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The 21st Century Bear Market

August 4, 2011

Prepared by: David Justin Ross Chief Investment Officer Radiant Asset Management, LLC

Good investment decisions require close understanding of the market conditions likely to prevail across the duration of the investment. This is particularly true in chaotic economic times such as those currently faced those investing in the United States. To aid in that understanding, this paper demonstrates that the U.S. stock market is in a protracted bear market that started in 2000 and that is likely to continue for several more years. If past behavior is indicative, this bear market will end with a Price Earnings Ratio around 15 and the S&P 500 Equity Index near 1000. There are, needless to say, wide margins of error on these estimates, but there is sufficient historical experience to lay out a reasonable course for the market over the next few years. Armed with this information, including the most likely movements of the markets, investors can take a more active role, investing appropriately for the changing conditions between now and the commencement of the next bull market. Investing profitably in bear markets is far more difficult than in bull markets. This makes it critical to understand how bear markets behave and how that behavior impacts investment value. During bear markets, passive investment strategies experience wild swings, subjecting the investor to considerable investment risk that is usually accompanied by a loss in real investment value. Active investment strategies offer hope for profitable investing in such times, but using them requires an understanding of the conditions economic, financial, and even cultural that drive bear markets. In addition, there are specific indicators that signal the end of a bear market and the commencement of a bull. Understanding these indicators can prevent premature and costly optimism. The old proverb says the race is not always to the swift, nor the battle to the strong but that is the way to bet. While markets will always present investors with novel conditions, the lessons of past markets should only be discounted with good reason. This paper presents two different kinds of bull and bear markets: cyclic markets that respond to factors such as business and political cycles and much longer secular markets that are primarily behavioral in origin. Secular markets are remarkably similar in duration, price behavior, and change in the PE Ratio across them. This regularity gives strength to predictions about the current market. On an even longer scale, this paper will show a gradually improving market risk profile driven in no small measure by the Federal Reserves efforts to stabilize long-term economic factors and lower overall market risk. It combines that information with statistics on the five secular bear and four secular bull markets of the past 140 years to provide insight into the progress of the current market. Ed Easterling in his important book Probable Outcomes1 establishes the existence of the current bear market and studies how such markets unfold as PE Ratios fall and inflation accelerates. This paper extends Easterlings approach in several directions, with a primary emphasis on causal factors that may play important roles in the progress and end of the current bear market. Secular markets are phenomena of the Price Earnings (PE) Ratio2. Secular bull markets see PE Ratios3 broadly climbing while secular bear markets see them falling, but the behavior of both prices and

Probable Outcomes, Easterling, Ed, Cypress House, 2011.

A way to see this is to consider secular markets as the products of perceived continuity of earnings. In the Shiller PE Ratio used in this study, the numerator is the inflation-adjusted price while the denominator is the simple 10year average of trailing earnings (also adjusted for inflation). A major component of a securitys price is the net

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earnings along the way can be quite variable. A complete secular cycle takes approximately a generation during which the PE Ratio swings from highs to lows and back again. Though many things can trigger the switch from secular bull to bear or back, none can act unless the markets are overextended in one direction or another. Then, like a crystal falling into a supersaturated solution, bears suddenly end and bulls start, bulls peak and collapse into bears. The current bear market will not end until falling PE Ratios fully erase the excesses of the 1990s. Quantitative Easing and other efforts to prop up a weak market will only extend the bear market and delay the start of the following bull market. Secular bear markets are not primarily the creatures of economic conditions4 and economic tweaks cannot overcome them. This paper, through a thorough study of past markets, presents the factors that will end the current market and allow the first secular bull market of the 21st Century to begin.

Properties of Bull and Bear Markets

This section assembles the tools needed to predict the remaining course of the current bear market. It studies how secular bull and bear markets behave internally and the influence various economic and non-economic factors have on that behavior. Before beginning the study, however, a word of caution is needed. The secular market cycle is generational. As a result there have only been five partial or complete secular bear markets and four complete secular bull markets since 1871. That is not a lot of data, particularly for an economy that has changed so dramatically across that period. It would be futile to speculate about future performance based on such scanty history were it not for the substantial regularities in those markets. In this analysis, two kinds of persistent patterns will be given particular weight: those whose behavior is understandable from the proposed cause (e.g. rising interest rates contributing to lower earnings) and those, regardless of cause, that are universal or very nearly so.
present value of future earnings (with the other main component being speculation). In this sense, one component of the PE Ratio, the price, is forward-looking (comprising a speculative factor and a factor related to future earnings) while the other, trailing earnings, is backward-looking. Thus, minus the speculative component, secular bull markets are periods where discounted earnings are expected to rise faster than their recent history and bear markets are periods where earnings growth is anticipated to slow. As will be seen in this study, earnings do accelerate during secular bull markets and decelerate during secular bears. To understand discounted future earnings, it is necessary to understand their three components: expected true earnings (i.e. adjusting for inflation), the expected inflation rate (rising inflation drives up nominal future earnings), and the rate at which the market discounts those future earnings. That discount rate rises in periods of uncertainty and falls in economically calm times. In later sections this understanding of discounted future earnings will be used to predict future PE Ratios.

This paper uses the Shiller PE Ratio throughout: the ratio of the inflation-adjusted market price to the ten-year simple average of inflation-adjusted earnings. Easterling in Probable Outcomes points out that there is a lag caused by using trailing 10-year earnings and that since earnings generally grow with time, earnings used in creating the average ought first to be projected forwards to the current day at the average growth rate. This generally decreases the Easterling PE Ratio by about 15% compared with the Shiller PE Ratio (reflecting an average 3% growth rate for inflation-adjusted earnings over an average of five years). Because this additional factor makes no difference in the conclusions of this paper, this analysis follows Shillers simpler approach.

They are much more the cause of them.

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This analysis proceeds with caution, not reading too much into the existing data, but keeping in mind that past behavior often provides a glimpse of the future.

Types of Bull and Bear Markets

There are two kinds of bull and bear markets: cyclic and secular. Cyclic markets typically last one to a few years and are economics-driven. They are often, but not always, tied to periods of economic expansion (bull) and contraction (bear). The secular markets that are the main topic of this paper typically last more than a decade and are characterized by rising (bull) and falling (bear) PE Ratios and inflation-adjusted prices. A secular bull market takes PE Ratios from long-term lows to long-term highs while secular bear markets take the PE Ratio back down to long-term lows. There are typically one bull and one bear secular market in a generation5. Throughout this paper, when bull or bear is used without a qualifier, it refers to a secular market. Chart 1 shows the S&P 500 Index and its predecessors back to 18716. Secular bull markets are shown in green and secular bears in red. While it is clear that prices rise during bull markets, it is not clear that they fall during bears7. Indeed, for the most part they do not and secular bear markets often end with prices at or above where they were when the market started. As is clear from Chart 1, however, the ride in bear markets is violent, with frequent excursions of 30% or more.

S&P 500 Price

S&P Price in Secular Bull Markets S&P Price in Secular Bear Markets

Source: http://www.econ.yale.edu/~shiller/data.htm

Chart 1: S&P 500 Index Prices 1871 to Present


Frequency analysis of the PE Ratio indicates a peak at 34 years. The average length of a bull/bear cycle has been 33 years. The sum of the averages of bull market and bear market lengths is 35 years. All these numbers are very close to one full cycle per generation.

