Earlier this week, a friend asked me if I thought this stock bear was over.  My first thought was “which bear?” for there isn’t just one.  The stock-market action over the last couple years has been a tale of two bears.  Investors who have failed to understand this critical truth are very confused on what to expect from stocks going forward.

The key to understanding stock-bear cycles is to realize that there is a pair of concurrent cycles, a tale of two bears.  They operate like those Russian Matryoshka nesting dolls, a smaller bear cycle existing within a larger bear cycle.  The larger bear cycle is measured in decades, while the smaller one nesting within is measured in years.  The larger bears are known as secular bears while the smaller ones are cyclical bears.

Making this secular/cyclical distinction is absolutely crucial when using the word “bear.”  If the bear being discussed is not explicitly specified, confusion is the inevitable result.  Confusion invariably leads to poor investing decisions and loss of capital, both in a literal sense and in the opportunity-cost sense.  So, we need to start by defining each type of bear.

The word “secular” means long periods of time, and the secular bear is well deserving of this moniker.  Throughout history, secular bears have had average durations of 17 years each!  These great bear markets follow great bull markets, which also happen to average 17 years.  One complete secular-bull-to-secular-bear cycle runs 34 years, a third of a century.  I highly encourage you to read my latest ‘Long Valuation Waves’ essay if you are not familiar with these great stock-market cycles.  They are crucial to understand.

Meanwhile, the smaller cyclical bears are much shorter and occur within secular bulls and secular bears alike.  Typically, a cyclical bear averages a couple years in duration.  While secular bear markets are driven by valuations, cyclical bear markets are usually driven by sentiment.  The former start at overvalued levels, while the latter start at overbought levels.  This distinction may seem subtle, but it is important.

Our current secular bear market started back in early 2000 because stock valuations were extreme.  The U.S. stock markets were trading at staggering prices relative to the underlying profits of the corporations the stocks represented.  While the long-term average price-to-earnings ratio of the general stock markets is 14x (14 times), as this secular bear dawned the SPX was nearly triple that at 44x!  This disconnect in valuation had to be addressed.

And the 17-year secular bear is the naturally-occurring market mechanism that remedies extreme overvaluation.  Stocks do not fall for 17 years, but grind sideways for 17 years.  This gives earnings time to slowly catch up with the high stock prices.  As discussed in depth in my LVW research, this secular bear will not end until stocks reach deeply undervalued levels (7x earnings, half the average) out in 2016 or so.

So from a valuation perspective, today’s secular bear is indeed only half over.  Over the next 8 years, the stock markets are unlikely to get materially higher than their early 2000 and late 2007 levels at best.  This is around 1550 on the SPX.  Investors are indeed wise and prudent to respect this secular bear and trade accordingly.  But an overarching 17-year sideways grind certainly does not mean they should totally avoid stocks in a secular bear.

This is an excerpt from June 2009 issue of Trader's Journal.