Bull's Eye Investing (Almost) Ten Years Later

By John Mauldin

June 30, 2012

It's been almost a decade since I co-authored with Ed Easterling of Crestmont Research some research in this letter that later became chapters five and six of Bull's Eye Investing. Although the ten-year anniversary of the book is actually 2013, the current vulnerabilities in the markets encouraged us to revisit the material a bit early, to prepare you for what lies ahead. Reflecting back to yesteryear gives us the opportunity to assess the accuracy of our insights.

I am in Tuscany at the moment, watching the sun set over the Tuscan hills; so I will thank Ed for doing the heavy lifting in this letter while I get to relax, although there is so much going on and I am such a junkie that I am forced to get my current-events fix every day. I must say, the news certainly provides some very pure adrenaline rushes. But more on that at the end. For now we take the longer view of the stock market that I first wrote about at the end of the last century, and to which Ed added some real meat in early 2003.

Bull's Eye Investing (Almost) Ten Years Later
By John Mauldin and Ed Easterling

Our discussion of a coming secular bear market almost ten years ago was not hypothetical forecasting, but rather it was a discussion about the fundamental factors that drive stock market returns. Even though it is challenging to predict the market over months and quarters or even a few years, we believe the data shows that the stock market is quite predictable over some longer periods. Those periods are the secular stock market cycles of above-average bulls and below-average bears.

In the opening paragraphs of chapter five, in bold emphasis, we wrote:

We will make the case that it is more useful to analyze stocks during secular bear markets in terms of value than in terms of price... These cycles generally take a generation to work their way through the investor public, have significant magnitudes of becoming undervalued and overvalued, and have significant implications for the way that investors should approach each of these periods.


We emphasized that:

Further, we show that volatility and frequent large rallies are the norm and not the exception, thus giving the astute investor some terrific opportunities. Finally, we will make a connection between inflation, interest rates, and stocks that will give us further indications of the direction of the stock and bond market in the coming decade.

If the cycles of the past century continue to repeat, most of the first decade (or more) of this century will experience a secular bear market – an extended period of generally down or sideways and choppy stock market conditions....

These periods in the past have been the result of market valuation cycles represented by the P/E ratio. The valuation cycles have resulted from generally longer-term trends in inflation toward or away from price stability. The short-term, somewhat random, market gyrations are the result of then-current circumstances and market forces wrestling stock prices around a gravity line of the broader cyclical trend.

What did P/E do over the past decade and where is it today? What does it tell us about the future? What new insights can we glean by adding nine years of history to some of the charts and graphs in the original chapters? In addition to chart updates, there are quite a few new charts here from Crestmont Research. Well, there is a lot to review as we look back over the past decade, with an eye on the next decade.

Reliving the Past Nine Years

For a good overview of the past nine years and this secular bear market, here's an update to Table 5.6 in Bull's Eye Investing. When we wrote the chapters in 2003, the charts and graphs were current through year-end 2002. At the time, P/E was a lofty 26though it had come down significantly from bubble levels in the 40s. To reduce the distortions to P/E caused by the earnings cycle, earnings (E) were normalized using the approach popularized by Robert Shiller at Yale (which uses earnings over a ten-year period). The resulting P/E is often called the cyclically adjusted P/E, or P/E 10.



There are several points to emphasize in the chart above. This secular bear (so far!) has been relatively calm compared to historical secular bears. The typical bear has more negative years than positive years (only 42% positive), yet this cycle so far has had more positive years (58% positive). The gain and loss years have been more muted, with gains and losses averaging around two-thirds of normal levels.

Certainly this secular bear has not been calm as we have experienced it in real time, but the relative calmness compared to past cycles may be an indicator of what lies ahead before the bear retires.

Some investors certainly do think the current secular bear has been extreme.

Here's what it has brought us so far:


The pattern and process have not been very different from what we expected in 2003. As we wrote in Bull's Eye Investing, "... volatility and frequent large rallies are the norm and not the exception" in secular bear markets. Here's the previous secular bear (1966-1981) as an example. Yes, the 54% decline by 2009 was greater than the 45% in 1974, but the pattern of numerous short-term surges and falls had again repeated.

There is another approach to assessing volatility that was included in Bull's Eye Investing. Table 5.1 revealed that the stock market is much more volatile than most people realize. Rather than use confusing and boring statistics, we took more of a layman's approach. We highlighted that the market moves up or down more than 10% annually in almost 70% of the years. It moves more than 16% in either direction in half of all years. So what has happened so far in the present cycle?

