2-6-2013 comment

Pascal mentioned endless money printing in his comments. It is difficult to see how the end phase of the current situation (secular bear market) will unfold. However it brings to mind this scatter plot of 112 years that may help us understand what needs to happen to enter an end phase (beyond cyclical bull and bear markets that make no overall progress).

The X axis is S&P P/E ratio and the Y axis is inflation rate. The P/E ratio is the cyclically adjusted P/E using 10-year average earnings (a la Robert Shiller from Yale). Each data point represents a single year.
You can see that the conditions in history that have supported high market value (high P/E) only come with inflation rate in a very narrow range around +2%. If you were the FED, where would you try to guide inflation rate? In history low P/E values (and the end game) come from the two legs of the Y-formation.

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Secular bull markets have all begun from very low P/E (under 10). We are above 22 right now still locked in the secular bear market that began in 2000. The end phase then should come coincident with a low P/E condition. The low P/E will be driven by higher inflation or significant deflation (two legs of the Y-plot). If we take the inflation way out the secular bull market will come when inflation quits rising and then starts declining (like the 1982 setup). So it seems it comes down to two ways out:
[INDENT]1. We actually start growing at a significant rate increasing the velocity of money pushing inflation up.

2. The FED runs out of the political will of the nation that allows them continuous printing of endless streams of money. This would allow market forces to return (either inflation or deflation). [/INDENT]
As long as the FED continues to be able to keep inflation rate locked into the current range the secular bear market may remain in hybernation. Another decade of this is probably in order as this could take a very long time for events to pass. Just think how long would it take for inflation to set in, and then fought and then broken?

[QUOTE=mscott;24821]

As long as the FED continues to be able to keep inflation rate locked into the current range the secular bear market may remain in hybernation. Another decade of this is probably in order as this could take a very long time for events to pass. Just think how long would it take for inflation to set in, and then fought and then broken?[/QUOTE]

There are clearly many possible paths to relatively few outcomes. Methods are not perfect and neither are the people applying them so it stands to reason that P/E compression with either negative or positive excess inflation will happen at some point. Perhaps it comes sooner with a natural event risk.

The question becomes when rather than how. Another decade of locked inflation would, in retrospect, likely be viewed as another great moderation with prices generally moving higher - perhaps not what one would view as part of a secular bear absent time frames of lifetimes.