The following Frequently Asked Questions reflect key concepts and details about material on this website, in Unexpected Returns, and in Probable Outcomes.
Frequently Asked Questions
- Several versions of same question: “Did the market P/E get low enough to start another secular bull market?”; “Did P/E stay low enough for long enough to start a secular bull?”; or “Since we’re close to the average length of secular bears, is a secular bull near?”
This appears to be a very active question over the past year. It is 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 be a “secular” cycle, the fundamental driver of the inflation rate must grind P/E higher or lower over an extended period. The result is an extended era–or secular period–of P/E effect on stock prices.
When P/E becomes misaligned with fundamental principles (e.g., financial crises, sudden crashes, euphoric bubbles), the move into misalignment is cyclical and the restoration to general alignment is also cyclical. Cyclical moves occur fairly quickly once the 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:
- Secular cycles are driven by the inflation rate (deflation, price stability, and higher inflation)
- Secular bulls occur when P/E starts low and ends high over an extended period
- Secular bears occur when P/E starts high and ends low over an extended period
- Cyclical bulls and bears are interim periods of directional swings within secular periods
- Cyclical cycles are driven by market psychology, illiquidity, or other generally temporary condition(s)
- Time is irrelevant to the length of secular stock market cycles
- Secular bulls require a doubling or tripling of P/E
- Secular bears occur as P/E stalls and falls by one-third to two-thirds or more
- 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
- If economic growth shifts upward or downward for the foreseeable future, the natural range moves upward or downward, respectively
- Inflation drives P/Es location within the range; economic growth drives the level of the range
- 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 stays in crisis for a week or 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 the 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. Even though it spent time near 10, it no longer is positioned for a secular bull. A secular bull cannot start from high P/Es–it requires a doubling or tripling of P/E over time to create the effect of a secular bull.
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 has taken 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 touching-base below average–even if quickly recovered–enables a secular bull era. The missing link is that P/E must be positioned to double or triple to produce a secular bull. A drained pond now refilled is not safe to walk across!
- What are the lessons for today’s investors from the Crestmont Stock Market Matrix?
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 compared to what they did 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.
- What are the messages of the Crestmont Stock Market Matrix?
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 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 it. The Crestmont Matrix reveals a heat map of returns that tells the story of calm blue average returns over the long-term, yet 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 relate 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 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 than the past. Stock market history repeats itself, with slight 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. Alternatively, for example, breaking-even in the stock market during deflation can provide better purchasing power than positive returns that don’t keep up with inflation.
- What led to creating the Crestmont Stock Market Matrix?
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. The objective, in the summer of 2001, 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 does it distort 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 has the risk of providing invalid information.
After many long hours, a detailed presentation was developed. Rather than looking at one date in the distant past, every decade was chosen as a starting point. 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 a 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?”
Responding 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 have been downloaded from CrestmontResearch.com.
- Just one more question. I'm really having trouble understanding why higher inflation pushes down P/E...
Inflation can be somewhat of a phenomenon. We talk about inflation whenever prices go up, but not all price increases are inflation. When the price of one or a few things go up, it’s just a price increase. When the aggregate price of everything that you buy increases, then it’s generally caused by inflation. Inflation occurs when the federal government prints more money than there are goods in the economy. The result is that the prices of things adjust upward to reflect the loss of money 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 go up as inflation rises and fall as inflation declines. This is why bond prices and yields rise and fall as the expected inflation rate changes.
Bonds are financial securities that pay interest over time. For example, a $100 bond with the interest rate of 5% pays $5 per year throughout its term. When market interest rates, as driven by inflation, are 5% then the bond is worth $100. But what happens when inflation rises and market interest rates go to 10%? Well the bond is not worth as much. Actually, the price of the bond declines so that the $5 interest payment and the $100 maturity value will yield 10% over the life of the bond. 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. The result between bonds prices and inflation is a fundamental relationship driven by principles of finance.
Now let’s consider the stock market. Stocks are also financial assets. They often pay dividends from earnings quarterly or retain the earnings to build more value in the future. Either way, stocks are financial assets with a value today that is based upon future cash flows. And just like bonds, when inflation rises the value of stocks today fall 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 in order to receive a higher return to compensate for inflation. Conversely, falling inflation drives stock prices and P/E higher.
When the inflation rate falls to deflation, there’s another financial principle that causes P/E to fall. But we’ll save that for another day.
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 (1930s), but we’re saving that for another day…) 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 known as The Y Curve Effect (both charts are available on the Crestmont Research website in the Stock Market section).
- I am interested in purchasing Probable Outcomes. My question is if you feel it is necessary to read Unexpected Returns first, or if Probable Outcomes is essentially an updated version of Unexpected Returns.
Probable Outcomes was written to stand alone, but depending upon your familiarity with the topics, Unexpected Returns can be a preferable start for someone that 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 more specific to the reasonable outlooks for the stock market over this decade.
Are you familiar with the concepts of P/E (as a measure of valuation in the market), inflation (as a driver of interest rates and bond yields and other financial assets), market volatility (the concept of erratic swings and up and down days), and similar concepts?
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 is a revisit of the primary concepts from Unexpected Returns to refresh prior readers or to inform those that did not read it. Some people that read Probable Outcomes first may choose to then read Unexpected Returns since it provides concepts that were not included in Probable Outcomes and will further enhance a reader’s understanding of the concepts. Some recent readers of Unexpected Returns have found it help to put the messages into perspective by reflecting upon the period since then—like reading an analyst’s report years after it was written when it can be contrasted with history. Neither book, however, provides a forecast…but rather they provide the concepts and insights to enable readers to understand the 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.”