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The "Secular Bear" Thesis Re-Visited

Steve Saville
Oct 23, 2007

Below is an extract from a commentary originally posted at www.speculative-investor.com on 18th October 2007.

With the Dow Industrials Index and the S&P500 Index having quite recently made new all-time highs we thought we'd re-visit our opinion that US equities are, as a group, immersed in a secular BEAR market.

When money can be created in unlimited amounts 'out of thin air', as it can be today, it is not reasonable to define secular trends in terms of nominal price changes because the situation can arise where most prices are in rising trends solely due to the depreciation of money. For example, if the US money supply continues to expand at its current pace then seven years from now we will conceivably be in the situation where the Dow Industrials Index is trading at double its current level while the US dollar's purchasing power is half its current level. In this example a doubling of the nominal value of an investment in the US stock market results in ZERO increase in wealth.

The above hypothetical example is not especially farfetched because there have been real-life cases of stock markets literally gaining millions of percent within the space of a few years due to a total collapse in the value of the money in which the stocks were priced. Therefore, it is obviously important to distinguish between real gains and gains that do nothing more than partially offset the fall in the value of money. After all, money is NOT wealth; it is just a medium of exchange. If the global money supply were to miraculously double tomorrow there would be no more wealth (purchasing power) in the world than there is today.

Further to the above, it only makes sense to say that a particular investment is in a secular bull market if that investment is delivering REAL long-term gains; that is, if people increase their purchasing power over the long-term by holding the investment. By the same token, it is nonsensical to claim that an investment is in a long-term bull market if that investment is losing ground in purchasing power terms.

In a nutshell: although most people measure their wealth in terms of money, what they really desire is increased PURCHASING POWER. We therefore say that an investment is in a secular bull market if it is delivering long-term gains in purchasing power. If not, then we say it is in a secular bear market.

That's all well and good, but we run into a big problem when we try to MEASURE an investment's real long-term performance because it is not possible to determine a single number that properly represents the purchasing power of money. The problem stems from the fact that money is involved in millions of transactions every day and the purchasing power of money is different in each of these transactions. Moreover, even if it were technically possible to calculate the average of all of these millions of transactions an average of totally disparate items will inevitably be a meaningless number (the CPI would be a meaningless number even if an honest attempt were being made to calculate it).

Because it is not possible to come up with a single number that properly represents changes in the economy-wide purchasing power of money it is also not possible to calculate an investment's real performance. Fortunately, though, there are ways of 'seeing' how an investment is performing in real terms; and in our opinion the best of these ways is to look at how the investment in question is performing relative to gold. Gold works particularly well in this regard because long-term trends in the gold price reflect changes in both the objective and the subjective value of money, meaning that they reflect changes in both the purchasing power of the money and the general perception of the money. This is important because over reasonable investment timeframes the 'subjective' will often dominate the 'objective'. To explain further, let's quickly review what happened during the 1970s and 1980s.

During the 1970s the rise in the gold price was vastly greater than the corresponding fall in the purchasing power of money. This was partly due to the fact that the gold price had been fixed at $35/ounce for the preceding three decades, but it was mostly due to confidence in the monetary system declining at a much faster rate than monetary purchasing power. The purchasing power of money then continued its decline during the 1980s, but confidence in the monetary system rebounded strongly during this decade causing the gold price to trend downward.

As we've shown before and as we demonstrate again via the chart displayed below, when the Dow Industrials Index is viewed in gold terms the secular trends become clear. This chart cuts through the veneer of currency devaluation.

A second way to define the secular trends in the stock market is via long-term swings in valuation, with secular bull markets being characterised by rising valuations (rising P/E ratios, falling dividend yields, etc.) and secular bear markets being characterised by falling valuations. Note, for example, that the bottom section of the following chart, which shows the price-to-peak-earnings ratio of the S&P500 Index since 1926, reveals almost identical cycles to the above Dow/gold chart. The point is that while the S&P500's earnings move relentlessly upward over time with only short-lived downward blips, investors are sometimes prepared to pay more than 20-times earnings and at other times they are prepared to pay only 8-times earnings. It is this market-wide desire to pay increasingly more or increasingly less for earnings that determines the stock market's long-term trend; a desire that is linked to monetary confidence and, hence, to the gold market.

A third way of 'seeing' the stock market's secular trend would be to create a long-term chart of a senior stock market index relative to the total money supply. Displaying the stock market's performance in this way would account for long-term changes in the objective value of money, although it wouldn't take into account the changes in the subjective value of money that usually dominate over periods of less than 10 years. In any case, we've shown in the past that the Dow/M3 ratio has followed similar long-term cycles to the Dow/gold ratio and the price-to-peak-earnings ratio.

The bottom line is that whichever way we account for the effects of inflation we arrive at the conclusion that a secular bull market ended, and a new secular bear market began, during 1999-2000.

If our interpretation is correct then a buy-and-hold investor in an S&P500 Index fund (or similar) will not be rewarded with real gains over the coming five years, and real gains are the only gains that matter. If the supply of money continues to be inflated at a rapid rate then the stock market may well continue to trend upward in nominal terms, but the central bank cannot create a genuine bull market in equities by reducing the value of money. All it can reasonably hope to do is disguise the real trend, but the real trend will persist until its logical conclusion -- the point when the Dow/gold ratio is below 5 and the S&P500's price-to-peak-earnings ratio is below 10.

Steve Saville
email: sas888_hk@yahoo.com
Hong Kong

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