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By Patrick McKeough  | Wednesday, January 29, 2014

Well-known for his four investment newsletters, his TV and radio commentary, and as a best-selling author, Pat McKeough is also a portfolio manager. For two decades he has been providing advice and guidance to a group of Canadian investors through his Successful Investor Wealth Management service. Pat and his team of experts handle hundreds of millions of dollars for their clients. He also issues quarterly reports on the state of the markets and what his clients can expect in the months ahead.

We have secured permission to publish the most recent of those quarterly reports, Patís analysis of the secular bull market weíre currently going through.

"In my last couple of quarterly letters, I talked about my belief that weíre in a secular bull market. This is a long-term stock-market rise that carries the market to successively higher levels over a period of a decade or two, if not longer.

Secular bull markets generally start after a period of financial distress, when many investors feel at least somewhat negative toward the stock market. This period of financial distress may have lasted up to a decade, or longer. Itís a time when corporate earnings are weak or irregular, and investors assume they will stay that way indefinitely. Investor sentiment becomes extremely negative, and investors take it for granted that the market may be headed for another big downturn. The secular bull market begins around the time when investors begin to swing back to a more positive view of the stock market.

We entered a period of financial distress like this around the end of the 1990s, with the Y2K scare, followed by 9/11, the war in Afghanistan and Iraq, and the financial crisis that hit later in the 2000s. Iíd say we are just starting to pull out of it.

A secular bull market lasts a long time because it is related to or grows out of a long depressed period. In contrast, a typical bull market only lasts two to four years. Thatís because the typical bull market is related to or grows out of a typical business cycle, which generally lasts around four years.

Iíd say the current secular bull market (assuming thatís what it is) began around March 2009. Thatís when stock prices generally hit bottom and began rising in Canada and the U.S. At that time, the market had been going sideways in a wide range for nearly a decade; prices had dropped by roughly half from the peak of a couple of years earlier. Investment sentiment in March 2009 was as negative as Iíve seen it, going back to the early 1970s.

If we are in a secular bull market as I believe, stock prices are likely to keep on rising till 2020. Weíll still see market setbacks along the way, of course. But when the setbacks end, we can expect prices to recover quickly and go on to record highs.

As I said earlier, the new secular bull market is my working hypothesis, not a prediction. After all, nobody can predict the future. A prediction is nothing more than a deeply held opinion. Making predictions can backfire, because it can involve your ego and spur you to fall in love with your own opinions. This can keep you from considering alternate possibilities.

Itís far better to keep an open mind. That way youíll stay alert for new data or new ideas that may challenge your working hypothesis.

Stocks continue to act as if theyíre in a secular bull market, if only by going up and surprising many investors. The U.S. stock market has hit a series of all-time highs in recent months, after surpassing its 2007 peak earlier this year.

Resources sector holds our market back

The Canadian stock market has lagged behind the U.S. market. However, it recently hit its highest level since summer 2011. But it remains below its peak of spring 2011, and even further below the all-time peak it hit in summer 2007.

Our marketís relative weakness probably grows out of the fact that Canada is more dependent than the U.S. is on resource prices. Prices of many metals and grains began moving up, along with stock prices, after the stock market hit bottom in 2009. But modest economic growth since then has undermined the commodities markets. Without rapid economic growth, businesses have no reason to stockpile commodities. Instead, they are focusing on cost cuts to improve profits. These cost-cutting efforts often result in more efficient use of commodities, and this cuts into commodity demand.

Further along in the economic expansion, demand for commodities will probably expand. Thatís likely to spur a faster rise in the Canadian economy and stock market.

Pessimism persists for years

One key factor in a secular bull market is that stock prices rise faster and longer than most investors expect. Often the market manages to out-perform the general level of expectations for years.

After World War Two, in the final years of the 1940s, people assumed that when Canada and the U.S. demobilized their armed forces, returning soldiers would flood labour markets and drive wage rates down to pre-war levels. They braced themselves for a resumption of the 1930s Depression. Instead, the reverse happened.

Soon after the soldiers came home, they married and began having children. This was the start of the Baby Boom, which ignited a continent-wide boom in home construction and consumer-goods manufacturing. Instead of a postwar depression, North America experienced a post-war boom. The boom lasted until the end of the 1960s, and spurred a six-fold rise in stock prices by 1965.

The stock market then went into a wide-ranging, 17-year sideways trend. Economic growth was irregular in those years, interest rates and unemployment stayed high, and gold soared.

Pessimists were skeptical when the market began shooting up in the summer of 1982. They assumed it was just another temporary price rally that would soon fade, like all previous rallies since the mid-1960s. After all, interest rates remained extremely high. President Reagan, elected in 1980, had pushed through a series of tax cuts that were bound to push the U.S. budget deficit to terrifying new heights. A fierce war was underway between Iraq and Iran and it threatened to spread and cut off Mideast oil exports. The Soviet war in Afghanistan also seemed to raise the risk of conflict between the U.S. and the Soviets. But a secular bull market began that summer and continued till the end of the 1990s.

Keep in mind, however, that the market still goes through sudden, unpredictable downturns, even in the midst of a secular bull market. In fact, on Monday, October 19, 1987, the Dow Jones Industrial Average dropped more than 22%. This was the biggest one-day stock-price plunge in history. That day was five years after the start of the 1982-1999 secular bull market.