Much of the data in this paper comes from Robert Shillers web site http://www.econ.yale.edu/~shiller/data.htm. The sources of his data are described in Chapter 26 of Market Volatility, Shiller, Robert, MIT Press, 1989.

Investors generally believe that prices fall in secular bear markets. On the average they do, but only very slightly, and sometimes they rise considerably (in nominal terms). At one point during the 1966-1982 bear market the S&P was 50% higher than at the end of the previous bull market. Secular markets are determined by PE Ratio behavior, not (nominal) price behavior.

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While most investors think of markets in terms of price, the Price Earnings Ratio provides a better way to distinguish bull markets from bears. Secular bull markets have PE Ratios that climb from long-term lows to long-term highs, often with substantial retrenchments along the way. Secular bear markets see PE Ratios generally falling toward long-term lows, though with even stronger ups and downs along the way. Chart 2 is therefore the defining chart of these markets. It shows the PE Ratio over the past 140 years along with an indicator of the associated secular bull and bear periods. The red line is high during bull markets and low during bears.
Shiller PE Ratio during Secular Markets
Shiller PE Ratio
Source: http://www.econ.yale.edu/~shiller/data.htm

Chart 2: S&P 500 Index Price/Earnings Ratio The data presented in Chart 2 will appear many times in this paper and is worth studying in some detail. The most obvious property of the PE Ratio is its variability within a fairly well-defined range. The great majority of the time it oscillates between 10 and 25 with occasional excursions at the extremes of bull or bear markets. On a shorter timescale, the PE Ratio line oscillates vigorously around its secular market trend line. These shorter-term oscillations are the cyclic bulls and bears associated with the business cycle. While it is very clear that a secular market it not an uninterrupted march between PE Ratio extremes, it is equally clear that the range of PE Ratios in a typical secular market is many times greater than those produced by the business cycle. Determining the factors that cause broad secular market behavior will occupy most of the rest of this paper.

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Characteristics of Secular Markets8

Before looking into the abovementioned factors, it is first necessary to characterize secular market behavior in more detail. By definition, a secular bull market is a period of rising PE Ratios, heading toward a long-term peak, while secular bear markets are periods of falling PE Ratios. This study looks at the period from the January 1871 to April 2011. During that period of 1,684 months (140 years) there were 798 months in secular bear markets (47%) and 886 months (53%) in secular bull markets. The average secular bull market lasted 222 months and the average secular bear 195 months. Table 1 summarizes the performance statistics. It will take some discussion to make its meaning clear. Markets overall spend 69% of the time in expansions and 31% in recessions9. Secular bull markets spend a higher percentage of the time (73%) in expansions than secular bear markets (64%). Expansions are somewhat more likely to take place in bull markets (56%) and recessions in bear markets (54%). These modest differences in relative proportions of recessions and expansions are not nearly enough to account for the strong differences between the two secular periods, however. Far more important than the economic expansions and contractions themselves is the markets response to those factors. Bull markets respond much more positively to good news and bear markets much more negatively to bad. This provides the first indicator of what will become a theme of this paper: secular bull markets are times of societal optimism, while secular bear markets are times of pessimism. This difference in response shows up clearly in the fraction of months where stocks are rising in price. These range from a high of 67% for bull markets during expansions to a low of 38% in bear markets during recessions. In all categories, bull markets are positive a higher percentage of the time than bears. Perhaps most important is that during secular bull markets, stock prices rise in half the months when the economy is in recession.

The Depression is difficult to categorize in terms of bull and bear markets. In Probable Outcomes Easterling divides it into two bears and a bull. This paper follows the more traditional approach of calling the entire period from September 1929 to May 1942 a bear market. There is justification for either approach. Easterling is correct that the PE minimum in 1932 of 5.57 is lower than the 1942 minimum of 8.51. The Depression taken as a single bear market, however, much more closely resembles other historical bear periods, even though so taken it is still the shortest secular bear market of the past 140 years. The Depression, so characterized, is classified as a weak bear market on the basis of its ending PE Ratio (see below). Had we followed Easterling, the Depression would have been divided into a strong bear market (September 1929 June 1932), a weak bull (June 1932 February 1937), and a weak bear (February 1937 May 1942).

Market prices are known to be leading indicators of economic conditions. To reflect this fact we have offset price changes from expansions/contractions by three months. Thus when Table 1 refers to performance during an expansion, what it really means is the performance from three months prior to when an expansion began until three months prior to its end.

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Time in Condition Fraction of Bull Fraction of Bear Fraction of Total Time Fraction in Bull Fraction in Bear Up/Down Bull Bear


Expansion 72.6% 64.4% 68.7%

Recession 27.4% 35.6% 31.3% 46.1% 53.9%

Average Duration

52.6% 47.4%

55.6% 44.4%

194.7 months 221.5 months

62.3%/37.7% 52.8%/47.2%

66.7%/33.3% 60.9%/39.1%

50.2%/49.8% 38.3%/61.7% Outperformance of Expansion 1.40% 2.48% 2.03%

Average Monthly Price Change Bull Bear Total Outperformance of Bull

Overall 0.92% -0.13% 0.42% 1.06%

Expansion 1.30% 0.76% 1.06% 0.53%

Recession -0.10% -1.72% -0.97% 1.62%

Source: http://www.econ.yale.edu/~shiller/data.htm

Table 1: Performance in Secular Bull and Bear Markets The average monthly price change is the most obvious difference between secular bulls and bears. Over the past 140 years the average monthly price change over all markets was 42 basis points, but performance was far from uniform. Bull periods advance an average of 92 basis points while bears retreat an average of 13 basis points per month. Thus, overall, bulls outperform bears by 106 basis points per month. Looking more closely at Table 1, it is clear the pessimism of bears is stronger than the optimism of bulls. During periods of expansion, bulls outperform bears by only 53 basis points per month, while during recessions bears underperform by 162 basis points per month. Thus while bear markets have a lower positive response to good news than bull markets do, they have even greater negative response to bad news. During secular bull markets, recession periods underperform expansions by 140 basis points per month. During bear markets, however, this monthly underperformance rises to 248 basis points. This single performance difference accounts for most of the difference between the two market periods: recessions hit bear markets far harder than they hit bull markets10. The trajectory of earnings is also substantially different in secular bull and bear periods. Earnings growth, generally positive in all conditions, accelerates during bull markets and decelerates during


There is no strong evidence that recessions in bear markets are any more severe from an economic perspective than those during bull markets. The recession that started the Depression (1929-1933) was extremely strong but the initial recession (2000-2001) of this bear market was one of the weakest on record.

