THE CASE FOR A SECULAR BEAR MARKET

Why stocks may provide poor returns for years

The history of stock markets is one of long bull markets and long bear markets.

We believe that U.S. stocks are in a secular bear market - one that could last years, rather than months.

Secular bear market underway

Bull and bear market cyclesHere’s a quick overview of the last 100 years:

• 1909 - 1921: Stocks entered the 1900s trending higher, and rose 35% in less than three years. But stocks swung wildly, peaking in 1909. By August 1921, the broad market was 40% lower.

• 1921-1929: In the famous bull market of the Roaring ‘20s, stocks returned more than 400%.

• 1929 - 1948: Stocks plunged, recovered significantly by 1937, but by 1948, stocks were down more than 50% from the ’29 peak.

 

Bull and bear market cycles…

• 1948 - 1973: Stocks prices produced a six-fold increase, culminating in the Nifty-Fifty market of 1972.

• 1973 - 1982: The S&P 500 was lower in August 1982 than in January 1973. Adjusted for inflation, the results were far worse.

• 1982 - 1999: The S&P 500 index rose by a factor of 12. The NASDAQ ended the 90s at 21 times its 1982 level.

 

Most stock returns come from secular bull markets

Based on S&P Composite 1900-1999, dividends not included

Annual price change for 1900 - 1999 5.6%

Long term compound annual price change from Secular Bull periods only (last century)

Compound annual price change, no Secular Bulls

Excludes: 1921-28, 1949-66, 1982-99

Excludes: 1900-20, 1929-48, 1966-81

13.8%

-1.1%(Simple ave. +2.1%)

1966:

The next decade saw the most severe bear markets* in the last half of this century: 1969-70: -34% 1973-74: -47%

(Between December 1968 and December 1974, the unweighted Value Line Index of 1700 stocks lost more than 74%)

1929:The next decade saw the 2 most severe bear markets* in the first half of this century:

1929 peak –1932 trough: -86%

1937 peak –1938 trough: -54%

*Based on S&P Composite, dividends excluded

’29 peak to ’38 trough: -73%

Periods following secular bull markets can produce dismal returns

Secular Bear Markets can devastate investors

$1,000 Year Initial # of Invested at Investment Years toPeak of Recovered Recover

1929 1953 24

1966 1993 27

Inflation adjusted recovery period, excluding dividends

We can conclude:

Secular Bear Markets usually parallel the Secular Bull markets that precede them

Bear follows bull - another view:

100 Years of Stock Market HistoryS&P Composite (log scale)

1

10

100

1,000

10,000

1900 1909 1918 1927 1936 1945 1954 1963 1972 1981 1990 1999

Bull

Bull

BearBear

Bear

Bull

What drives speculative manias?

Credit excesses fuel speculative asset bubbles. In fact, all great speculative manias have been associated with rapid credit growth.

The greater the credit excesses the wilder the speculation.

1630s Dutch Tulip Mania Trading on credit notes for future delivery

1690s British Stock Market Boom Establishment of Bank of England, coin debasement, expansion of bills of exchange

1720 Mississippi Bubble Banque Royal, bank loans for stocks, paper currency

1720 South Sea Bubble Sword Blade Bank financing of stock

1820s South American Mining Mania Credit by unregulated country banks

1830s Jackson Boom Wildcat banking fueling fever for canals, land and railways

1907 Knickerbocker Trust Panic, New York

Unregulated trust companies

1920s U.S. stock market boom Installment credit, diluted gold standard, margin loans, lending against property

The following table from “Crunch Time for Credit? An inquiry into the state of the credit system in the United States and Great Britain” by Edward Chancellor highlights the source of credit fueling famous speculative manias.

Credit booms drive speculative manias

Date Mania Source of Credit

Source: Crunch Time for Credit? An inquiry into the state of the credit system in the United States and Great Britain

Credit booms and manias, con’t…

1982 Kuwait stock market bubble $91 bill. of post-dated checks fuel boom

1980s Leveraged buy-out mania Junk bonds

1980s Japanese bubble economy Bank capital linked to stock holdings, growth in non-bank financing

1990s Asian boom Currency peg yields cheap foreign financing, growth in non-bank lending

Late 1990s

U.S. and European Tech Bubbles Credit derivatives embolden banks, junk bonds

Date Mania Source of Credit

Was the late ’90s stock market a credit-fueled mania?