In all, the 1987 market drop took the Dow Jones Industrials down by 36.6%, from 2,750 in September, 1987 to around 1,750 by the end of that year. But, as generally happens in a secular bull market, prices soon began rebounding. The index hit a new high in September, 1989, two years after the 1987 peak.

Though it included some investor-rattling moments, the 1982-1999 secular bull market spurred a 15-fold rise in stock prices.

If this is a secular bull market, itís following the usual pattern

The rise in the stock market in the past few months seems to have surprised a lot of pessimists. Iíve seen a string of articles with a negative outlook. They claim to show how the market has gone up too far, too fast; that stock prices are expensive in comparison with past times similar to today; that stock buyers are deluding themselves with unrealistically high expectations; and that investors fail to understand whatís likely to happen when the Federal Reserve quits buying bonds and allows U.S. interest rates to go up.

A lot of these arguments are based on anecdotes. For instance, the p/e on the Standard & Poorís 500 Index moved up this year due to a combination of rising stock prices and some shrinkage in 2013 earnings estimates. But the current p/e is still only 15.2, compared to the 50-year average of 14.0.

Some pessimists draw negative conclusions out of the high level of investor enthusiasm for Twitter Inc. Twitter came out at $26 a share on November 7 this year as a new stock issue. It hit $50 on its first day of trading. (It ended its first day at $44.94, a gain of 73% from the issue price.) The pessimists take any investor enthusiasm as a sign of a new bubble in the market. However, some investors are always willing to pay high prices to be first to buy revolutionary new stock issues. Their zeal doesnít say anything about the market as a whole.

In its day, Netscape Communications seemed as revolutionary as Twitter seems today. The company developed the first widely used web browser, Netscape Navigator.

Netscape was going to begin trading at $14 when it came on the market as a new issue. After a last-minute consultation, the underwriting brokers decided to double the price to $28. Even that proved too low. The stock got as high as $75 on its first day of trading, and ended the day at $58.25. This was back in August, 1995, more than four years before the end of the last secular bull market.

In October the following year, Federal Reserve Board Chairman Alan Greenspan made headlines when he said in a speech that investors were showing "irrational exuberance" for stocks. But the secular bull market still had three years of life left in it.

Low expectations get to be a habit

A pessimistic mindset is natural in the early years of a secular bull market. When the stock market stays in a wide-ranging sideways trend for a dozen years or so, as it did from 1999 through 2011, observers get used to the idea that stocks will continue to move sideways. Expectations tend to remain low, long after the market comes out of a period of weak performance.

In the course of a secular bull market, stocks on the whole go from extremely low valuations to extremely high ones. In the early years of the 1982-1999 secular bull market, many high-quality stocks traded at 10 times earnings or less. Only gold stocks traded at extremely high prices, and stock market speculation was relatively rare. By the end of that rise, lots of extremely ordinary stocks traded at 30 or more times earnings. Moreover, the Internet stock mania was underway by the late 1990s. Lots of Internet start-ups had market capitalizations (total value of all stock outstanding) in the hundreds of millions or even billions of dollars.

Itís clear in retrospect that stocks were cheap in March 2009, when I think we entered a secular bull market. Prices since then have risen by 200% to 300% in many cases. Even now, I think stocks are reasonably priced, just by historical comparisons. They are extremely cheap in light of todayís low interest rates.

Interest rates will move up again one day. But thatís only likely to happen when economic growth speeds up and businesses begin borrowing to expand. As that happens, stock prices are likely to move up too, in response to the improving economy. Before the secular bull market ends, stock prices are likely to have moved up into extremely high valuations.

Selling too early kills your returns

In any bull market, conservative investors often wind up selling their best stocks way too early. Often they do so because their stocks seem to have gone up "too far, too fast", or because "I can buy it back on a dip", or because "theyíre no longer cheap". These are all bad reasons to sell.

Thereís a large random element in all stock-price changes. When it seems to you that stocks have gone up "too far, too fast", it may mean youíre mistaken about how far or fast they should go up. You may be unaware of good things that are going on out of sight and raising their value. Perhaps these things have already happened, and the stock is going up as the news spreads.

In a secular bull market, "theyíre no longer cheap" is a particularly insidious rationale for selling. As Iíve mentioned, most stocks are cheap at the start of a secular bull market. As time passes and the rise continues, investors get more confident. A virtuous circle develops. Investors are willing to pay ever higher prices for earnings, sales and improving prospects, and this leads to higher levels of earnings, sales and prospects, pushing investor confidence and stock prices higher still. Eventually the fun ends, of course, but conservative investors tend to under-estimate how long it can last.

If you sell when stocks are simply "no longer cheap" (or are "fully priced," as a broker might put it), you will miss out on a lot of profit."

© 2014 by Successful Investor Wealth Management Inc. All rights reserved.

Pat McKeough is President of Successful Investor Wealth Management Inc., a professional portfolio management service based in Toronto. The foregoing is for general information purposes only and is the opinion of the writer. Any investments mentioned carry risk of loss, and no guarantee of investment performance is made or implied. It is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.

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