The Difference Between Secular and Cyclical Bear Markets

Let's start with the definitions of secular and cyclical bear markets.

To me, a secular bear market is a decline in the major stock averages of at least 40% – and considerably more in secondary stocks – where the decline lasts at least three to five years. The fall is then followed by a long hangover that drags on for a number of years as the excesses are purged. There can be cyclical bull markets during this period, but it will be a long time before a new secular bull market begins in which the popular averages exceed the old highs and climb toward new peaks. By contrast, a cyclical bear market is a fall of at least 15% but less than 40% that rarely lasts more than a year. Apanic is a very short, sharp break.

Length is an important part of the secular bear market definition, because time and sustained pain are what alter behavior patterns and change society. By these definitions, I count two secular bear markets in the United States in the past century (1929 to 1938 and 1969 to 1974), at least three panics (1916, 1929, 1987), and 25 garden-variety cyclical bear markets.

The long cycles in the U.S. equity market in the last century could be defined like this: 1921 to 1929, secular bull market; 1929 to 1949, secular bear; 1949 to 1966, secular bull; 1966 to 1982, secular bear; 1982 to 2000, secular bull. I think it is obvious that a new secular bear market began in 2000, and that we are now in a cyclical bull market rally in the hangover period. The two big issues are: Have we seen the lows of this secular bear market, and what will be its duration?

I think we have seen the lows, but I keep remembering Japan and the long, cruel, secular bear market that still is grinding on almost 15 years later. As the years went by, the Japanese market kept having short, sharp, cyclical bull market rallies, but each one was a sucker rally that was eventually followed by a further decline to new lows.

A number of professionals I respect a lot, such as Jeremy Grantham, David Swensen, and Ned Davis, believe that U.S. equities eventually will break through the lows of the fall of 2002 and the spring of 2003. Before it's over, they look for levels of around 600 on the S&P 500 and maybe 6,000 on the Dow Jones Industrial Average. That's roughly down 45% from today.

The bears argue Nasdaq is impeccably following the classic burst bubble pattern. I agree. Nasdaq won't see its year 2000 summits for years. But so what? The Nifty Fifty, Nasdaq's 1970s look-alike, took a decade to recover, too. That doesn't mean the world equity markets are going to new lows or that other markets can't prosper.

The bears also say they worry most about derivatives and their fat tails. Nobody really knows how dangerous the derivatives overhang is. All anybody knows is that there is a $2 trillion liability out there that is opaque from the outside and probably from the inside as well. Wringing their hands, the doomsayers wail that derivatives are a huge tumor inexorably growing day by day like a cancerous lump in the world's gut. By definition, it is true that derivatives, which are designed to mitigate specific risk, at the same time may actually be increasing systemic risk because every major financial institution is entwined in the web. The collapse of LTCM gave us a frightening glimpse into the financial devastation that can result from a death spiral of risk taking. It also proved that the greatest mathematicians and geniuses in the world are far from infallible in their ability to compute and manage risk.

But what are you as an investor going to do about the apocalypse risk? The right thing to do has been always to bet against a return to the Dark Ages and not worry about hedging the unknowable.

How long it will be this time before stocks begin a true, new secular bull market is very difficult to guess. The conditions for such a renaissance are that money should be cheap and amply available, the debt structure should be deflated, there should be pent-up demand for goods and services, and, probably most important, stocks should be clearly cheap based on absolutevaluation measures.

Today, money is cheap and available, but the other conditions are not in place. United States equities are far from cheap, but, considering the level of interest rates and inflation, they are not expensive, either. Who knows how long it will be before the Dow and the S&P exceed their 2000 highs, and what about the Nasdaq? The world economy, led by China and India, could grow a lot faster than all the dirigists now think. I also recall all too well the agonizing, extended hangover from the secular bear market of the early 1970s. The U.S. equity market wandered up and down in a relatively narrow range for years.

What itches uncomfortably in the back of my mind is that the stock market bubble in the United States and the rest of the world in the 1990s had more pervasive excesses than most of the bubbles that preceded earlier busts. Nevertheless, so far we haven't had anywhere near the distress of the late 1970s or the pain that Japan has experienced. Even after the rally in 2005, Japanese equities are still down 70% from their peak. Japanese real estate prices have declined 50% and have only just begun to stabilize, and the assets of the Japanese equity mutual fund business have fallen by 95% from their peak in 1990. That's what a secular bear market does to the financial services industry. Imagine what would happen to the massive U.S. financial services industry if that happened here! And what would be the impact of a 50% decline in prime commercial real estate?

Secular bear markets in the past have always taken valuations back to the levels at which the preceding bull market started, or even lower. Price to book value is the most stable measure of value, because it is not sensitive to the cyclical swings of the economy as all measures of earnings are.

Take Japan. The roaring bull market and then the craziness of the bubble took the price to book ratio to over five times; now almost 15 years later, it has fallen to 1.5 times, which is about where it started way back in 1975. At the peak in 2000, the United States also sold at almost five times book. Today it is about 2.9 times.

Good investing,

Barton Biggs