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bears. To measure this acceleration and deceleration we introduce the earnings ratio11, the current earnings divided by the simple 10-year (120-month) average of the earnings (both adjusted for inflation). The history of the earnings ratio is shown in Chart 3. The black line in Chart 3 is rising when current earnings are growing faster than in the previous 10 years, while a falling line indicates they are growing slower or contracting. Once again the red line shows secular bulls (when high) and bears (when low). Green and dark red lines show how earnings accelerate in bull markets and contract in bears12.
Earnings Ratio during Secular Markets
Earnings Ratio
Source: http://www.econ.yale.edu/~shiller/data.htm

Chart 3: Earnings Ratio This section gave particular importance to the price and the earnings behavior of secular bull and bear periods because secular markets are defined in terms of the PE Ratio. There are, however, many other factors that influence or are influenced by the secular market cycle. These will be investigated in later sections, but before turning to them in detail, an entire secular cycle will be reviewed to get a feel for its general progress. During secular bull markets, confidence is high. Stock prices are rising but PE Ratios are partially constrained by the acceleration of earnings. There are periodic recessions and contractions but the optimism of the period shows up in weak responses to bad economic news and strong responses to good news. Indeed the response to recessions is so weak that nominal stock prices barely retreat at all. Eventually, however, the PE Ratio rises too high and the risk of owning stocks is no longer adequately compensated13. The higher the PE Ratio rises, the less compensation is paid for owning stocks. As long

The denominator of the Shiller PE Ratio is the simple 10-year average of (inflation-adjusted) earnings. The earnings ratio follows the pattern of the Shiller PE Ratio by normalizing inflation-adjusted current earnings (instead of current price) by the 10-year average of those earnings.

The places where the black line in Chart 1 slopes downward correspond quite well to recessions, while the upward sloping periods match periods of economic expansion.

The PE Ratio is, roughly, the inverse of Earnings yield (the ratio of earnings to the money invested the stock price to make those earnings). Earnings yield is the compensation paid to those who hold stocks, some directly as dividends (of obvious immediate value to the investor) and some invested into the business, presumably increasing future dividends. Thus a high PE Ratio means low compensation and a low PE Ratio means high compensation. Market direction depends on whether investors believe those compensations are appropriate for current conditions.

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as the perceived risk of owning stocks is also falling (as often happens in periods of rising confidence and rising prices), everything is fine. Once investors come to believe that stock ownership is undercompensated, however, that belief becomes a self-fulfilling prophecy: investors demand higher earnings yield for the perceived higher risk. The only way (short term) to get higher earnings yield is to lower the price of stocks. Falling stock prices increase actual risk of stock ownership and the feedback loop drives the market into a bear. A period of market pessimism ensues with falling prices and slowing earnings both contributing to a rising risk premium (and therefore a falling PE). This continues until the PE Ratio gets too low and stock ownership is overcompensated. Two seemingly contradictory things are true. First, secular markets are not primarily driven by business cycles and the economic factors associated with them since secular markets extend over much longer timescales. They are, however, strongly correlated with longer-term economic factors. In particular, high PE Ratios, and hence the progression of secular bull markets, are associated with benign economic conditions while low PE Ratios generally occur in periods of higher uncertainty. This uncertainty has far more to do with longer-term fiscal policy and investor confidence than with any particular business cycle14. This important point that uncertainty is the enemy of secular bull markets and high PE Ratios will be emphasized repeatedly in what follows and strongly influences the conclusions. Before investigating these longer-term factors in detail, we first present a somewhat surprising relationship between secular markets and birth rates that may relate to the underlying cause of secular market behavior.

Secular Markets and Population Growth

Chart 4: US Population Growth versus Secular Markets


Which is cause and which is effect is a matter of debate. It is likely that investor confidence, long-term economic conditions, and PE Ratio change all play off against each other, with that feedback loop driving a generation-long behavioral cycle.

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A major hypothesis of this paper is that secular markets are not primarily driven by economic factors15 but are behavioral in nature and generational in scope. Bull markets represent periods of societal optimism while bear markets are marked by caution and sometimes fear. It is true that there are somewhat more recessions in secular bears and expansions in secular bulls, but those may simply be the shorter-term economic responses to the underlying driver of secular bulls and bears: long-term optimism and pessimism16. If secular markets are driven by a generation-long cycle of optimism and pessimism, that cycle ought to have other, measurable effects on society. A study of these effects is, in general, well outside the purview of this paper but a look at one of them is instructive. Chart 4 compares birth rates over the past century to the dates of recessions and secular markets. The red line shows birth rates17, peaking in the early 1920s, the late 1950s, and the late 1980s18. It has a frequency peak of about 35 years, practically identical to that of the PE Ratio19. The black line in Chart 4 is high when the stock market is in a secular bull market and low otherwise. Blue shaded areas show periods of recession. The correlation of birth rates with secular cycles has certainly been strong the past century. Since there is no time offset20 in Chart 4, secular markets are

though clearly influenced by them.


In other words there may be more recessions in secular bear periods simply because consumers are more pessimistic and respond more unfavorably to normal fluctuations in business activity.

Comparison can be made with immigration rates and population growth rates as well as birth rates. Immigration rates appear uncorrelated with secular cycles and growth rates are only correlated through the birth rate. It is th worth noting that the period of highest immigration to America came during the bear market that started the 20 Century.

Though 19 Century birth rate data is spotty, there was also a peak around 1880. This is shown in Figure 1 of th Vice and Comstockery: Abortion Access and the 19 Century Demographic Transition by Ananat and Lahey, March 2007, draft. That paper cites no source for the data presented in their Figure 1, however. Supporting the evidence th of a 19 Century bull market birth rate maximum is data from the http://usgovernmentrevenue.com which shows a peak in population growth between 1875 and 1885.


though offset in phase by approximately 8 years. This offset may mean that it is higher than average birth rates, not rising birth rates that are indicators of the societal optimism/pessimism associated with bull/bear markets

Offsetting the data by one generation shows a similar, but weaker, correlation, perhaps indicative of cyclic reinforcement. As a particularly large cohort of children (product of the previous period of societal optimism) reaches maturity, they contribute greatly to both increased productivity and increased consumption. If there is any tendency toward another secular bull market, this increased productivity (and consumption) will enhance it. The resulting good times lead to more optimism and more children, preparing for another cycle. Since those producing the children are themselves members of an out-sized cohort of now-30 year olds, the effect is further strengthened. The generational pattern of secular bull and bear markets is an example of a pattern with logical support. First, it makes sense that at some level each generation must learn anew what the previous generation had figured out. Second, children are often more like their parents than either resemble unrelated people. Therefore if your parents are members of an optimistic generation that had more children than usual, it is more likely that you also will be a member of such a generation. Thus reinforcement of the optimism/pessimism and bull/bear pattern on a

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unlikely to be caused by the higher or lower birth rates (e.g. by increased productivity). Far more likely is that the same thing causes both: optimistic societies and optimistic times produce more children. Regardless of their actual cause, secular markets have observable interrelationships with many different factors in addition to population growth. Studying these interrelationships provides substantial information on the way the current bear market is likely to play out. The next sections consider several such factors. Of all external21 economic factors, trends in U.S. Treasury yields and inflation have the greatest impact on the progress of secular markets. This makes them the most important pieces of the puzzle and the ones discussed first22.

generational level makes sense: even if historical events or economic factors perturb the system, the length of a generation and the tendency of children to resemble their parents (and grandparents) will tend to swing the pattern back into a generational one.

