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Welcome to Another Lost Decade


How to play this one a little smarter.

The stock market's performance over the next decade will be very similar to the one since 2000 -- the Wall Street Journal appropriately named it "the lost decade."

Stocks will go up and down (setting all-time highs and multiyear lows), stagnate, and trade in a tight range. At the end of this wild ride, when the excitement subsides and the dust settles, index investors and buy-and-hold stock collectors will find themselves not far from where they started in 2000.

Welcome to secular (long-lasting) range-bound markets or, in the tradition of giving pet names to market cycles, what I call the Cowardly Lion market, whose occasional bursts of bravery lead to stock appreciation, but are ultimately overrun by fear that leads to a subsequent descent.

Over the last 200 years, every long-lasting bull market (and we just had a supersized one from 1982 to 2000) was followed by a range-bound market that lasted about 15 years or so (the only exception was the Great Depression).

Despite common perception, secular markets spent a lot more time in bull or range-bound phases, roughly half in each, and only visited a bear cage on very rare occasions. This distinction between bear and range-bound markets is seldom made but extremely important, as you'd invest very differently in one versus the other.

Let me explain why this takes place. Though it's hard to observe in the everyday noise, in the long run stock prices are driven by two factors: earnings growth (or decline) and/or price-to-earnings expansion (or contraction). Take a careful look at the two tables and you'll be hard pressed to find an economic metric that was responsible for a stock market cycle.

Though economic fluctuations were responsible for short-term (cyclical) market volatility, as long as longer-term economic performance was not far from the average, secular market cycles were either bull or range-bound. Valuation -- the change in price to earnings, its expansion or contraction -- was mainly responsible for markets being in a bull or range-bound phase.

Prolonged bull markets started with below- and ended with above-average P/Es. This vibrant combination of P/E expansion (a staple of bull markets, a great source of returns) and earnings growth, which doesn't have to be spectacular, just more or less average, brings terrific returns to jubilant investors.

Range-bound markets follow bull markets. As clean-up guys, they rid us of the high P/Es caused by bull markets, taking (reverting) them down toward and actually below the mean. P/E compression (a staple of range-bound markets) and earnings growth work against each other, resulting in zero (or nearly) price appreciation plus dividends, though this is achieved with plenty of cyclical volatility along the way.

The 1982-2000 the bull market ended at the highest P/Es ever! Thus it will take longer for earnings growth to deflate them. Though continued economic growth appears to be a wildly optimistic assumption, given what is taking place in the economy, it's not particularly unrealistic to assume that we'll see nominal economic growth over the next decade. The Fed and our government are working very hard to achieve that, at any cost.

Bear markets are range-bound markets' cousins; they share half of their DNA: high starting valuations. However, where in range-bound markets economic growth helps to soften the blow caused by P/E compression, during secular bear markets the economy isn't there to help. Economic blues (earnings decline) throw water on an already dying fire (the compression of high starting P/Es) and bring devastating results to investors.
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No positions in stocks mentioned.

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