Crestmont has updated that volatility analysis through 2011, and it now reveals new insights by breaking out separate details for bulls and bears. It is striking that overall volatility is relatively similar for secular bulls and bears. Note the frequency inside the 10% and 16% ranges. In both secular bulls and bears, nearly 30% and 50% of the years fall inside the respective ranges. The difference is that bulls predominantly have upside years, while bears have more downside years.

The results so far for this secular bear have been a bit different. First, there have been more inside years another indication that the first part of this secular bear has been a bit tamer than usual. Second, notwithstanding the crisis plunge into 2009, the downside years have been under-represented. Why?

So far, this secular bear has not made much progress through the fundamental process that a secular bear must undergo. As we highlighted in Bull's Eye Investing, "The valuation cycles have resulted from generally longer-term trends in inflation toward or away from price stability." Other than an occasional flirt with deflation or inflation over the past decade, we're stayed relatively close to price stability. There are certainly lots of pressures building for deflation and inflation, either of which would drive this secular bear to its den. But for now, the choppiness has us in a bit of a holding pattern. The stock market's gyrations and underlying earnings growth over the past nine years have driven P/E from the mid-twenties to the low twenties, but the market has yet to experience the full process of valuation declines in the face of an adverse inflation rate trending into deflation or high inflation.


Are We There Yet?

Here are two new charts from Crestmont Research that explain how we got here and just how much farther we have to go. The charts reflect the normalized P/E ratio for the S&P 500 Index for all secular bull and secular bear cycles since 1900. The lines on the charts show the price/earnings ratio (P/E) over the life of each secular cycle.

First, note that secular bulls start when P/E is low and end when P/E is high. Similarly, secular bears start when P/E is high and end when P/E is low. In the charts, the low range is designated with green shading and the typical high range is shaded red.

Look at the secular bull of the 1980s and 1990s. It is as though that secular bull ran its course through the mid-1990s, then P/E more than doubled again. The already high P/E ascended to the bubblesphere.

Compare the two graphs. Every secular bear cycle prior to our current one followed a secular bull that ended with P/E in or near the red zone. That set the starting point for every subsequent secular bear. But this time, the super secular bull of the late 1990s ended nearly twice as high – it was a major bubble. The past twelve years saw the bubble popped and P/E restored to levels typically associated with a low inflation rate. It has taken more than a decade to wear away the effects of the late 1990s extremes.

The current valuation of the stock market is relatively high, but it is not overvalued, considering today's conditions. Low inflation-rate conditions should be accompanied by relatively high P/Es. But if deflation or high inflation (or both) are likely upcoming, the market is very expensive. On the other hand, if the inflation rate happens to remain near price stability, then this secular bear could remain active a while longer – but how likely is that?

High P/E, Low Returns

In Bull's Eye Investing we explained that high market valuations (P/E) necessarily drive low long-term returns. This occurs because periods that start with high P/Es often end with lower P/Es, eating away at returns. Further, high-P/E periods have low dividend yields. As a result, we could write with confidence nine years ago that subsequent returns would be well below average.

In all cases, throughout the years, the level of returns correlates very highly to the trend in the market's P/E ratio. The P/E ratio is the measure of valuation as reflected by the relationship between the prices paid per share to the earnings per share (EPS). Higher returns are associated with periods during which the P/E ratio increased and lower or negative returns resulted from periods during which the P/E ratio declined.

This may be the single most important investment insight you will get from this book. When P/E ratios are rising, the saying that a "rising tide lifts all boats" has been historically true. When P/Es are dropping, stock market investing is tricky; index investing is an experiment in futility. As we will see in later chapters, in these secular bear market periods, successful stock market investing requires a far different (and sometimes opposite) set of skills and techniques than what is required in bull markets....

Given the current and recent level of P/Es, the prospects are not encouraging for general market gains (the emphasis is on general or index funds) over the next two decades. This dismal outlook is not from some congenital bear perspective; it corresponds to the series of factors driving the current secular bear market.

Although P/E has declined over the past nine years, from 26 to near 20 (using the Shiller method), stock market valuation remains relatively high. Almost everything in chapters five and six of Bull's Eye Investing remains true today. The market has chopped around with fairly typical volatility. P/E is in the lower end of the red zone rather than above it. Most importantly, currently high valuations portend low returns from here.

How low? That depends upon the outlook for deflation or higher inflation.

Our crystal balls are showing us different things on that question, although our fundamental conclusions are the same. Ed sees moderate probabilities for either higher inflation or deflation. On his optimistic side, he even allows for the prospect of continued price stability for quite some time. John, however, sees flashing danger signs of upcoming deflationary pulses, to be followed later by higher inflation. He outlined his reasoning in Endgame.

