Secular Cycles and Valuations

My last entry discussed how volatility is a common element in a secular bear market. The second common denominator involves valuations. Secular bear markets tend to start when an asset class has abnormally high historical valuations and a tipping point occurs where valuations begin reverting to the mean. Often times this mean reversion carries enough pessimism where the momentum depresses prices to historically low valuation levels.

For stocks, the price earnings ratio (PE) is a common way to determine valuations. Below is a chart depicting the past secular cycles in the stock market since 1901.

As indicated above, most secular bear markets ended when the PE ratio was in the single digits. The only exception was in 1941 when the PE ratio bottomed out at 12. During this secular bear cycle, the PE ratio hit a low of 13 in March of 2009. Was this the bottom? It’s possible. But with the current PE ratios at 22, I would err on the side of caution. In my next entry I will discuss the keys to investing in this type of environment.

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