The Crestmont Matrix provides every starting year and every ending year, and then calculates the annualized return for the periods. In addition, the Crestmont Matrix uses modes of coloration and ancillary information to enhance its effectiveness as a communication tool. Returns are denoted in shades of red, blue, and green to reflect the level of returns. Further, information about economic growth, inflation, and historical events over the past century are included to add depth to the chart’s messages. Today, around the world, hundreds of thousands of copies of the Stock Market Matrix have been downloaded from CrestmontResearch.com.

The area in the Y that is most out of place is the zone on low inflation and low P/E. For illustration, let’s focus on the dots for years with the inflation rate between -1% and 3% (2 pts either side of 2% inflation) and P/E below 15.

There are 16 points that represent seven periods (a number of the dots reflect two or more years in succession). These points occur for various reasons. Most often, the periods are fast transition points from deflation to higher inflation or periods where deflation and inflation were churning back and forth (e.g., 1913-1915, 1923-1926). The inflation rate was much more erratic before the 1950s.

Of the seven periods, five occurred before 1950. One of the seven periods occurred in the 1950s (1950-1954, excluding 1951). In the years before that period, the inflation rate was fairly high and erratic…in 1951, the inflation rate spiked to 8%. Apparently it took quite a few years across the early 1950s to convince the market that inflation was coming under control…after 1954, P/E surged and ultimately ended that secular bull at 23.

In the past 60 years, since 1954, there was only one year in the group of seven: 1986. During 1986, the inflation rate experienced a sudden and significant drop in the inflation rate…the years before and after that year averaged 4%-5%. Therefore, 1986 was an outlier in the trend of relatively high inflation—it was not an indication of a decline toward price stability. A Y Curve chart for the years 1955-2013 shows a tighter relationship to the upper fork of the Y Curve and excludes the deflation periods (occurring prior to 1955) associated with the lower fork of the Y.

The relationship between P/E and the inflation rate is grounded in financial principles, not coincidence. Stocks are financial assets with values determined by their future cash flows (dividends and retained earnings). A stock’s value is based on market expectations for long-term future earnings.

Future cash flows are assessed based on their likely growth rate and associated risks. These cash flows are discounted to present value using a risk-adjusted rate that considers individual company risk and the inflation rate to compensate for inflation.

While an individual stock’s value is influenced by its specific characteristics, the overall market aggregates these individual premiums or discounts. Therefore, stock market valuation (measured by P/E and other metrics) is largely driven by the inflation rate and expected future earnings growth, which is tied to economic growth. The stock market’s value is based on the present value of future cash flows using a discount rate that varies with changes in the expected inflation rate.

Before 2000, economic growth was consistent over extended periods, so the growth rate had little impact on long-term valuations. However, slower economic growth since 2000 and expected future demographic changes have led many economists to anticipate slower future economic growth. If this holds true, growth could become another factor affecting P/E.

Thus, the level of P/E is driven by the level and trend of the inflation rate, with short-term volatility and subjectivity causing significant short-run fluctuations in P/E. Let’s examine past secular cycles using the Secular Cycles Profile.

The first secular stock market cycle of the 1900s began in 1901 and lasted 20 years. During the first five years, P/E started at 23 and averaged near 20; the inflation rate was choppy but averaged around 1%. In the middle ten years, significant inflation and deflation fluctuations caused P/E to decline to an average of 14. In the last five years, rising inflation drove P/E down to 5.

The subsequent secular bull market began in 1921 with deflation but anticipated price stability. Gains in 1921 and 1922 started P/E upward. By 1928, with near-zero inflation, P/E returned to levels in the 20s, peaking in 1929 at the start of a secular bear market.

The 1929 secular bear lasted four years as P/E fell to 8 amid significant deflation. By 1933, as deflation gave way to low inflation, P/E rose to 19. In 1937, erratic inflation, reaching 11% six years later, drove P/E to a low of 9. This period saw dramatic shifts in inflation, driving P/E highs and lows three times over thirteen years.

The longest secular bull started in 1942 and ran for 24 years. In 1942, with inflation at 11%, P/E troughed at 9. For most of this period, fluctuating inflation kept P/E just above 10 until stabilization in the late 1950s led P/E to climb to 23 by 1964. Rising inflation in 1966 marked the start of a secular bear lasting sixteen years as inflation exceeded 10% and P/E fell to 7.

The most significant secular bull began afterward as inflation slowly descended to around 2%. Responding to this moderation, P/E rose from 7 to mid-20s levels before doubling again above 40. When it became clear that new technologies would not elevate future economic growth rates significantly, a market bubble burst. A secular bear started in 2000 with a readjustment from ultra-high to normally high P/E levels.