So, together, we have several scenarios. We have some side bets as to who will be right; but more importantly for you, none of the outcomes deliver good overall equity market returns, because we are still at a relatively high P/E.

Next week we will return to a few more paragraphs from Bull's Eye Investing, and then we will explore the implications of the entire analysis.

But enough. Have a great week! I certainly will.

Your wondering why I am not here for at least a month analyst,

John Mauldin

Copyright 2012 John Mauldin. All Rights Reserved

July 1, 2012 7:42 pm

The real victor in Brussels was Merkel

By Wolfgang Münchau

Mario Monti faced down the German chancellor and won the battle. He will survive a few more weeks or months in politics. It was clever of him to threaten a veto on something Angela Merkel badly needed. He had her in the corner. It was an example of classic EU diplomacy.

But this was only the foreground spectacle. If you look behind the curtain, you will find that, for Italy at least, nothing has changed at all. The European Stability Mechanism was already able to purchase Italian bonds in the open market. The instrument was there, but not used. The agreed changes are subtle. Italy must still sign a memorandum of understanding, and subject itself to the troika – the International Monetary Fund, the European Central Bank and the European Commission. The procedure will be less invasive, more face-saving. But there will still be a procedure.

The real constraint for ESM bond purchases had less to do with the rules than with the overall size limit of the ESM. It has a lending capacity of €500bn – and that has not changed. No matter how you twist and turn it, the ESM is simply not big enough. It will inject equity into Spanish banks.

It will need to refinance the programme for Greece, Ireland, and Portugal. It will soon have to cope with Cyprus and, who knows, maybe Slovenia as well. A full-scale programme for Spain still looks likely. I cannot see how you can fit Spain under the umbrella, plus Italian bond purchases.

One of the lessons from the history of financial crises is that bazookas must be big to be effective. This one is not. Nor was the now defunct securities markets programme of the ECB. It did not stem the crisis because the ECB’s commitment was strictly limited – and contested by members of its governing council. The ECB still spent more than €200bn on this programme, and yet it did not work. The ESM’s budget for bond purchases will probably be lower.

Mr Monti may have secured the right kind of deal politically but to solve the ESM’s size problem he really should have insisted on a banking licence. With that, the ESM could have leveraged its lending ceiling to a more realistic level. It will not be able to do this now.

This is why I believe the real winner of last week’s summit was not Mr Monti but Ms Merkel after all. She managed to keep Germany’s liabilities unchanged. Someone will have to explain to me how we can have no change to Germany’s overall liabilities, nor of ECB policies, and yet Italy and Spain can now be safe when they were not safe a week ago.


The deal on Spain was marginally better – on paper. But it, too, is not what it seems. I see three obstacles:

1. A mandate to inject equity into the banks will be conditional on a political agreement for joint banking supervision. This is where Ms Merkel can still exact her revenge. Do not expect this to proceed easily. A joint system of banking would be a very big deal, and I doubt that a sensible agreement can be agreed by October.


2. Direct bank recapitalisations may require a change in the ESM treaty. I know this point is disputed. EU officials say they can do it by diktat. But I cannot see how one can conceivably let the ESM inject equity into banks directly when the treaty says specifically that the ESM lends money to member states for that purpose. Would the treaty not have mentioned this important detail? The head of the Bundestag’s budget committee also seems to think that a treaty change is now needed.

3. The new facility is still constrained by the same overall funding limits of the ESM as the bond purchases. I believe the Spanish banks will ultimately need a lot more than the €100bn earmarked for this programme once you take into account the effects of both the housing crash and the depression. The ESM is seriously overloaded.


The most important event last week was probably not the agreement at the summit anyway, but the statement by Ms Merkel that there will be no eurozone bondsfor as long as I live”. My belief is that this statement reveals she is not serious about political union, to which she has been paying lip-service over the past few weeks. Her tactics remind me of the “coronation theory” of the 1980s: the Bundesbank used to say that monetary union was acceptable but only after full political union was completed. It was another way of saying never. I always suspected all this talk about long-term solutions might be a ruse. Now, it seems, we know.


If Ms Merkel is right and there are no eurozone bonds in her lifetime, the eurozone will not survive. Without eurozone bonds or a change in ECB policy, Italy’s and Spain’s debt – and eurozone membership – is not sustainable. That was as true on Wednesday as it is today.