Price and Earnings are considered internal factors of secular markets since secular markets are defined by the performance of the Price/Earnings Ratio.

Interest rates, Federal deficits, and inflation are clearly deeply interrelated, perhaps most importantly through the money supply. Particularly since the start of the Great Moderation in 1982, but visible in Fed behavior and market performance well before, the three play the central role in Federal Reserve attempts to control and moderate the economy. Rising deficits sometimes (but not always) lead to higher inflation which lead to both market and Federal Reserve forces toward higher interest rates. These, in turn, tend to lower economic activity, reducing both current stock price rises and projected earnings.

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Treasury Yields and Secular Markets

U.S. Treasury yields are moving in a supportive direction when they are rising during secular bear markets and falling during secular bull markets23. They are moving in an adverse direction when they rise during bull markets and when they fall during bear markets.

Long-Duration Interest Rate (%) Bull Market PE Ratios Bear Market PE Ratios

Source: http://www.econ.yale.edu/~shiller/data.htm

Chart 5: Mid-Duration Treasury Interest Rates versus PE Ratio

Chart 5 shows the yield on intermediate-term24 Treasury securities (green) and the PE Ratio (red in secular bear markets and black in secular bull markets). While the co-movements of the PE Ratio and Treasury yield are complex25, they are clearly related. This section explores that interrelationship.


The reason for this terminology should be obvious: rising Treasury yields are accompanied by rising borrowing costs for businesses. Those costs must be removed from future earnings calculations, lowering the current stock price and hence its PE Ratio. Thus rising yields support falling PE Ratios in secular bear markets.

We use intermediate-term Treasury yield (essentially that of the 10-year note) as the representative interest rate primarily because its duration most closely matches both the length of secular markets and the average borrowing time of longer-term corporate debt. A similar analysis using the rates for short-term paper gives very similar results.

When interest rates and PE Ratios both change direction, Treasury rate changes always lead or occur at the same time: interest rates started climbing in February 1901 but the bull market did not end until July. Interest rates next changed direction in January 1921. The great secular bull market of the 1920s started the same month, though stock market prices did not reach bottom until August. In January 1941 Treasury rates started their long climb to their 1980s peak. The bull market started in June 1942, 17 months later. This is the longest delay from interest rate to PE Ratio direction change and the only change in Treasury direction that was adverse to the new market. It is likely that increases in both production and money supply at the start of WW II, not interest rate direction change, started that bull market. This is instructive particularly because the next change in interest rates will be adverse to a new bull market, and hence may be well separated from it in time.

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Table 2 shows each of the secular markets of the past 140 years, their duration and whether they were of long or short duration26, whether they were weak or strong27, their ending PE Ratio, and the general direction of Treasury yields during the market. Blue background in the final column indicates that the general direction of Treasury yields was supportive, while gray background indicates it was adverse. Perhaps the most important lesson in this table is that strong markets are always supported by Treasury yield direction and weak markets almost never are28.
Period ..-1877 1877-1901 1901-1921 1921-1929 1929-1942 1942-1966 1966-1982 1982-1999 1999-Present Type Bear Bull Bear Bull Bear Bull Bear Bull Bear Months ??? 288 234 105 152 284 198 209 152-194? Long? ??? Yes Yes No No Yes Yes No No? Strength Weak Weak Strong Strong Weak Weak Strong Strong Weak? Final PE 8 25 5 33 9 24 7 44 15? Yield Direction Falling Falling Rising Falling Falling Rising Rising Falling Falling

Source data from: http://www.econ.yale.edu/~shiller/data.htm

Table 2: Bull and Bear Market Characteristics

Several patterns are apparent in Table 2. Bull markets are always of the same strength as the preceding bear, while bear markets are of the opposite strength as the preceding bull29. This predicts that the current bear market and the bull that follows it will both be weak30. Table 2 shows the duration of the secular markets. The average length of a bear market was 16 years, two months while the average bull market lasted 18 years. The fourth column of Table 2 shows
Finally, the current decline in interest rates began in September, 1981 and the Reagan bull market started in August 1982, 11 months later. There were three additional changes in PE direction: September 1929, January 1966, and December 1999, all negative. While none of these followed broad change in interest rate direction, both the 1929 and the 1999 reversals followed sharp interest rate rises in the middle of a period of falling rates and the 1966 reversal followed a resumption in the post-1942 interest rate rise that had been halted since the late 1950s.

A long market lasts longer than the average market of its type.


A secular bull market is considered strong when its PE Ratio climbs above the average bull market maximum PE Ratio of 31.5. A secular bear market is considered strong if its minimum PE Ratio falls below the average bear market minimum of 7.06.

The only exception was the weak bull market that ended the 19 Century.



These patterns are instructive and certainly interesting but it is again necessary to remember how few total secular markets there have been in the period studied.

The likelihood of this is enhanced by the current adverse direction of yields (falling in a bear market) and the high likelihood that they will be rising (and hence again adverse) during the coming bull.

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whether a market was longer than these averages or not. This leads to two more examples of regularity in the pattern: first, in every case weak bulls and strong bears are long-lasting while strong bulls and weak bears are short. Second, each bear/bull cycle has one short and one long market, with the pairs alternating every cycle. A continuation of this pattern would indicate that the current bear market will be relatively short and the following bull long. Since the average duration for a bear market is 194 months, the patterns would indicate that the current secular bear market will last somewhere between 152 months (the shortest bear on record) and 194 months (the average bear market duration). This would predict an end of the current bear sometime between August 2011 and February 2016. Additional considerations, developed below, indicate a time nearer the end of that period. An easier way to show the relationship between interest rates and PE Ratios is to plot them against each other. Chart 6 plots the intermediate duration Treasury yield (in percent) along the horizontal axis, while the vertical axis shows the contemporaneous PE Ratio. The red dot shows conditions as of April 2011. Most of the circled area, representing periods of low PE and low yields, occurred prior to WW II and the rest occurred during the recent financial crisis. It seems likely, therefore, that the path to lower PE Ratios (required to end this bear market) will be through higher interest rates. Another way of looking at this is that the relatively high present PE Ratio may be an artifact of artificially low interest rates and, once either the Federal Reserve or the bond market starts driving interest rates higher, lower PE Ratios will follow.
PE Ratio vs Mid-Duration Interest Rate

Shiller PE Ratio

Source: http://www.econ.yale.edu/~shiller/data.htm

Chart 6: PE Ratio versus Treasury Yield The supportive or adverse effect of U.S. Treasury yield movement is extremely important. Rising yields impede earnings growth both directly by increasing borrowing costs and indirectly by enhancing Radiant Asset Management, LLC P. 14

overall pessimism, while falling yields enhance both earnings and optimism. The next factor considered inflation has a comparable impact on PE Ratios.