Current conditions reflect a highly valued market, with the likelihood of below-average returns into the future, especially over the next decade or two.

Fairly-valued markets do not indicate average returns ahead. “Fair value” means stocks have been appropriately valued given the level of the inflation rates. Low inflation drives higher “fair values.” Higher valuations lead to below-average returns due to lower dividend yields and potential declines in future P/E ratios. Should P/E then decline, the effect would offset some or all earnings growth, leading to well-below-average returns.

To explain why higher inflation drives down P/E, let’s first think about the phenomenon of inflation itself. We talk about inflation whenever prices rise, but not all price increases are inflation. When the price of one thing or a few things increases, that’s just a price increase. When the aggregate price level across the economy rises, that constitutes inflation. Inflation occurs when the federal government prints more money than the value of goods in the economy. The result is that the prices of goods and services adjust upward to reflect the loss of monetary value.

That’s where interest rates come into the picture. Interest rates help to offset the loss of value due to excess money creation. That’s also why interest rates generally increase as inflation rises and fall as inflation declines. It is also why bond prices and yields rise and fall as the expected inflation rate changes.

To illustrate, bonds are financial securities that pay interest over time. A $100 bond with an interest rate of 5% pays $5 per year throughout its term. As long as market interest rates remain at 5%, then the bond will be worth $100. But if inflation rises and market interest rates go to 10%, the bond will no longer be worth as much. New bonds, with a market rate of 10%, will be worth $100, but a 5% bond will trade at a discount to compensate for its lower interest rate (up until the bond matures).

The key point is that rising inflation drives bond prices lower. Conversely, falling inflation makes those bond payments worth more since new bonds will pay lower interest payments. Bond prices and inflation, in general, are inversely related.

Now, let’s consider the stock market. Stocks are also financial assets. They often pay dividends with a portion of earnings and retain the balance of earnings to support the company’s operations. As a result, stocks are financial assets with a value today based on future cash flows. And just as with bonds, when inflation rises, the value of stocks today falls to reflect higher market rates.

We measure the value of stocks using the ratio of market price to current earnings (the price/earnings ratio, or P/E). When inflation rises, stock prices fall–so the ratio of P/E falls too. This enables new buyers of stocks to pay a lower price to receive a higher return to compensate for inflation. Conversely, falling inflation generally drives higher stock prices and P/E.

When the inflation rate falls into deflation, there’s another financial principle that causes P/E to fall. But we’ll save that for another discussion.

Note the graph below. When blue line inflation is high (red circles), the green line P/E is below average (yellow arrows). Whenever inflation is low (green check marks), note that green line P/E is well above average. (There’s one good incidence of deflation and lower P/E in the 1930s.) Inflation and P/E do bounce around a bit, yet the relationship follows the financial principles described above. Some people like the chart below (generally presented without the markings), and others prefer the one called The Y Curve Effect. Both charts are available on the Crestmont Research website in the Stock Market section.

Probable Outcomes was written to stand alone, but depending upon your familiarity with the topics, Unexpected Returns can be a preferable start for someone who intends to read both.  If you only want one, then the question would be whether your interest is general and related to stock market returns and cycles, etc., or whether it more specifically concerns reasonable outlooks for the stock market over this decade.

Probable Outcomes is not a sequel or an update, but rather it is an application of the principles from Unexpected Returns to the current decade (with lots of extra and new details).  The second chapter of Probable Outcomes revisits many of the primary concepts from Unexpected Returns to refresh prior readers or to inform those who did not read it.  Some people who read Probable Outcomes first may choose to then read Unexpected Returns since it deals with some concepts that were not included in Probable Outcomes and will further enhance a reader’s understanding of those concepts.  Some recent readers of Unexpected Returns have found that Probable Outcomes helps to put the messages of Unexpected Returns into perspective by reflecting upon the period the first book was published–like reading an analyst’s report years after it was written from a historical perspective.  Neither book, however, provides a forecast; rather they provide the concepts and insights to enable readers to understand the dynamics that determine the investing environment and to understand which scenarios are reasonable. Further, both books offer encouragement that, with awareness, investors can plan and invest in ways that will enhance success.

According to Brian C.: “If I were to suggest that anyone read just one of your books I would have to say Probable Outcomes.  Unfortunately I can’t say why with specificity but the points came home more clearly as I read it.  That obviously could have been greatly enhanced from having read the first book.  It’s also more timely obviously as it relates to the future.  The first book gives a lot of credibility to your analysis since you were right about your predictions going forward to 2010 however the second book came more to life for me.”