According to financial historian Edward Chancellor, there are several indicators that a credit boom is underway and placing an economy at risk:

Rapid credit growthSpeculative buying (inflows) by foreignersInvestment and/or consumption boomDecline in credit quality Financial liberalizationInflux of new credit providers and increasing competition among themZeal for lending against assets (rather than income)Concentration of riskTendency by lenders/investors to underestimate risk

What does a credit boom look like?

The ‘90s stock market certainly resembled other stock manias of the 20th century

260 week run to peak for '29 Dow, '89 Nikkei and '00 S&P 500, Nasdaq

(Indexed to 100 at week 260)

100

175

250

325

400

475

550

625

260 237 214 191 168 145 122 99 76 53 30 7

Weeks from peak

'00 NASDAQ

'89 Nikkei

'29 Dow

'00 S&P

Here’s another sign of a mania...

Number of Equity Mutual Funds

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

105% more equity funds in 5 years!

Source: Investment Company Institute

In his book, “A Short History of Financial Euphoria,” Economist John Kenneth Galbraith outlines common features of a market mania. See if any of these sound familiar:

Brevity of financial memory, disaster is quickly forgotten (S&L debacle, junk bonds, Japanese bubble, Mexico collapse, Orange County, Asian collapse, LTCM)

Association of money with intelligence (Derision of those who question New Era market, elevation in status of CEOs, financial commentators, money managers)

Arrival, development of something new (Internet, telecom and myth of increased productivity)

Claims of financial innovation (Increased use of derivatives, Internet trading, home equity loans, minimum payment mortgages)

Sound familiar?

Credit fueled our recent mania$ Billions of private nonfinancial borrowing & borrowing to change in GDP (left scale)

$0.00

$0.50

$1.00

$1.50

$2.00

$2.50

$3.00

$3.50

$4.00

66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04

Source: Fed's Z-1, Bureau of Economic Analysis

0

200

400

600

800

1000

1200

1400

1600

1800

$ Bill

Borrowing/change in GDP: More and more borrowing required for a dollar of GDP growth

Non-federal Borrowing

The credit surge, another view

Total Credit Market Debt Outstanding1985 - 2004 ($Billions)

7,000

12,000

17,000

22,000

27,000

32,000

37,000

85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

Source: Federal Reserve Z-1

And another view

Total Debt Outstanding to GDP1964 - 2004

1.30

1.40

1.50

1.60

1.70

1.80

1.90

2.00

2.10

64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04

www.prudentbear.com Source: BEA, Federal Reserve Z-1

Credit flooded the corporate sector in the late ’90s, supplying financing to too many marginal companies and credit excess capacity, particularly in telecom.

When credit growth slowed in these sectors, the Federal Reserve tried to buoy the economy by easing monetary and credit conditions further. The result was a middling economy and a bubble in the home mortgage sector. For the first time in memory, rather than retrenching, consumers took on more debt during the recession.

Credit fueled our recent mania

Business Sector BorrowingQuarterly borrowings at annual rate, Q1 '70 - Q4 '04

-50

50

150

250

350

450

550

650

750

850

Mar-70

Sep-72

Mar-75

Sep-77

Mar-80

Sep-82

Mar-85

Sep-87

Mar-90

Sep-92

Mar-95

Sep-97

Mar-00

Sep-02

Source: Federal Reserve

Telecom helped business borrowings explode in the late ’90s

When business borrowing collapsed, the mortgage sector more than made up for it

Mortgage & Business Sector BorrowingQuarterly borrowings at annual rate, Q1 '70 - Q4 '04

0

200

400

600

800

1000

1200

1400

1600

Mar-70

Sep-72

Mar-75

Sep-77

Mar-80

Sep-82

Mar-85

Sep-87

Mar-90

Sep-92

Mar-95

Sep-97

Mar-00

Sep-02

Source: Federal Reserve

$Billions

Business Sector Borrowing

Household Mortgage Borrowing

More lending = more spendingCash out volume for prime conventional loans ($bill.)

