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Market Cycles – What Drives Stock Market Returns?

Investment Theory - Part III

Market Cycles – What Drives Stock Market Returns?

Market cycles are one of the less widely understood investment concepts with particular relevance in the current market environment. With global equity markets reaching record highs, many investors try to see the current situation in relation to historic trends and their eventual outcomes.

Basically, secular bull and bear markets are exactly that: long-term trends. It is important to note that a trend, by the nature of the very word, means a divergence from the usual, and is, hence, the reason for its own reversal.

Secular vs. Cyclical (Bull and Bear) Markets

In a financial market context, the term “secular“ basically means very-long-term. Cyclical, on the other hand, describes the shorter-term ups and downs within a very-long-term move. Now, one might ask: if there are several cyclical ups and downs within a secular trend, why does it matter what the secular trend is?

The answer is twofold: firstly, expected long-term (annual) returns are higher in secular bull markets compared to secular bear markets and hence one should adapt their investment strategy to the respective secular market. As Ed Easterling of Crestmont Research puts it:

“Buy and hold is not an all-weather investment strategy.”

Secondly, secular market moves are driven by fundamentals, while cyclical market moves are largely impacted by psychology and sentiment. This makes secular markets more recognisable and predictable.

There are different opinions and explanations of what characterises a secular market trend in general and, more interestingly, whether the world is currently in a secular bull or in a secular bear market. The views of Ed Easterling (author of “Unexpected Returns“), Howard Marks (“The Most Important Thing“) and Ray Dalio (“How the Economic Machine Works“) are relevant here.

Long-term Stock Market Performance

Long-term investors like pension funds, who in today’s world constitute a large share of overall assets in the market (and are hence moving markets through their decisions), look at decades as their investment horizon. One of the main decisions they have to make is on asset allocation, part of which requires an opinion on how much of their assets to commit to equity markets.

The share of capital allocated to equity is influenced by the long-term return equity markets promise at the time at which the allocation decision is made. Here are some interesting findings from Crestmont’s research on past market cycles in the Dow Jones Industrial Average with regard to equity market returns:

  • During secular bull markets (54 years in total since 1901), there were only two years with double-digit declines. There were 36 years of double-digit gains. In other words: during secular bull markets, most volatility is upside volatility. During secular bears (61 years), however, the dispersion of <-10%, -10% to + 10% and >+10% is almost equally split.
  • Looking at rolling 10-year stock market returns (e.g. periods from 2003-2013, 2004-2014, 2005-2015), then the S&P 500 has returned on average 10% annually since 1909. There were only four years in which this rolling 10-year annualised return was negative (late 1930s, 2008 and 2009).

But average rarely happens. Rolling annualised returns are very volatile. There are many periods where the 10-year annualised return is closer to 12% and many periods where it is closer to 8%. One should aim to identify periods that are more likely to belong to the 12% group and invest in those, rather than points in time that are more likely to be in the underperformance group.

What History Tells Us

From the historic data it can be seen that in periods in which P/E values were above 25, it is likely that the subsequent decade will deliver less than 8% return annualised. Historically, almost any of the underperforming decades started in a year with very high P/E values. The opposite is the case for the outperforming decades. If more than a hundred years of market history is a reliable indicator, then one can even define secular markets in terms of hard numbers:

  • It is a secular bull market when there is a doubling or tripling of P/E
  • It is a secular bear market when P/E falls by 1/3 to 2/3 or even more

The Significance of P/E Ratios


In order to understand secular bull and bear markets, it is worth to initially look at what drives stock market returns in the long run. Following Ed Easterling’s approach, the most important component of stock market return seems to be the level of P/E ratios. How he reaches this conclusion is outlined in the following.

To start with, total return from the stock market is limited to capital gains (stock price change) and dividend yield:

                          Dividend Yield + Stock Price Change = Total Stock Market Return

The stock price change is the much more impactful and volatile of the two components and hence should be analysed more in depth. Stock price changes consist of earnings growth (EPS change) and P/E change:

                                Change in P/E * Change in EPS = Stock Price Change

As a result, there are only three components of stock market return:

  • Dividend yield
  • Earnings growth
  • Change in the market’s P/E ratio

Historically, the change in P/E levels has been the most significant contributor of the three. To show that this is in fact not someone’s theory, but a simple mathematical derivation, look at this:


                          P/E = P / EPS

                          P/E * EPS = P.

            P = Stock market level (e.g. S&P500 at 2350)

it follows that

           Change in P/E ratio * Change in EPS  = Change in stock market level (= market return)

Note that this is not a theory but a mathematical equation.

Drivers of the Return Components

If one believes that changes in the market’s P/E ratio and EPS growth are the major components of stock market returns, then one should be interested in knowing which factors are the main drivers of changes in these two components. Ed Easterling’s view is that while changes in P/E are driven by inflation, earnings growth (EPS growth) is driven by (nominal) GDP growth (economic growth). Looking at historic data, Easterling recognises some interesting relations.

Inflation Rate

  • Low and stable inflation drives P/E higher
  • Too high inflation or deflation drives P/E lower (not a theory, maths)
    • high inflation means future earnings are worth less, hence P(rice) should decline
    • deflation means nominal level of future earnings declines
  • The peak for P/E generally occurs at low and stable rates of inflation
  • P/E low point with high inflation or deflation has typically been around 5 to 10

On that note, it is still somehow puzzling that in bond markets it is widely accepted that higher inflation means lower bond prices, while in equity markets there is a wide-held belief that inflation means higher prices. Maybe this has to do with a lack of distinguishing between stable low and (too) high inflation.

Economic Growth

In periods of real economic growth near 3% (historical average)

  • natural P/E ceiling 25
  • natural P/E floor 5-10

It is important to note that the historical average of 3% is composed of

  • 1950 – 1999: ca. 3.7%
  • 2000 – 2013: ca. 1.9%

Hence it could be the case that the historical average is not an accurate indicator of the long-term economic growth prospects of today. On the other hand, the (relatively short) 2000-2013 period includes the Great Recession, which significantly impacts the average towards the downside.


Following Ed Easterling’s view, secular bull markets are characterised by above average (long-term) returns, which result mainly from an increase in P/E. With the components of stock market returns and their drivers in mind, it becomes clear why P/E is an important indicator of decade-horizon returns. If the market P/E ratio is at high levels already, it does not have that much further to go (if history is an accurate indicator), and hence the factor P/E change in the equation cannot increase much further. This leads to the other side of the equation, change in stock market level, also being restricted in its further rise. This is one of the most significant principles in Easterling’s view on market returns as it explains secular cycles mathematically rather than as coincidentally or phenomena-driven.

With Easterling’s explanation of secular market cycles, it becomes possible to compare historical levels of the drivers (like P/E) and subsequent stock market performance. This allows judgments on what kind of secular market currently being experienced, given current levels of inflation, GDP growth, P/E ratios and EPS. Having an idea about this big picture allows predictions on long-term return potential.

One of the most contrarian conclusions from this view of market cyclicality is that the stock market is not significantly correlated to the economy. The economy (GDP growth) is a driver of earnings growth and drives the range of possible P/E values. However, the inflation rate remains the most significant element in the overall equation as it drives the P/E level within that range.

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