Inflation31 and Secular Markets

The PE Ratio is very sensitive to the inflation rate. Rates significantly far from the average32 of 2.25% per year have a deleterious impact on PE Ratio. Chart 7 plots the PE Ratio (vertical axis) versus the inflation rate for the period 1877 to present. The triangular structure of the distribution is remarkable.
PE Ratio vs Inflation Rate
Shiller PE Ratio
Inflation Rate (%)
Source: http://www.econ.yale.edu/~shiller/data.htm

Chart 7: PE Ratio versus Year over Year CPI Change The red dot shows the data for April 2011 with a PE of 23 and a year-over-year CPI change of 3.49%. While the current datum is not extreme by historical standards, there is not much room for inflation to rise without a substantial drop in the PE Ratio. Clearly the inflation rate and the interest rate are related, both because the bond markets demand higher return in inflationary periods and because, at least since the start of the 1980s, the Federal Reserve has used the interest rate as its primary tool in the fight against inflation. Appendix A shows the three-way relationship among interest rate, inflation rate, and PE Ratio in more detail.


This section could just as easily have been about the money supply per unit output as about inflation. The close correlation between increases in the money supply and increases in inflation ensures this. Each chart in this section would be practically identical were the money supply studied instead of the inflation rate. For a more complete discussion of the correspondence between money supply and inflation, see Appendix C.

over the period 1871 to present

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Chart 7 shows that inflation rates well away from the average negatively impact the PE Ratio, but inflation rate volatility33 has an even larger impact34. Chart 8 plots the PE Ratio versus the variance of the inflation rate. Because the range of variance is so great, the horizontal axis is on a log scale. This shows the extreme range over which inflation rate volatility has varied during the past 140 years.
PE Ratio vs Inflation Rate Variance
Shiller PE Ratio

Variance of Inflation Rate

Source: http://www.econ.yale.edu/~shiller/data.htm

Chart 8: PE versus One-year Variance of Inflation Rate The red trend line in Chart 8 shows how a thousand-fold change in the volatility of inflation has changed the PE Ratio from an average of 10 at the high end of volatility to 27 at the low. The red dot again shows current conditions. It is highly unusual to have such a high PE Ratio with this much uncertainty in the inflation rate, especially since that uncertainty has more than doubled in the past two years. Inflation rate volatility has not been as high as currently since 1988 as the Carter inflation was being brought under control35 and the PE Ratio was 14.

An excellent and detailed discussion of the relationship between this volatility and secular bear markets is available from Secular Bear Markets and the Volatility of Inflation, Hester, William, June 2009. It is available here: http://www.hussmanfunds.com/rsi/secbearinflation.htm

The way volatility in inflation produces lower PE Ratios is easy to understand. The form of volatility plotted here, the variance, is a standard definition of risk. Higher volatility in an economic or financial factor results in higher perceived risk. That higher perceived risk manifests as a higher discount rate that investors apply to future earnings, since those earnings are now less certain. This higher discount rate lowers projected earnings and hence the current security price.

The period from 1982 to 2003 is known as the Great Moderation. It was a period in which the primary approach to economic control was through the interest rate and a time of extremely stable economic factors. After this period and apparently afraid of Japanese-style deflation, Greenspan kept interest rates abnormally low, prompting (among other things) the housing bubble. The crash that followed when interest rates were finally raised required them to be rapidly lowered again until short-term rates were effectively zero. These very low interest rates going

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After reviewing similar statistics for the changes in Gross Domestic Product, we will present the way volatility in the inflation rate and GDP change have evolved over time and what the cause may have been.

Gross Domestic Product and Secular Markets

Another economic factor that plays a role in secular markets is the growth rate of the Gross Domestic Product. Chart 9 plots the PE Ratio versus the inflation-adjusted year over year change in the GDP36. The current position is shown by the red dot. The anemic 0.43% real GDP growth coupled with an inflation rate of 3.47% (year over year) does not yet spell stagflation but it should provoke worry. Most periods where GDP growth was this weak have seen far lower PE Ratios.
PE Ratio vs Inflation-adjusted GDP
Shiller PE Ratio

Inflation-adjusted GDP Changes

Source: http://www.econ.yale.edu/~shiller/data.htm

Chart 9: PE versus Inflation-adjusted One Year GDP The long-term average inflation-adjusted annualized GDP growth rate is 3.61%. Chart 9 might be somewhat surprising at first glance. It seems obvious that sharp drops in GDP would be associated with lower PE Ratios, but why are large rises in GDP also associated with lower PE Ratios? The reason is

into the Financial Crisis gave the upper hand to supporters of fiscal control and to those who favored Quantitative Easing (otherwise known as printing money), at least in part because interest rates could not be lowered further. Both the flail in interest rates and the actions of fiscal policy supporters have resulted in a much more volatile economy.

We use changes in the inflation-adjusted GDP so that the effect of inflation is isolated to the charts of the previous section.

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simple: it is during low PE periods37 that the GDP, like the inflation rate, is most volatile. As a result, both sharp declines and sharp rises in both statistics preferentially occur in such periods. Instability in the GDP, like instability in the inflation rate, is the enemy of high PE Ratios. The need for stability is clear in Chart 10 which shows the relationship between the variance of the GDP changes and the PE Ratio. As with the inflation rate, GDP volatility this high has not been seen since 1988 when the PE Ratio was at 14.
PE Ratio vs GDP Variance

Shiller PE Ratio

Variance of GDP Changes

Source: http://www.econ.yale.edu/~shiller/data.htm

Chart 10: PE versus One Year Variance of GDP Change It is clear that lower volatility in either GDP or inflation is beneficial to the PE Ratio, but neither Chart 8 nor Chart 10 has a time component to it. Chart 11 presents the same data across time, showing how both financial indicators have evolved and providing some indication of why.


when many forms of risk are elevated

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0.1 0.01

Source: http://www.econ.yale.edu/~shiller/data.htm

Chart 11: Variance of Inflation, GDP Change, and Interest Rates Chart 11 shows that the dramatic decrease in the variability of both the inflation rate (red curve) and the GDP growth rate (green curve) has been accompanied by an equally dramatic rise in the variability of long-term interest rates (black curve). The trend line in each case shows a change of two orders of magnitude38. This chart is of interest for several reasons. Of particular relevance is the strong anti-correlation of interest rate volatility with the other two factors. The chart shows very clearly that the Federal Reserve, through its control of interest rates, has removed volatility from the economy and deposited it into the yield of U.S. Treasury securities. Interest rate change has been a component of economic moderation39 throughout the 140 years, but really gained steam after WWII when the volatility of inflation and the GDP started downward in earnest. Interest rate control became the primary control mechanism only at the end of the 1970s. Once that happened, the Federal Reserve succeeded in lowering both economic and interest rate volatility by rapidly applying their controls during the Great Moderation, a period of generally lower risks across the economy. The chart provides some evidence that the Great Moderation ended around 2003. As economic uncertainty has lessened there has been a generally-rising trend in PE Ratios across both bull and bear markets. This trend reflects the overall perception that the risk of owning stocks has declined across time. While this is doubtless helped by increasing transparency in corporate operations, the greatest cause is the increasing stability of the broad economy. To make this explicit, Chart 12 compares interest rate and GDP volatility with the PE Ratio, all plotted on the same log scale.