$0

$20

$40

$60

$80

$100

$120

$140

$160

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004(e)

2005(e)

Source: Freddie Mac

Cash-out refis were key to the surprising strength in consumer spending

When the refi boom faded…

Mortgage Bankers Association

Mortgage Refinancing Index

0

2000

4000

6000

8000

10000

Jan-95

Oct-95

Jul-96

Apr-97

Jan-98

Oct-98

Jul-99

Apr-00

Jan-01

Oct-01

Jul-02

Apr-03

Jan-04

Oct-04

… home equity lending surged

Home Equity Borrowing

0

50

100

150

200

250

98 99 00 01 02 03 04

* Annualized Source: Federal Reserve, Z-1

…enabling the mortgage finance bubble to keep going

Total Mortgage Borrowing

0.00

100.00

200.00

300.00

400.00

500.00

600.00

700.00

800.00

98 99 00 01 02 03 04

All Other

Home Equity Borrowing

Source: Federal Reserve, Z-1

$ Billions

New & Existing Home Sales1969 - 2004

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03

Source: Nat'l Assoc. of Realtors

Millions of Units

Bubble!

The physical evidence of the bubble is obvious

For another view of the mortgage bubble, consider the dollars involved

Transaction Value of New & Existing Home Sales ($billions, thru Jan. '05)

200

400

600

800

1000

1200

1400

1600

1800

2000

Jan-90 Oct-91 Jul-93 Apr-95 Jan-97 Oct-98 Jul-00 Apr-02 Jan-04

Source data: National Assoc. of Realtors, Census Bureau

New Homes SalesExisting Home Sales

Annualized new + existing home sales x mean sales price

Meanwhile, the mortgage bubble squeezes consumer income

Fed's Financial Obligation Ratio - HomeownersMarch '80 - Sept. '04

13

14

15

16

17

Mar-80

May-82

Jul-84

Sep-86

Nov-88

Jan-91

Mar-93

May-95

Jul-97

Sep-99

Nov-01

Jan-04

Includes consumer and mortgage debt. Source: Federal Reserve

Refi booms: a help, not a cure

Fed's estimate of debt service to disposable income

Household Debt as % of GDP

40%

45%

50%

55%

60%

65%

70%

75%

80%

85%

70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04*

*Q3 2004 debt, 2004 GDP Source: Federal Reserve Z-1, Bureau of Economic Analysis

And balance sheets bear the burden of excess

Despite credit-induced ‘wealth creation’ consumers are more leveraged to housing than ever

Home Equity as Percent of Home Market Value1965 - Q3 2004

50

55

60

65

70

75

65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03

Source: Fed's Z-1

%

From the previous pages it’s clear that the credit bubble is ongoing. The Fed’s aggressive posture simply shifted the stock bubble to new sectors. Asset price inflation, which is dependent on credit, continued and has crept back into the stock market as well.

What happens when the credit bubble bursts?

Savings RateSavings as % of disposable income, Q1 '90 - Q4 '04

0

2

4

6

8

Mar-90 Dec-91 Sep-93 Jun-95 Mar-97 Dec-98 Sep-00 Jun-02 Mar-04

Source: Bureau of Economic Analysis

%

What will drive the economy once the desire to save returns?

Greenspan once had it right about how credit booms can distort an economy: “The excess credit which the Fed pumped into the economy

spilled over into the stock market - triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in braking the boom. But it was too late: by 1929 the speculative imbalances had become so overwhelming that the attempt precipitated a sharp retrenching and a constant demoralizing of business confidence.”

Alan Greenspan, Gold and Economic Freedom, 1966

Have we had our bear market?

Valuations never reached “bear market” levels

The following charts reveal that stocks remain expensive by a number of measures.

Dividend yields unattractive

S&P Composite Dividend Yield (%)1871 - 2004

0

1

2

3

4

5

6

7

8

9

10

1871 1883 1895 1907 1919 1931 1943 1955 1967 1979 1991 2003

Source: Global Financial Data

Stocks look pricey relative to gold

Dow to GoldDow Jones Industrials divided by Gold Price

1920 - 2004

$0.00

$5.00

$10.00

$15.00

$20.00

$25.00

$30.00

$35.00

$40.00

1920 1928 1936 1944 1952 1960 1968 1976 1984 1992 2000

Stock mania

Stock mania

Gold mania

S&

P In

du

str

ials

pri

ce

to

bo

ok

va

lue

Bond yield/stock yieldSource: Elliott Wave International

We are here!

