This report was originally published on 5/18/09.

From time to time, we’d like to provide you with some thoughts on books we have read in the past that have enhanced our investor acumen or at the very least, improved our understanding of the markets. One such book, which we recommend that everyone read is: Anatomy of the Bear by Russel Napier. Mr. Napier is a consultant with CLSA and a professor at Edinburgh Business School. For anyone who generally believes in the theory that “Past is prologue”, this is a book for you.

Investors are consistently criticized for having short memories. Truth be told, we are as guilty as anyone else on Wall Street in many respects. It is a survival instinct. It is far too easy to get wrapped up in past investment failures or become self-congratulatory about prior successes. We strive to learn from our mistakes and our failures. However, having a short memory should not prohibit us from delving into history to develop a better road map for navigating any particular market environment. Every economic environment is a bit different, but the term “unprecedented” should be eliminated from the lexicon of the investor community. The current economic environment and magnitude of the bear market are not unprecedented. If you haven’t figured it out yet, bear markets are not unprecedented. Deflation is not unprecedented. They are all part of normal market cycles.

In Anatomy of the Bear, Mr. Napier examines the conditions leading up to and following the four major secular bear markets of the 20th century. He has identified four periods during which equities were particularly cheap and subsequent returns were their highest. Those periods were: 1921, 1932, 1949, and 1982. Mr. Napier has done a masterful job of examining economic conditions, investor sentiment (through Wall Street Journal articles), fed policy, and the status of the bond market during these periods to help give the reader a better understanding of what might be strong signals that a bear market is coming to a close and/or stocks have become significantly undervalued.

Some Key Conclusions from Anatomy of the Bear:

• Contrary to popular belief, the most significant bear market bottoms have been characterized by the inability of stock’s to respond to good news, not an overabundance of negative news
• According to Napier, Tobin’s q ratio and Shiller’s 10-year cyclically adjusted P/E ratio (CAPE) are the best barometers to determine when stocks have become significantly undervalued (more on this later)
• A material disturbance to the price level (either inflation or deflation) is a major factor that leads up to extreme undervaluation in equities
• It takes stocks 14-years on average to go from being overvalued (as measured by the q ratio and CAPE) to undervalued
• Stocks always rebound before earnings do
• Corporate bonds typically outperform stocks in advance of major bottoms
• Bear market bottoms are characterized by low trading volumes, not a capitulative spike as many pundits on CNBC would have you believe.
• Commodity price stability is a major coincident/leading indicator of a stock market bottom. Copper is the most important commodity in that context.

Tobin’s Q ratio and Shiller’s Cyclically Adjusted P/E

Both of these valuation methodologies have grown in popularity over the past few years. Tobin’s Q ratio is a modification of the price/book ratio that most investors are familiar with in valuing companies. The Q ratio was developed by James Tobin of Yale University who postulated that the combined market value of all companies on the stock market should be about equal to their replacement costs. In short, the Q ratio is calculated by taking the entire capitalization of the stock market and dividing it by book value (the best proxy available for replacement cost). The table below outlines the Q-ratio over the best 100-years.

Source: James Tobin

As you can see from the chart, the lowest the Q ratio has been over the past 100 or so years has been right around 0.3x. According to Napier, a Q ratio of 0.3-0.4x has typically represented a significant market bottom and the point at which going forward stock returns are the highest. According to John Mihaljevic, in the first quarter issue of Equities and Tobin, the ratio reached 0.43x in March of 2009. That would put the ratio at .55-.60, well below the averages of the past 100-years or so. In theory, this should bode well for the potential for above average returns in the market over the next decade.

The 10-year cyclically adjusted P/E was developed by Yale professor Robert Shiller as a way to smooth out the volatility in annual EPS for the S&P 500. Shiller takes the current price of the S&P 500 and divides it by the 10-year average EPS for the S&P 500 to determine if we are in a period of overvalued or undervalued stocks. Professor Shiller used this data in his book Irrational Exuberance to call a peak in the stock market in 2000. In the bear market bottoms characterized by Napier the 10 year cyclically adjusted P/E ratio was less than 10x. The current cyclically adjusted P/E is about 15-16x. Too put this in perspective, based on current 10-year cyclically adjusted EPS of 52-53, the S&P 500 would have to trade to 400-500 for a glaring buy signal to be triggered under Shiller’s methodology.

It is important to note that neither of these valuation methodologies has proven to be predictive of short term market returns. In fact they really have only proven to be useful to identify extreme buy or sell signals. We think they are best used as a barometer of potential future market returns. The ratio’s will not help to identify a starting point for a cyclical bull or bear market within a secular bull or bear market. For example, we have been in a secular bear market from the start of 2000 until now. The last secular bull market started in 1982 and ended in 2000. Neither Shiller’s cyclically adjusted P/E ratio nor Tobin’s q ratio would have indicated to buy stocks in early 2003 at the start of a new cyclical bull market.

A Few Of Our Own Observations/Conclusions from Anatomy of the Bear:

• Periods of deflation are not that uncommon
• Short sellers have been blamed in bear markets going all the way back to the start of the 20th century
• Even within secular bear markets huge returns can be generated from going long stocks. Timing is the key.
• Each major bull market in this country was caused by a seismic shift in technology or production which enabled growth with price stability

We would like to spend a minute on this last observation. It has never been our intention at PAA Research to be market strategists. We think we can generate money-making investment ideas in any market environment. However, a 30-year veteran of the hedge fund industry once told us: “You have to get the big picture right”. As a result, we do spend quite a bit of time looking at things from a top-down perspective. We’re not interested in providing near term S&P 500 targets for our readers, but we are willing to say the following about the market:

We are in a secular bear market and will remain so, until a new era of price stability is introduced. For now most investors and economists are concerned about deflationary pressures. We think those concerns will be short term in nature after which, inflation will become the sole focus of central banks, economists and investors. A combination of loose monetary policy and the re-emergence of growth in BRIC countries will likely lead to serious inflation pressures within the next 12-18 months. The deleveraging of the US consumer will mitigate inflationary pressures somewhat (due to below trend growth), but crude oil prices will revisit triple-digits once global GDP growth exceeds 2.5% for any period of 12-months.

When we think about public policy in this country, we view energy as “the one problem that can solve them all”. Stated another way, to the extent that renewable alternative energy sources can be developed and deployed on a massive scale it would: enable the US to reduce trade deficits, usher in a new paradigm for foreign policy in the US, enhance the real per capita income of US citizens and foster in a new era of growth with price stability – a perfect recipe for equity investors. In the 1920’s it was the proliferation of electricity which led to growth and price stability. In the 1930’s it was the popularization of the automobile as a form of transportation. In the 1950’s and 1960’s new technologies emerged. From 1982-2000 a combination of globalization and the emergence of the Internet kept prices in check, while growth remained robust. It is our view that a major secular bull market will not develop until one, if not several sources of renewable alternative energy are deployed on a massive scale.

Until then, we are likely to have a cyclical bull market (if not more than one) and perhaps another cyclical bear market, all within the secular bear market trend. In the meantime, we will continue to identify what we think are compelling investment ideas. We are market agnostic and investment idea focused.

Here’s what Mr. Napier himself had to say at the end of Anatomy of the Bear about the current secular bear market:

“So, if this bear is going to look like the other bears, quite a few things still have to happen. Equities will have to fall to below fair value and the likely catalyst for this will be a bout of deflation…. There will have to be a bear market in bonds and a recession. Before the bear market is over, the DJIA is likely to decline by at least 60%…The bear market will likely come to an end sometime after 2009, although probably nearer to 2014….”

Keep in mind this book was published at the end of 2005.

As always, please act accordingly…