Absence of a Bull Market Means That We Are In a Bear Market

Many people don’t believe that we are in a secular bear market because they don’t see the potential for double-digit percentage declines, especially over a multi-year period. And classical bears (including yours truly) have done too much to feed the notion that a bear market is characterized by such moves. These do occur during a secular bear market, but they are actually a special case, rather than the norm. Instead, we are now in a bear market using a more pedestrian, but useful definition: the absence of a bull market.

In the last secular bull market from 1982 to 1999 (comparing year-end closing numbers), the S&P went up every year—except 1990, which was punctuated by the Desert Shield build-up preceding the Persian Gulf War. (The actual onset of war triggered a “relief rally” early in 1991.) Absent this exogenous, non-economic, factor, there probably would have been zero down years during that stretch. The Dow did almost as well during this span, retreating only in 1984, as well as 1990. In the longer but less robust secular bull market from 1942-1965, the Dow fell in only six years, only one in four. (I am using the Dow for historical reasons, because the S&P didn’t exist in its present form until 1957.)

And of those down years, three were marked by major political crises: the Berlin Airlift (1948), the end of the Korean War (1953), and the Cuban Missile Crisis (1962), leaving only a handful of declines caused by economics.

On the other hand, in the most recent secular bear market, from 1966 to 1981, the Dow was down year-to-year in seven years (1966, 1969, 1973, 1974, 1977, 1978, and 1981), or less than half. That’s right: the market rose in the majority of years during that period, making it possible for bulls to earn good money on rallies in Presidential election and pre-election years. But the declines were larger than the advances, and at the end of 1981, the Dow had only returned to 1964 levels in nominal terms, actually losing the 1965 gain. (Forget for a minute about what stocks did in real terms during those inflation-ravaged years.)

Yes, We Have Been in a Bear Market Recently

Have we been in a bear market recently? Yes. In the past six years, we had three down years, 2000-2002, and three up years, 2003-2005, a bear-market-like 50-50 split, returning us to 2000 levels on the Dow and 2001 levels on the S&P, which also characterizes a bear market.

Expect Two of the Next Three Years Will Be Up

Will we soon be in a new bull market going forward? My best guess is that two of the next three years from 2006-2008 will be up, and one will be down (with 2006 being the down year because of the Fed transition and mid-term election year dynamics), with the one decline roughly canceling out the two gains, so that the markets will be little, if at all higher at the end of 2008, than at the end of 2005. In that case, we’d still be in a bear market. If the optimists are right and all three years are up, then the burden of proof would shift to bears like me to show that we are not in a bull market. This burden could be met by a decline in 2009 (a post election year) and/or 2010 (another mid-term year) that took the averages back down to about current levels. If we had five up years between now and 2010 (or say, four out of five, with the fifth doing only minor damage), then I’d say we were in a new bull market. But I don’t see this yet for reasons discussed below.

Back-and-Forth Action Characterizes a Bear Market

The most common argument I’ve heard in favor of a new bull market is that it is currently “not expensive,” with the market P/E ratio approaching (but still slightly higher than) the long-term average of about 15. That is actually a bear market observation. An average, by definition, is a number that actual results “bob around.” That is, they are higher than the “average” one year and lower another. So we might go from a 17 P/E to a 13 P/E, to a 15 P/E and back to a 17 P/E over the next few years. This would drive the back-and-forth action that characterizes a bear market i.e., the absence of a bull market.

Bull Markets Start With the Market P/E Ratio at Rock Bottom

In a bull market on the other hand, the P/E ratio starts at rock bottom levels (8-10), not average. Then you have five to ten years of consecutive (or near-consecutive) rises to the average P/E ratio, using a statistical phenomenon called regression to the mean. After that, the process feeds on itself, and the P/E ratios (and market averages) continue to rise above the mean, based on what the statisticians call “autocorrelation” or what George Soros calls “reflexivity.” Finally, valuations get too stretched, and you have a bursting of the bubble (as in 2000), that creates a bear market.

How Do Bull Markets Start?

So how do bull markets start? This is where the special bear market case comes in. To get to “rock bottom” from “average” valuations, there have historically been two or more years of a bear-market sell-off, with a 20% or more decline each year. In 1929-1932, there were four consecutive annual declines, that took the Dow from 300 at the end of 1928 to 60 at the end of 1932, an 80% total fall, or a 20% “arithmetic” average annual decline. This set the stage for a bull market beginning in 1933, which was interrupted in 1937 (the year Japan invaded China), and 1939-41, (the years that Hitler went on a rampage in Europe). It resumed in 1942, the year that the Allies started winning World War II. More recently, we had two back-to-back years of huge declines in 1973-74, that set the stage for a multi-decade bull market in small caps beginning in 1975. (But the onset of the bull market was delayed for blue chips until 1982, because the overly aggressive Nixon Presidency caused Americans to choose two weak Presidents, Gerald Ford, and (especially), Jimmy Carter in the interim.)

So when will we have our next bull market? If history is any guide, not until we’ve experienced two or more back-to-back years of 20%-plus declines that takes the market P/E down to 10 or less. This could happen in 2006-2007, or 2016-2017, or anytime in between. Since it hasn’t happened yet, I don’t see a bull market (as defined above) on the horizon.

© 2006 Thomas P. Au
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