What long term charts tell us

Asset classes follow long cycles.
Consider stocks for example. Empirical evidence suggests that stocks follow long cycles (called secular cycles) that last many many years, sometimes even more than a decade. We see evidence of secular bull cycles followed by secular bear cycles both lasting for long periods.

A secular bull cycle is a period when stock prices generally rise over time.
A secular bear cycle, in contrast, is a period when stock prices either fluctuate in a broad range (if corporate earnings keep going up) or stock prices go down (if corporate earnings fall).

Each cycle is characterised by a change in the P/E ratio of stocks and the markets as a whole.
In a secular bull cycle, P/E ratios start at low levels and keep rising to end at a absurdly high level. This accompanied with rising corporate profits means a fast rise for prices.
In a secular bear cycle, there is a compression/fall in the P/E ratio of the markets. P/E ratios start at very high levels and keep falling overall till they become very low. If corporate profits rise, they compensate the fall in PE ratios and the markets remain range bound. If profits also fall, it is a double whammy for prices.

How do such cycles start?

Each secular bull cycle starts with low valuations. Markets are really cheap but there is very little interest for the same. There is general apathy and dis-illusionment among people regarding stocks. Trading volumes are low and retail participation is also low. People's savings as a percentage of their total savings is also very low. The secular bull cycle is preceeded by a long secular bear phase where many people have ended up either losing a lot of money or not making anything. The secular bull cycle needs a catalyst to trigger it off.

Each secular bear cycle if the mirror image of a secular bull cycle. It starts off with the end of the secular bull cycle. Valuations get very high. Prices have shown a parabolic upmove. Mass particpation is high, frenzy pervades the markets and people are very optimistic. There are million reasons thrown around as to why "it is different" this time around and why high valuations are justified. It starts off with a big bust in the secular bull cycle.

However, a secular cycle does not mean that prices keep moving up or down all the time. There are counter-cyclical moves that happen on and off within the larger supercycle. Secular bull cycles witness bear markets lasting a while and secular bear cycles witness bull markets that also last a while. But such counter-cyclical moves do not change the direction of the secular cycle.

Let us now look at the long term chart of the stock market to see what it tells us.

The chart for the BSE Sensex from 1979 till June 2008 is shown below.

Despite my efforts to make it clearly visible, the chart does remain a bit hazy. For the original chart, you can go to the following link:

http://www.chartsrus.com/chart.php?image=http://www.sharelynx.com/chartstemp/free/chartind1CRUl.php?ticker=^BSESN

The chart is in log scale so as to bring out the ups and downs better. The X axis represents time and Y axis represents the value of the sensex. You would note that since the chart is in in log scale, the Y axis numbers are spaced unevenly.


We see that from the period 1979 till about 1992, the markets had an upswing marked by some corrections on the way. The sensex went up 42 times or thereabouts in a period of 13 years starting at the value of 100 in 1979 and ending in 4200+ in 1992. i.e a 42+ fold increase in value! This was a secular bull cycle

Even this secular bull cycle was interrupted by bear markets and sharp corrections. There was a bear market that started in 1986 and lasted till 1988 correcting by about 40% or so. Then there was another sharp pullback in 1990 that gave back 30-35% of its value.

Also note that every such bear market has occured after a sharp upmove. I call this a mini-bubble within the overall secular bull market.

From the period of 1992 top till about 2003, the sensex was largely range bound in a secular bear cycle. Note that even secular bear cycles have the occassional bull runs (1993-95, 1997-98, 1999-2000). But each get sold into and the market falls back either back into a range or lower still.

So with little piece of history, let us analyse what is happening currently.

Revisit the chart to see that from mid 2003 onwards, we are in a secular bull cycle again. Recall the mood and the sentiment in 2003, recall the valuations then and recall the period before 2003. Conditions were ripe for a secular bull cycle and that is exactly what we have seen.

Prices have been generally up since 2003. Prices broke out of the broad range establised between 1992-2003. Valuations also rose in PE terms. Participation has increased. The bull cycle was interrupted by corrections in 2004 and 2006, but that did not change the general direction of the market, which was up. Each time the markets made a new high. This was also characterised by high earnings growth of Indian corporates.

Note however that in 2008, this secular cycle has been interrupted by a bear market. In January 2008, valuations hit a mini-bubble level. People were enthusiastic about stocks and prices were rising very sharply. Everything looked rosy and the stage for a bear market was set. And we have got a counter-cyclical bear market within a secular bull cycle.

Why is it only counter cyclical and why does this not signal the end of the secular bull run? Because valuations got 'only' to mini-bubble levels and not to totally absurd levels. Participation was nowhere as high as is witnessed at the end of a secular cycle. There was some frenzy but not a total mania.

Markets will peak out and the current secular bull cycle will end when earnings growth peaks out as also expectations of earnings growth peak out. This has some distance to go, maybe 6-8 years or so, who knows. Going by history, we could see much higher levels, even to the tune of 50000+ on the sensex before the markets peak out in this secular cycle.

So what about the current bear market? How long could it last and how low can it go?

Looking at previous bear markets, it could last for 2 years or so. So assuming it started in Jan 2008, it could go on till end of 2009. It would start exactly the way a secular bull market starts, though in a lesser degree. People would need to give up hope and lose interest in stocks for the secular bull run to resume again. Right now, there is too much hope among the retail investors that we could see the resumption soon, just as we saw it in 2004 and 2006.

How low could it go?

The current PE ratio of the Nifty stands at 18.17 as per NSE data. Bull markets dont commence at such high PE ratios. Valuations need to come down to lower levels, say 12-14. Assuming that the bull market resumes by late 2009, assuming a forward PE ratio of the markets at 10-12, and assuming a EPS for Sensex at 1050 for FY2010, we can say that the market could go down to anything between 10500-12600. This would be about a 40-50% correction from the top, which is in line with prior bear markets as well.

So all is not lost, far from it. There will be opportunities in the future, very profitable opportunities, in my opinion.

PS:
Assets like Gold, Silver, Crude Oil, all are showing signs of being in classic secular bull cycles. So while in the near term, we dont know what could happen to their prices, my own sense is that there is a long way to go up for these commodities before they peak out...so Gold at $980/ounce or crude at $148/barrel may not be the eventual peaks.

Crude at $200 could be very bad for India and may upset the extent of the secular bull cycle case...India imports 76% of its crude oil. India's oil import bill this year will be around $110 billion to $120 billion. This is 11-12% of our GDP...we would be handing over 12% of our total income to foreign countries! What would that do to our currency and what would that do to a neutral currency like Gold? The wise investor stays alert...