As we discussed in 2013: Year in Review, the past year was kind to equity investors, particularly those invested in US stocks. 2013 was the best year for the S&P 500 since 1997, thanks to record corporate earnings, increased confidence among investors and consumers, and record low levels of debt obligations for Americans. Quantitative easing, on the other hand, is not (in our opinion) driving appreciation in the US stock market, no matter what you hear on CNBC or from your friends. But with the S&P 500 surging well past its pre-recession high of 1,560, people are wondering: Is this just a cyclical bull market within a secular bear market that has yet to end, or are we now in the early stages of a long, secular bull market?
Beginning of a bull or a bubble waiting to burst?
A secular market cycle occurs over a longish period of time, typically 10 to 30 years. From late 1998 to early 2009 we were in a secular bear market for stocks, just as we were in a secular bull market from late 1982 to early 2000. Cyclical market cycles are shorter, typically 3 to 7 years, and occur within secular market cycles. For example, within the most recent secular bear market was an undeniable cyclical bull market from 2003-2007. Back then people speculated that we were already starting a new secular bull market, after stocks rose from the ashes of the dot-com collapse and the fall of Enron. But once housing prices and the credit markets went down the tubes, it became clear that bearish days lay ahead.
To many investors, the past 4 years feels like 2003-2007 all over again—a cyclical bull market head fake within a secular bear market that has yet to end. Some people are waiting for the next “bubble” to burst while others think the stock market is being “artificially” inflated by QE dollars and will deflate when the Fed finishes tapering. There are some who believe that rampant inflation will debase our currency and punish stock investors, and of course there are those who argue that the market is “due” for a major drop after four years of strong returns.
While the “doom and gloomers” shout ever louder even as their ranks dwindle, more investors are starting to believe that we are in the early years of a long, secular bull market. While we neither agree nor disagree with this assessment, as we prefer to avoid predicting the future, we do think there are some compelling arguments to be made for the secular bull case. One of the strongest is the flow of money into and out of mutual funds, which is a good proxy for how individual investors (the “dumb” money) are allocating their funds.
Typically, non-professional investors “chase performance,” buying what has recently done well and selling the underperformers. Because investment performance tends to “revert to the mean” (meaning both over- and underperformance tend to average out over time), these amateurs end up buying high and selling low. Thus, doing the opposite can often be a lucrative strategy.
True to form, individual investors have recently been shooting themselves in the foot. According to TrimTabs, which follows money flows, investors moved $1.2 trillion into bond funds from late 2006 through the end of 2012, while simultaneously taking $600 billion out of equity funds over the same period. While bond investors initially did well, they finally got creamed in 2013 as interest rates rose sharply. As it will probably turn out in retrospect, last year was the end of the longest secular bond bull market in history, one that began in 1982 and lasted nearly 31 years. Not surprisingly, individual investors jumped most heavily into bonds during the final 20% of this great bull market.
If 2009 represented the start of a new secular bull market for stocks, individual investors are behaving as expected. It wasn’t until last year that amateurs started buying stocks and selling bonds, 4 years after the S&P 500 bottomed and subsequently rose +150%. But it was a trickle rather than a deluge: in 2013, investors bought about $352 billion of equity mutual funds (and ETFs) while selling about $86 billion of bond funds. That $86 billion represents only 7% of the amount that flowed into bonds over the past 6 years, while the $352 billion in stock purchases only puts these investors halfway back to where they were in 2006.
After watching their beloved bonds return +25% during the same 4 years that stocks grew +150%, and lose -2% in 2013 while US stocks gained +32%, the “Great Rotation” from bonds into stocks may finally have begun. Demand from funds shifting from bonds into stocks—along with money moving from low-yielding bank deposits (which alone have grown about $3 trillion in the past 5 years) into riskier investments—could continue to propel the stock market for many years to come. In addition, as the economy continues to improve, investors will be earning ever more cash that will eventually need to find a home, with stocks continuing to gain favor over bonds.
Keep expecting the unexpected
We can speculate on the future of the stock market and the economy all we want, and the truth is that no single indicator or event is going to determine what happens from here. It will be a series of events that shape the future, some of which are not only unknown but also unforeseeable. There will probably be more natural disasters and foreign debt problems over the next decade of two, just as there will be more earnings surprises in both directions that will move stock prices.
We will continue to monitor the events of 2014 keep you posted on the most important ones as they transpire, and we hope you’ll direct any questions, comments or suggestions our way so we can continue delivering information that is of value to you as you make important financial decisions.
Until next week,
Dr. Ken Waltzer MD, MPH, AIF®, CFA, CFP®
Founder and President – Kenfield Capital Strategies (KCS)
Director of Business Development – Kenfield Capital Strategies (KCS)
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