It is probably significant that the volatility in the inflation rate has fallen more than that of GDP growth. Control of inflation has long been of greater importance to the Federal Reserve than moderation of economic growth. Indeed, the classic Taylor formula weights the inflation rate twice as heavily as changes in the GDP. See Discretion versus Policy Rules in Practice, Taylor, John, 1992.

whether imposed by the market or by the central bank

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PE Ratio Trend vs GDP and Interest Rate Volatility

Va riance, Shiller PE Ratio


Source: http://www.econ.yale.edu/~shiller/data.htm

Chart 12: PE Ratio and Economic Volatility across Time It is clear from Chart 12 that the fall in the volatility of inflation and the GDP has been accompanied by a gradual rise in the PE Ratio. Decreasing risk has therefore translated into a progressive rise in the PE Ratio40. The correlation with the PE Ratio is -0.38 for inflation volatility and -0.48 for GDP growth rate volatility. The best explanation is that the increasing effectiveness of the Feds monetary controls drove a general rise in PE Ratios through this risk reduction mechanism.

Federal Deficits and Secular Markets

Federal deficits have a somewhat different effect on secular markets than the factors considered so far. Rather than generally affecting the PE Ratio across the markets, they have much greater influence as triggers of the start of bull and bear periods41.


The chart (and the correlation numbers) indicates that the anticorrelation extends to smaller details of the three curves. Note, in particular, how both the green and (especially) the red curve tend to rise in secular bear market periods (when PE Ratios are falling) and fall in secular bull markets.

As will be shown, deficits are supportive of rising PE Ratios when they occur at or just before the start of a bull market and adverse if they continue too long.

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Annual Deficit (% GDP)

Source: usgovernmentspending.com

Chart 13: Budget Deficits and Bull/Bear Markets The connection between Federal Deficits and the direction of secular markets is nowhere near as clear as the connection with Treasury yields. Nonetheless, deficits are certainly not the enemy of bull markets. Chart 13 shows Federal deficits as a percentage of the GDP. Large deficits either preceded42 or were contemporaneous with the start of the last three bull markets spending associated with World War I, the Depression and World War II, and the Cold War. The remaining bear market the one that started in 1877 had no period of deficit spending preceding it. It did, however, show falling surpluses. Each bear market, on the other hand, began with the Federal Government running a surplus (1901, 1929, and 1999) or with a falling deficit (1966)43. It is likely that there is both a cause and an effect going on here. Bear markets lower government tax revenues (both directly through capital gains reduction and increased unemployment, and indirectly through decelerating earnings) and therefore tend to end in a higher deficit. All else being equal, bull markets tend to raise those revenues.


By the time the 20s bull market got started the government was running a surplus. It appears that deficits during the years preceding the secular market start, not at the start itself, are more important.

It is worth asking whether the only effect of the deficits is to increase the money supply and inflation rate (in which case this section is redundant with the previous one). A comparison of Chart 13 with Chart C-1 in Appendix C shows that while there is some correlation between deficits and increases in both the money supply and inflation, the relationship is by no means a close one. Even if one accepts the Quantity of Money explanation of inflation (which the author does with some reservations), it has to be pointed out that Federal deficits are not necessarily inflationary for the simple reason that they do not necessarily increase the money supply. Insofar as they are financed by sources of money included in M2 (e.g. by savings, the Social Security trust fund (through taxes), and so on), they do not increase the money supply and are not inflationary. Of course when they are financed by Federal Reserve purchases based on fiat creation of money, they do increase the money supply. The situation is less clear when they are purchased by foreigners. That raises the US money supply at the expense of, say, Chinas money supply. If that were all there was to it, the effect would be to increase inflation in the US. If, however, the money used to purchase debt instruments would otherwise have been used to purchase other American goods or assets, those Treasury security purchases are not inflationary, since they just move money from one M2 component to another.

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While deficit spending appears to have less influence on the long-term course of a secular market (as opposed to providing a trigger to start one), it is worth pointing out one relatively weak effect that nonetheless provides supportive evidence on the end of the current bear market.
Shiller PE Ratio

Full Upper Envelope

Full Upper Envelope Upper Envelope w/o Tech Bubble Trend Line Lower Envelope

Annual Deficit (%)

Sources: usgovernmentspending.com and http://www.econ.yale.edu/~shiller/data.htm

Chart 14: PE Ratio Predicted from Deficits Chart 14 is similar to Charts 7 and 9 in that an economic parameter provides the horizontal axis while the PE Ratio is measured along the vertical axis. This one is different, however, in that the PE Ratio is not contemporaneous with the deficit but takes place five years in the future. The red line shows the trend, indicating that higher budget deficits are correlated with somewhat lower PE Ratios five years later. The gray oval shows the interception of the trend line with the current deficit of 10.9% of GDP at a PE Ratio just below 1544. The implications of this chart will be discussed in more detail during the analysis of the end of the current market.

Unemployment Rate and Secular Markets

Another important economic factor is the unemployment rate. While a notoriously lagging indicator, as Chart 15 shows, the relationship between it and the PE Ratio is far from random. The data shown in Chart 15 goes back to 1948, the earliest date for which unemployment data is provided by the Bureau of Labor Statistics. While there are several estimates of the unemployment rate back into the 19th Century45, such data sources agree on general trends but disagree strongly on the actual statistics and should be used with great caution.


The positive effects of deficit spending on starting bull markets but the deleterious longer-term effects parallel Keynes observation that deficit spending must be used as a short-term measure to jump start the economy but that protracted deficit spending prevents the real source of economic growth the private sector from recovering. As current deficits accelerate and the economy struggles, this lesson may need to be learned again in this generation. 45 See, for example, "Spurious Volatility in Historical Unemployment Data", Romer, Christina.

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Source: Bureau of Labor Statistics

Chart 15: PE Ratio and the Unemployment Rate The red dot in Chart 15 shows the current conditions which are clearly extraordinary. All data points within the black oval are from the start of the Financial Crisis to the present. It is obvious that the current high level of unemployment is more usually found with a PE Ratio below 10 and that the current PE Ratio is more typical of periods with unemployment below 7%. Such extreme levels have been seen only once before. Romer (see footnote) indicates that during 1937 during the brief recovery from the depths of the Depression unemployment had fallen to 17% while the PE Ratio peaked at 22, close to todays value. Then, as unemployment rose again, the PE Ratio fell below 10 over the following five years. Romer provides unemployment estimates back to 1890. Using that and data provided by the Bureau of Labor Statistics enables us to show that the unemployment rate generally falls across secular bull markets and rises across secular bear markets46.


The conditions in 1920 and 1942 are distorted by the end of WWI and the start of WWII.

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Chart 16: Unemployment Rate in Secular Markets These trends are by no means uninterrupted, of course, since unemployment also rises in cyclic bear markets and falls in cyclic bulls. This completes the study of the relationships between the PE Ratio and various economic factors. In the following section we show the degree to which the abovementioned factors are predictive of the PE Ratio.

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Predictive Factors for the PE Ratio

From the previous sections it is clear that the PE Ratio is strongly driven by the inflation rate and the growth rate of the GDP. They in turn are heavily influenced by the interest rate. Chart 12, in particular, showed that there has been a general up-trend in the PE Ratio across all markets, following fairly closely the trend in volatility in the inflation rate and the GDP growth rate. Chart 17 is remarkable and shows the factors previously studied account in considerable detail for PE Ratio behavior across all markets.

