Lost Decades and Bear Market Declines (ver. 1 by Peter Mauthe 052622)

For the past 100 years, the stock market has shown a pattern that is a period of great growth followed by a period of prolonged consolidation. These periods of consolidation have come to be known as “lost decades” since the popular averages tend to have returns only in the 0% to 3% range for a decade or more. These prolonged low returns can be very detrimental to a portfolio based on the buy and hold philosophy. However, these prolonged periods of sideways markets are ideal for many dynamic portfolio management approaches.

The illustration below shows this pattern. If this pattern repeats itself in the near future, we could see the S&P 500 trade in a wide range between approximately 5,000 and 2,000.

The 2 graphs below illustrate a closer view of the previous lost decade for both the S&P 500 and the NASDAQ 100. The top graph of the S&P 500 also illustrates the next bear market could be 60%, the largest since the bear market of 1929. I am building this in as a possibility since historically bear markets have declined to the level that leverage existed in the stock market during the previous bull market leading up to the decline.

In 1929 at the market (as represented by the S&P 500) high, investors were allowed to borrow on margin up to 90% of their stock purchases. When the market declined in 1929, it declined by 90%. The bear markets following that and up through 2003, concluded after approximately a 50% decline. During that period investors were allowed to borrow only 50% on their stock purchases. During the bear market of 2007-2009 the stock market fell by 55%, I believe, because we had built additional leverage into the market beyond the 50% margin leverage. This additional leverage came from options, futures, swaps, and leveraged ETFs.

Since the bear market of 2007-2009, I believe this leverage over and above margin leverage has grown even further. Therefore, I am anticipating the next bear market decline to be approximately 60% for the S&P 500 and 70%, or more, for the NASDAQ 100. If such bear market declines happen, it would not be surprising to see the forward-looking P/E on the S&P 500 get down to 10-12 at the trough of the next bear market.

I think it is also worth noting that in the past 20 years there has been a considerable migration of trading by individuals and institutions in ETFs and mutual funds rather than individual securities. Many of these funds are index-based meaning they are all buying and selling the same underlying stocks. For example, many of the NASDAQ 100 stocks are the largest components of the S&P 500. When investors sell the NASDAQ 100-based funds, they are also selling the largest components of the S&P 500. The reverse is also true.