Thus, my definitions of bull and bear markets are as follows:
• Secular bull market: This is an extended period of time, typically 10 to 20 years, driven by broad economic shifts that create an environment conducive to rising corporate revenues and earnings. Market volatility tends to decrease. Its most dominant feature is the increasing willingness of investors to pay more and more for a dollar of earnings as the bull market progresses.
• Secular bear market: This reflects the opposite: After an extended secular bull run, it is a period marked by increased volatility, frequent cyclical rallies and retreats in an economically challenging environment. The dominant feature is that investors become less and less willing to pay for that same dollar of earnings.
The two factors missing from the percentage-only definition are the broader secular underpinnings and the idea of earnings multiple expansion or contraction.
As we have noted before about secular economic cycles:
Waves of industrial, technological and economic progress make their way into employees’ wages, consumers’ pockets and corporate profits. Improving standards of living are reflected in the psychology of an era. Not surprisingly, markets do well, as investors become willing to pay more for a dollar of earnings as the cycle progresses. Multiple expansion, in the form of rising price-to-earnings ratios, drives returns even more than rising profits.
Hence, these are not short-lived and modest phenomena, and they instead represent significant society-wide changes. Think about the 20 years after World War II, or the tech era of the 1980s and 1990s. Both were 20-year-long booms with similar characteristics.
It is also why I have repeatedly argued that it isn’t the valuation of markets that is so important, but rather, which direction earnings ratios are moving.
When we look at the sources of market gains, earnings improvements are often a much smaller factor than multiple expansion. By my estimates, three-quarters of the gains of the 1982-2000 bull market may be attributable to rising price-to-earnings ratios. At the start of that bull market, the S&P 500 earnings in inflation-adjusted dollars for the year were $31.72 as of Dec 31, 1982; 18 years later, at the end of the bull market, they had more than doubled to 70.39. But during the same period of time, the broad indexes gained 1,000 percent. The P/E ratio for the index was about seven at the start of that cycle, and ended at about 34. Most of the market’s gains were attributable to the psychology of paying more for the same dollar of earnings, not rising corporate earnings.
People who are perplexed by a market that keeps rising -- despite the usual wall of worry -- should look at the psychology underlying this expansion. Bear markets begin when this psychology eventually begins to shift. So pay attention to what is actually driving markets in this period, and not the pundits.
This column was provided by Bloomberg News.