PE Ratio Predicted by Economic Factors

Shiller PE Ratio

Shiller PE Ratio Predicted PE Ratio

Source: http://www.econ.yale.edu/~shiller/data.htm

Chart 17: Actual versus Predicted PE Ratio

In Chart 17 the black line again shows the PE Ratio across time. The red line shows the best-fit (least squares) six parameter curve that matches the black line. The five weighted variables are an offset (close to the average PE across the period), the inflation rate, the interest rate, the variance of the inflation rate, and the variance of GDP changes. All four of the latter variables were either averaged (the first two) or calculated (the latter two) over 75 months (the sixth parameter). Although there are periods of substantial disagreement (e.g. around 1900 and during the Depression), the fit is remarkable much of the time. This fit indicates that substantial understanding of PE behavior can be achieved from understanding the inflation rate, the interest rate, and the GDP47 growth rate. In the following section this predictability will give us an insight into the end of the current market.

The End of the Current Bear Market

We now have the tools to estimate when the current bear market will end. Clearly there are large margins of error with the estimates, particularly since there have only been three complete bear markets in the past 140 years and data and market behavior from more than a century ago is suspect as a guide to present-day behavior. Still, the remarkable regularities in previous bear markets appear to still be in force in the current one.


Note that the changes in the GDP do not enter into the model, only the variance of those changes. The changes in GDP considered in isolation have little predictive value for the PE Ratio. They impact earnings and stock price roughly equally, which effects cancel out in the PE Ratio. It is therefore steady growth, moderate inflation, and low interest rates that drive PE Ratios higher.

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Three things have to be estimated about the end of the current bear market: its date, the PE Ratio, and the S&P 500 Index value.

PE Ratio
We approach the concluding PE Ratio of this bear market from several perspectives. The easiest is to assume it will be the average of the values that ended the four previous bear markets, 7.09. Once the ending PE Ratio is estimated, straightforward assumptions about earnings growth and inflation will translate those assumptions into a range of final dates and prices. The following assumes that earnings grow at a nominal rate of 3.38%, the average across bear markets48. The current PE Ratio is 23.14. If the current bear market ended today, the price would therefore be 7.09/23.14 times the current price of 1,335.25 or 409. This number rises 3.38% per year as rising earnings support a higher price at the same PE. This produces Chart 18 for the ending S&P price. If the bear market ends in the year shown at the bottom of the chart, the S&P would have the price shown on the left. The PE Ratio would be 7.09 in all cases. This may safely be said to be the most pessimistic of the predictions. Bear Market End

Ending S&P Price

Chart 18: S&P Price with PE = 7.09 There are several reasons to believe that both the PE and the price predicted from the average of previous bear markets are much too low. They would demand between a 58% (if bear market ends in 2020) and a 69% (if it were to happen immediately) decline in price, both of which seen unlikely today. Further, the analysis from the average ignores the risk reduction discussed earlier. Taking that risk reduction into account (and presuming nothing happens in Fed or fiscal policy to reverse it) makes a considerable difference in ending price and PE Ratio predictions.


It is quite easy to get nominal and inflation-adjusted data confused at this point. The PE Ratio is the ratio of the inflation-adjusted price and the 10-year simple average of the inflation-adjusted earnings. This would argue for using the inflation-adjusted values for price and earnings throughout. When an investor buys a share of stock, however, he pays the nominal price for it and when most investors want to know the value of the S&P 500 Index on a particular day, they want to know the nominal price.

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Rising PE Ratios across Time

Shiller PE Ratio
Source: http://www.econ.yale.edu/~shiller/data.htm

Chart 19: Trend of PE Ratio across Time Chart 19 shows the up-trend in PE ratios across time, corresponding to the falling risk of owning stocks. The black line is the trend line while the green and red lines are one standard deviation above and below the trend line. It is remarkable how often local peaks in the PE Ratio are near the green line and local troughs near the red. The red line today is at about 14 and will remain below 15 for the rest of this decade. This provides the first rough guess that the ending PE Ratio of this market will be between 14 and 15, with an average of 14.449. Chart 20 shows the S&P price range at that PE. The result is considerably less distressing than the previous one. Bear Market End

Ending S&P Price

Chart 20: S&P with PE = 14.4 Chart 20 would require a drop between 14% (2020) and 38% (immediately). While still substantial, either would be less alarming and more believable than the previous values. Chart 21 shows another way to look at the PE Ratio across multiple bear markets. It eliminates the starting PE Ratio by normalizing the PE Ratio throughout the bear market by its value at the start. In Chart 21 the 19th century bear market should be ignored because it started prior to the earliest data and hence is incorrectly normalized. The next three bear markets are shown in their entirety and the final one is shown to date.


Further caution is advised since two of the PE minima that ended bear markets occur well below the red line (1921 and 1982), one near it (1942) and one well above it (1877).

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Normalized PE Ratio

Chart 21: Normalized PE Ratio in Bear Markets In Chart 21 the green lines show the progress of this ratio for the average bear market (which happens to be very close to the bear market from 1966-1982). Thus each green line is the same. This shows how remarkably similar the various bear markets are from this perspective: far more regular than their initial or final PE Ratio is the ratio of the ending and starting PE Ratios. Table 3 shows the data. The three ending values are similar but they reveal an upward trend, shown by the red line in Chart 16. Normalized PE Ratio 6/15/1901 12/20/1920 0.19 9/3/1929 4/28/1942 0.26 1/19/1966 3/8/1982 0.29 12/31/1999 ???? ???? Table 3: Normalized Ending PE Ratio Bear Start Bear End This trend can be used to estimate the final normalized PE Ratio (and hence the final PE Ratio itself) for this market. It turns out the result is the same whether we create a trend by number (that is, bear 1, 2, 3, and (the current one) 4), by start dates, or (guessing the end of the current bear to be sometime between the start of 2013 and the end of 2016) by end dates50. Each approach yields an ending normalized PE Ratio of 0.348. Since the initial PE for this bear market was 44.2, this translates to an ending PE Ratio of 15.4. Chart 22 shows the final price range for this PE Ratio.


This reflects the remarkably even spacing of the lengths of full bull/bear cycles discussed above.

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Bear Market End

Ending S&P Price

Chart 22: S&P with PE = 15.4 This requires a drop of between 9% and 33% from current prices, depending on ending date. This is among the most optimistic estimates presented here. Chart 23 provides another way to estimate the ending PE Ratio of the current bear market. The jagged part of the red line is just the PE Ratio from Chart 2 for the period from 2000 to present. The smooth black line assumes that, starting at current values, both the S&P 500 Index price and earnings change at the average bear market rates. That is, it assumes that prices fall 1.57% per year and earnings grow at 3.38% per year. It also assumes an inflation rate of 5% for the period51. PE Ratio Real and Predicted

Projected PE Ratio using Historical Averages

Shiller PE Ratio

Projected PE Ratio at End of Current Bear Market

Real PE Ratio
Source: http://www.econ.yale.edu/~shiller/data.htm

Chart 23: Projected PE Ratio


One might expect the projection line to have no inflection points. The fact that it does is due to the ten-year average of earnings including periods where neither the price nor the earnings were changing at the average rates. The curve is relatively insensitive to the assumed inflation rate.