Copyright The Financial Times Limited 2012

Gold Price Correction Falls Behind Pace Set In 2006 And 2008

July 2, 2012

by: Tim Iacono

Amid steadily deteriorating sentiment in precious metals markets in recent weeks, Friday turned out to be a very good day for spot gold and silver prices as the former jumped 3.0 percent (or nearly $50 an ounce) while the latter surged 4.4 percent (or $1.17 an ounce), both metals bouncing off of dangerously low levels seen on Thursday prior to the big announcement from Europe about the latest plan to rescue the common currency. This one being perceived as more credible than previous ones over the last two-and-a-half years, for the time being at least.

Along with owners of other risk assets, precious metals investors were no doubt relieved to see prices move higher as gold ended the week with a gain of 1.7 percent, up from $1,572.30 an ounce to $1,599.10, and silver jumped 2.2 percent, from $26.90 an ounce to $27.49. At the mid-way point in 2012, spot gold is now up 2.1 percent for the year, down 16.8 percent from its high of over $1,920 an ounce late last summer, and silver moved back toward even for the year, now down 1.3 percent in 2012 and 44.4 percent below its peak from April of 2011.

On Thursday, the silver price reached a 19-month low at just over $26 an ounce and much was made of the metal's recent downward spiral as the price dipped beneath the low of $26.30 an ounce from late-December. To find a lower price than that seen on Thursday you'd have to go back to November of 2010 when silver was pushing through the $25 range, up from about the $18 level where it spent most of its time that year.

The Wall Street Journal carried the story Silver's Slide Riles Bulls and Bears on Thursday that, as is usually the case from this newspaper, was an even-handed account of the prospects for silver in which two major factors were cited in determining which way prices will go. First, the perils of sell orders being triggered on a dip below the $26 an ounce mark and, second, the fact that silver remains a monetary metal and will rise and fall along with the gold price during an era of money printing unparalleled in the history of the world.

As I've noted many times before, if you're invested in silver, you should be more concerned about the price of gold since, absent any new revelation of market rigging that would push the price sharply higher, silver is not likely to move back toward the $40 an ounce mark unless the gold price stages a similar advance, as was the case back in February when gold approached $1,800 an ounce.

As for gold, another test of the mid-$1,500 an ounce range has come and gone with the metal returning to near $1,600, though, without the news from Europe on Friday that resulted in the flipping of the switch from "risk off" to "risk on", it may have been an entirely different story.

As shown below, even after Friday's big move, the ongoing gold price correction is now behind both the pace set during the 2006 and 2008 corrections, some 16 percent below its former high at the 217 day mark.

(click to enlarge)

This is no cause for alarm, but, it bears close watching as we move further into the second half of the year.

Note that in both the 2006 and 2008 corrections it took well over 300 trading days for the gold price to recapture its previous high and I'm confident we'll see new all-time highs for the metal before year end, that is, when attention turns away from Europe and to budget troubles in the U.S. as our "fiscal cliff" approaches and elected officials "kick the can down the road" again.

But, between now and then, it could be rough going for gold investors as Friday's rally may be short-lived. To be sure, it's a good thing that the Chinese continue to buy gold and that central banks are stocking up on the metal at the fastest pace in decades because U.S. demand has waned, the U.S. Mint reporting last week that American Eagle gold coin sales during the second quarter fell to 127,500 ounces, the lowest since before the 2008 financial crisis.

In India, gold coin sales could face stiff headwinds from central bank measures to clamp down on commercial banks that collect high margins on these transactions. The Reserve Bank of India aims to change that by modifying bank regulations, part of an overall effort to reduce gold consumption that has been a major factor in the nation's widening trade deficit and plunging currency. India imports nearly all of its 900+ tonnes of gold per year and the government seems intent on reducing these imports, despite the cultural affinity Indians have for the metal.

The people of China and emerging market central banks continue to be the world's biggest source of demand for gold and, until investors in the West return to precious metals markets this fall for reasons cited above, gold and silver investors had better hope that the Chinese people and central banks keep buying.

June 30, 2012

What’s a Socialist?


Supporters of François Hollande, the first Socialist candidate elected president of France since 1988.

FRANCE has elected its first Socialist president since 1988 and then given the Socialist Party and its closest allies a whopping majority in Parliament. But how Socialist is François Hollande? And what does it mean to be a Socialist these days, anyway?

Not very much. Certainly nothing radical. In a sense, socialism was an ideology of the industrialized 19th century, a democratic Marxism, and it succeeded, even in (shh!) the United States.

Socialism meant the emancipation of the working class and its transformation into the middle class; it championed social justice and a progressive tax system, and in that sense has largely done its job. As the industrialized working class gets smaller and smaller, socialism seems to have less and less to say.