This chart combines price-to-book with dividend yield

Even over long periods, high PEs result in sub-par returns

S&P 500 PE = 20 as of Mar. 2005 Source: Crestmont Research

Poorest return decile burdened by periods with high starting P-Es

20-Year Rolling Returns of the Dow,

Ave. Return Ave. PEDecile For Decile at Start

1 1.20% 4.50% 3.20% 192 4.50% 5.20% 4.90% 183 5.20% 5.40% 5.30% 134 5.40% 5.80% 5.50% 125 5.90% 7.20% 6.50% 156 7.20% 8.80% 8.10% 167 9.00% 9.30% 9.20% 168 9.40% 10.80% 10.20% 129 11.00% 11.90% 11.70% 12

10 11.90% 15.00% 13.40% 10

1919-2003, Ranked by Decile

Total ReturnsRange of

Net Cash Flows into U.S. domestic equity mutual funds:

1995 – 2001: +$1,256 billion2002: -$28 billion 2003: +$152 billion2004: +$177 billion

Still no capitulation that typically follows a Super Bull

Source: Investment Company Institute

History has taught us:

Long bear markets are a natural outgrowth of long bull markets

Stocks remain expensive. Even if earnings grow at historic rates, stocks could provide poor returns over the next 5-10 years.

Credit is the driver of speculative manias. Historically, once credit becomes less available, asset prices suffer.

What could burst the credit bubble?

Higher interest rates

Credit creators become less willing to lend (delinquencies rise, spreads collapse)

Creditors become less able to lend (Regulators continue to constrain Fannie & Freddie)

Debt service becomes a drag on economy

Financial accident (hedge fund “blow up,” bank failure, market panic, derivatives incident)

Less foreign (& central bank) enthusiasm for US securities.

Are we nuts ?

Goldman Sachs Economist

“The FED should have done more to prevent the tech-stock bubble from getting too big in ‘98 & ‘99. The Fed should have raised interest rates in 1996-99 to fight asset price inflation. After all, with the benefit of hindsight, it’s pretty obvious that billions of dollars of investment spending have simply been wasted, Fiscal policy was too loose and so was Alan Greenspan's mouth. Greenspan may have helped investors abandon their caution with his enthusiastic endorsement of the new economy paradigm, Fed officials should view their job more broadly--not just to prevent inflation pressures, but also to prevent other types of economic imbalances that threaten the economy's stability.”

Bill Dudley, Goldman Sachs 8/27/01

The Bubble Trouble Remains

“Since early 2000, the US has gone through a mild recession and the most anemic recovery on record. Over that same period, America’s net national saving rate has plunged to a record low, the household sector debt ratio has risen to an all-time high, and the US current account has gone deeper into deficit than ever. All this smacks of a US economy that is living far beyond its means, as those means are delineated by domestic income generation. Far from purging the excesses of the late 1990s, the United States has upped the ante on structural imbalances as never before.”

Stephen Roach, Morgan Stanley 9/2/03

Conclusions

• Expanding money/credit simply attempts to re-ignite the bubble, problem is too much debt, not too little

• If money growth was the key to economic growth, then Latin America would be the world’s leader

• Constraints are now inflation, exchange rates, current account deficit and credit quality.

• Economy hasn’t crashed due to reckless mortgage growth that’s fueled a real estate bubble

• Once more credit no longer helps, you get “pushing on a string.” We’ll be lucky with Japan’s outcome

Historically, asset prices suffer when a credit crunch takes hold

Some Optimism …

“The world is a resilient place. And America stands for a special resilience and resolve that has shaped its destiny for 225 years. I have no doubt that the United States will weather this storm and come out the other side with an even greater sense of renewal and determination. That doesn’t mean it will be easy. Yet as day follows night, healing follows pain. And recovery will eventually also follow recession. This time is no different. Sadly, it’s just a lot more painful.”

Stephen Roach

End