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While the market investor needs 67% to recover from his 40% loss, the hedged investor only needs 25% to recover from one-half of the 40% loss (i.e., 20%). Yet when the hedged investor receives half of the market’s recovery, 33% from the near 67% surge, the hedged investor has exceeded the required 25% recovery return. As a result, the hedged investor achieves a net gain across the cycle. So the gains from a hedged portfolio are not coincidental to the recent five years, fourteen years, or the secular bear market of the 1960s and ’70s. The gains occur whenever overall market gains are muted—in every secular bear market. The current secular bear market has quite a way to go. The normalized price/earnings ratio (P/E) for the overall market is relatively high. The past fourteen years worked off the bubble levels from the late 1990s, but P/E has not declined to levels that are required to drive a secular bull market. A more detailed discussion and dramatic graphics can be found in an article titled “Nightmare on Wall Street” atwww.CrestmontResearch.com. YIELDING TO TEMPTATION For some people, looking back fourteen years seems like an eternity. Needless to say, those same people are the most skeptical about analyzing a century of secular stock market cycles. They are also the most susceptible after the past five years to Siren’s call to overweight equities today. Yet a market that has run up substantially is more susceptible to correction or decline than it was before its surge. The trend is not always your friend. One of the documented weaknesses of human nature in investors is the tendency to ride winners despite their waning fundamentals (and sell some losers despite their newly attractive fundamentals). Isn’t it ironic—in a Gary Larson Far Side kind of way—that the investor sticking his neck out may not be the tortoise-like rowing investor after all?! So although the temptation to follow the momentum of 2013 might drive an overweighting of equities, this may be just the time to consider leaning away from passive buy-and-hold strategies in the market. We may soon be approaching the start of the next cycle—from the top. Ed Easterling is the author of Probable Outcomes: Secular Stock Market Insights and the award-winning Unexpected Returns: Understanding Secular Stock Market Cycles. He is President of an investment management and research firm, and a Senior Fellow with the Alternative Investment Center at SMU’s Cox School of Business, where he previously served on the adjunct faculty and taught the course on alternative investments and hedge funds for MBA students. Mr. Easterling publishes provocative research and graphical analyses on the financial markets atwww.CrestmontResearch.com.
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