Center-right parties have embraced or absorbed many of the ideas of socialism: trade unions, generous welfare benefits, some form of nationalized health care, even restrictions on carbon emissions. The right argues that it can manage all these programs more efficiently than the left, and some want to shrink them, but only on the fringes is there talk of actually dismantling the welfare state.

“As an ideologically based movement, socialism is no longer vital,” says Joschka Fischer, who began his career on the far left and remains a prominent spokesman for the Green Party. Today it’s a combination of democracy, rule of law and the welfare state, and I’d say a vast majority of Europeans defend this — the British Tories can’t touch the National Health Service without being beheaded.”

Even in the United States, Mr. Fischer says, “you have a sort of welfare state, even if you don’t want to admit it — you don’t allow people to die on the street.”

So why the prospect of “European socialism” is so frightening to some Americans puzzles Europeans, a mystery as deep as the American obsession with abortion or affection for the death penalty.

Daniel Cohn-Bendit, a leader of the student revolt of May 1968, known then as “Dany the Red,” is nowDany the Green,” co-leader of the ecologist group in the European Parliament. “The fight between private property and state property is over,” he says, and traditional class distinctions are blurred. “There was never a purely socialist working class,” he suggested. “Socialism and social democracy today are about a society with more solidarity, more protection of people, more egalitarianism.” In a way, he said, socialism is defined today mostly by its contrast to neo-liberalism — by more reliance on the state and higher taxes on the wealthy.

Bernard-Henri Lévy was criticized three years ago for saying that the French Socialist Party was not merely dying, but “already dead,” a political alternative for those unhappy with Nicolas Sarkozy, then the president, but little more than a differently situated elite. France’sgauche caviar” — wealthy socialists like Dominique Strauss-Kahn or Jack Lang — were hardly revolutionary, but merely took their neckties off at lunch.

TODAY Mr. Lévy has not changed his views. “There are no more socialists — if they were honest they would change the name of the party,” he told me. Socialism evokes the nightmare of the Soviet Union, whose leaders named themselves socialists.” Today, he maintains, European socialists are essentially like American Democrats — there has been no ideological left in France that matters since the effective demise of the Communist Party, which was “the trueexception française.’ ”

In his bookBarbarism with a Human Face,” translated into English as “Left in Dark Times: A Stand Against the New Barbarism,” Mr. Lévy wrote: “I would dream of writing in a dictionary for the year 2000: ‘Socialism, masculine noun, a cultural genre born in Paris in 1848, died in Paris in 1968.’ ”

But democratic socialism of the nonbarbaric kind has a long history in Europe, especially in France.

Even today, delegates at the Socialist Party’s summer meetings address one another as “Comrade,” a gesture to the past for a party largely made up of academics and bureaucrats — in other words, state functionaries, of whom there are many in France. The French state represents 56.6 percent of gross domestic product, one of the highest figures in the Western world.

Socialism here is very statist,” says Marc-Olivier Padis, editor of the quarterly journal Esprit. The leading figures in the Socialist government are more creatures of the French establishment elite schools and careers — than those under Mr. Sarkozy, he explained, “a combination reproducing the profile of Hollande himself.” Mr. Sarkozy was more of an outlier than Mr. Hollande, and much closer to business.

Belief in the centrality of the state to run, regulate and innovate remains a core belief of French socialism, and the size of the state is hardly going to be reduced under Mr. Hollande, whose few concrete promises include hiring 60,000 more teachers over five years, raising the minimum wage (the highest in the European Union) and creating a state bank for innovation.

Alain-Gérard Slama, noting that Mr. Hollande won the presidency thanks to half of centrist voters and a third of far-right voters, all of whom detested Mr. Sarkozy, wrote in the newspaper Le Figaro that “the French don’t do anything like anyone else — they’ll give themselves a Socialist president, a Socialist Assembly, a Socialist Senate, Socialist regions, while, by a clear majority, they are not Socialist.”

To be honest, who is anymore? “Is socialism really more than pragmatism?” Mr. Padis wonders. Mr. Lévy pointed out that the excitement around the far-left French presidential candidate, Jean-Luc Mélenchon, got hearts racing for a while. But the rabble-rousing Mr. Mélenchon did not do as well as many hoped (or feared). This month he was trounced for an Assembly seat by Marine Le Pen. “Some believed the French exception was undergoing a revival with Mélenchon,” Mr. Lévy said. He then aptly quoted Marx’s famous line about Louis Bonaparte, that “history repeats itself, first as tragedy, then as farce.”


Steven Erlanger is the Paris bureau chief of The New York Times.