Is This Bull Cyclical or Secular?

By TOM LAURICELLA Many investors are now calling the rebound in stocks since early March the start of a new bull market. But it could be only a temporary respite from a longer-term bear market dating back to the beginning of this decade. If the market is poised for a multiyear run, investors can be more aggressive about diving into stocks. If the bear market will regain its grip on stocks and send prices lower again, investors need to be cautious. Historical data and the still struggling economy seem to point to the latter case, called a cyclical bull market in a secular bear market. For now, stocks are fully in bull-market territory, even if it doesn't feel that way given the losses that many investors are still nursing. After falling 33.8% last year, the Dow Jones Industrial Average finished last week 34% above its 12-year closing low on March 9. The Standard & Poor's 500-stock index is up nearly 40% from its low on that date. The traditional definition of a bull market is a 20% gain from a low point and a bear market is a 20% decline from a high. But the Dow remains 38% below its record close in October 2007, and the S&P is nearly 40% below its record. Even those who believe a more stable economy and lots of cash sitting on the sidelines will send the market higher remain cautious. "We have some very substantial headwinds on the economic front," says David Pedowitz, a senior portfolio manager at Neuberger Berman. Consumer spending is strained and there is significant excess capacity in the manufacturing economy, he says. Against that backdrop, expectations may be building for a bigger rebound in profits than will be possible, says Mr. Pedowitz. In late 2001, Ned Davis Research, a market analysis and money-management firm, raised the idea that stocks had entered a secular bear market, a long period of flat or declining stocks. That idea gained traction last autumn as stocks fell below levels of a decade ago. Ned Davis considers this the fourth secular bear market since 1900. The last one, from 1966 to 1982, ended when the Federal Reserve moved to aggressively crush inflation. These "secular" cycles run for long periods; secular bull markets have lasted from six to 24 years and bear markets 13 to 16 years. Within those cycles are many more cyclical bulls and bears -- nearly three dozen of each since 1900. (Ned Davis uses its own criteria for a cyclical bull or bear market, based largely on 30% moves.) During a secular bull market, the cyclical, or shorter, bull markets within them gained 110% on average and lasted nearly three years. Within secular bear markets, however, the gains in cyclical bull markets averaged 64% and generally were over within a year and a half. That could mean the current rally has a little more than a year to run but already has made more than half its gains. Still, stocks may not fall all the way back their lows this March. In the 1970s, for example, stocks hit what turned out to be their low in 1974 but went on to have three more cyclical bear markets before turning higher in 1982. Ned Davis Research says the rise in stocks since March 9 qualifies as a bull market, but doesn't see the most recent low as marking a transition into a new secular rally. That is in part because, according to the firm's calculations, market valuations didn't fall far enough during the sell-off. To calculate price-to-earnings ratios, Ned Davis focuses on as-reported earnings rather than operating profit, which excludes lots of one-time write-offs. In addition, its researchers avoid complications caused by negative earnings, which distort P/E ratios, and focus on the median P/E of the stocks in the S&P 500. On that basis, the S&P fell to a P/E of roughly 12 in early March and is now just shy of 16, which compares to a 40-year median of 16.5. "You compare that to the 1970s where we got down to P/Es below 10 and stayed there until 1982," says Tim Hayes, chief investment strategist at Ned Davis. The current secular bear market, he says, "is mature but it can go on for another several years." It is possible, Mr. Hayes says, that the current bull market will extend into next year but then get derailed by rising interest rates and inflation. Eventually, significantly higher inflation would likely boost earnings but depress stock prices, sending P/Es to the kinds of levels that might mark the beginning of a new secular uptrend. In the meantime, Mr. Hayes says investors may want to focus on what they see as a secular bull market in commodities that has been under way for the past seven to nine years. "We're recommending having some exposure to commodities and gold," he says. For now, at least, those who think this is the beginning of a long-lasting bull market are few and far between. Among them is James Paulsen, chief investment strategist at Wells Capital Management. Mr. Paulsen, who stayed largely optimistic even during the worst of last year's market collapse, in part argues that the U.S. economy is healthier than widely believed and exports will provide a bigger boost than in the past. Neuberger Berman's Mr. Pedowitz, meanwhile, is remaining cautious with part of the money he manages, while another portion is making more aggressive bets. "You want to maintain a balance in the portfolio between defensive and offensive" holdings, he says. He's keeping roughly 15% of his portfolios in cash. "That gives you plenty of capital if the market retreats and some dry powder" should bargains appear. He also has stocks that he counts as defensive, such as Cisco Systems and Oracle, which should profit as companies try to improve their efficiency during a tough economy. He also likes Teva Pharmaceuticals as a firm that he believes will benefit from health-care reform, unlike many other companies in the sector. Then, for the offensive side of his portfolio, Mr. Pedowitz owns J.P. Morgan Chase, along with economically sensitive stocks such as manufacturers Danaher and Roper Industries. It's simply too early to tell whether the March 9 lows were merely a cyclical bull market or the start of a secular bull, says Milton Ezrati, market strategist at Lord Abbett. "That will depend on how durable the economic recovery is," he says. "The jury is still out." But he believes there are opportunities in companies whose stocks do best early in an economic cycle, such as industrials, some commodities and consumer-discretionary stocks. "We can see this rally being sustained, although there could be short-term corrections," Mr. Ezrati says. Some financials make a "good trading play," he says, and could rally as concerns about bad real-estate loans start to fade as the economy stabilizes. However, "there are questions about their fundamental businesses" that could cap gains over the next year or two. Neuberger Berman's Mr. Pedowitz has a word of caution for investors. "Make absolutely sure you have been humbled enough by the markets to know that you can't really tell if this is a cyclical or secular bull market." Write to Tom Lauricella at tom.lauricella@wsj.com