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The circled red segment in Chart 23 spans the most likely end dates of the current bear market (see below). This brings the PE Ratio at the end of this market to between 15 and 18. Yet another estimation approach projects forward the predicted PE Ratio (see Chart 17). In producing Chart 24, it is assumed that the volatility in GDP and inflation remain constant at current values, that the inflation rate is 5%, and that the long-term interest rate averages 1.84% above the inflation rate (the average from the start of this bear market)52. PE Ratio Real and Predicted

Projected PE Ratio using Historical Averages and Other Factors

Shiller PE Ratio

Projected PE Ratio at End of Current Bear Market

Source: http://www.econ.yale.edu/~shiller/data.htm

Chart 24: Predicted PE Ratio The two curves in Chart 24 therefore predict the PE Ratio by two different methods. The black line predicts the PE Ratio by assuming the rest of this bear market proceeds like the average bear market, giving the same results as Chart 23. The red line, on the other hand, predicts the PE based on the inflation rate, the long-term interest rate, and changes in the GDP. The circled region is from 2013 through 2016, the most likely ending points of the current bear market. It predicts an ending PE Ratio of between 14.8 and 16.1. Our final approach to determining an ending PE Ratio for the current market is to look at the history of budget deficits and see how the current one fits in. Chart 25 duplicates Chart 14.


This, therefore, presumes a rise in interest rates between now and the end of the current bear market.

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Upper Envelope from Tech Bubble Upper Envelope from Tech Bubble Upper Envelope from Majority Data Trend Line Lower Envelope

Source: http://www.econ.yale.edu/~shiller/data.htm

Annual Deficit (%)

Chart 25: PE Ratio Predicted from Deficits In the previous analysis of budget deficits a discussion of their long-term effect on PE Ratios was deferred. Following is a look at that effect some detail. The horizontal axis is the budget deficit in percent while the vertical axis is the PE Ratio five years later. Thus if a point has the budget deficit of July 1988 for its X value, it has the PE Ratio of July 1993 for its Y value. Lack of experience with budget deficits of the current size makes conclusions from Chart 25 suspect, but it does show evidence supporting the conclusions of the other sections. The current deficit is 10.9 percent of the GDP. The four lines in Chart 25 show different ways to estimate the PE Ratio five years from now. The red line is simply the trend line of the data and associates a PE Ratio of 14.7 with the current deficit. The blue line is the top envelope of the distribution. It goes through -10.9 at about 9. The blue line is by far the most suspect because the entire set of data with the PE Ratio above 25 is from the Tech Bubble. The green line ignores that extreme data and forms a new envelope. It passes -10.9 at a PE of 12.5. The bottom envelope gives 13.2. While very noisy, the data in Chart 25 gives support to a final PE Ratio well above traditional lows and probably in the range of 12 to 15. Putting all these analyses together, and acknowledging the uncertainty in all this data, there is nonetheless reason to believe that the PE at the end of this bear market will be much closer to 15 than to 7. Chart 26 shows the final prices estimated at an ending PE Ratio of 15. It requires a price drop of between 11 and 35% from current levels

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Bear Market End

Ending S&P Price

Chart 26: S&P with PE = 15 Having estimated the final PE Ratio of this bear market, the next requirement is the end date. The average length of 20th century bear markets was 5,880 days, or just over 16 years. That would end the current bear in February 2016. If the pattern of the past 140 years remains true (see Table 2 above), the current bear market will be shorter than average, so this gives the outer limit of the projected end date. An alternative approach takes the trend line of the lengths of the previous bears. In so far as any trend can be established, bear markets have been growing shorter with time. This is consistent with a broad trend in the markets in which most things happen on a more rapid timescale53. Projecting the trend predicts the current bear market will end in November 2012. This and February 2016 therefore serve as bracket dates for the end of the current bear market. Using the assumption of an ending PE Ratio of 15, Chart 26 give a projected ending price between 912 if the bear market ends in 2012 and 1015 if it ends in 2016. Chart 27 takes a different approach to determining the final S&P price. It normalizes the inflationadjusted S&P price through the same procedure used above for the PE Ratio: it sets the inflationadjusted price of the S&P 500 Index to 1 at the start of each bear market and plots that price for the rest of the bear market. The green lines in Chart 27 show the average behavior of the three complete bear markets (all green lines are therefore the same). The black line shows the trend of the ending ratios. The projected ending value of that ratio is 0.425. That yields 823 for the inflation-adjusted ending price of the S&P. Assuming a 5% inflation rate, that gives a final price of 890 for the S&P if it ends in 2012 and 1042 if it ends in 2016.


Bull markets have also been growing shorter, but the trend is much less pronounced. Two competing trends may be at work the tendency of nearly everything in markets to speed up, and the increasing length of a generation.

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Source: http://www.econ.yale.edu/~shiller/data.htm

Chart 27: Inflation-adjusted S&P Price Ratio in Bear Markets

To summarize then: With considerable uncertainty, it is possible to make some predictions about the PE Ratio, price, and ending date of the current bear market. The mean result of this analysis has the current bear market ending with a PE Ratio of 15 sometime between late 2012 and early 2016 with the S&P price between 900 and 1050. This result, considerably better than previous bear markets, is due in large measure to the rising stability in the economy. Were we to return to the higher inflation and higher uncertainty of previous bear markets, the bear could become much worse and be much more protracted. It is a very long way down to the average PE minimum of 7.09. As Chart 18 showed, that would predict an S&P 500 price below 500. Continued budget deficits over 10%, rising inflation and interest rates, and increased driving of the economy may deepen and prolong the current crisis. Indeed there is already evidence that the Federal Reserves propping up of the stock market through Quantitative Easings 1 and 2 has prolonged the crisis by preventing the PE Ratio from falling sufficiently. The relatively optimistic view of this paper on the end of the current bear market depends on declining risk trends remaining in effect. More discussion of this can be found in Appendix B.

Signs of Alarm
There is certainly a moderate chance that things will turn out much worse than outlined in this paper. A terrorist attack or great natural disaster could derail any economic recovery for a considerable period. More concerning, however, and the most likely cause of protraction and deepening of the current bear market, is the increase in U.S. Government debt. This is not just because of the general trends outlined above where higher deficit spending leads to lower PE Ratios in the years that follow. Rather, it has to do with the specific causes of the current financial crisis: mishandling of personal and governmental debt. Under the influence of the Greenspan put individual investors used their houses and other investments as though they were automatic tellers. Dept was cheap because interest rates were kept artificially low54 and individuals took advantage to borrow and spend. Once interest rates began to rise again, housing prices collapsed and the party ended. Or rather the party shifted from individuals to the Federal and state governments.


Getting Off Track, John B. Taylor, 2009.

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The same pattern of borrowing at cheap rates and spending the money that got homeowners and consumers in trouble five years ago is being followed by governments today55. The excuse, of course, is that such deficit spending is required to get the economy going again. Unfortunately, such extreme spending hurts the economy as businesses restrain their own (and better targeted) spending fearing inflation, higher taxes, greater regulation, and other adverse moves by a Federal Government that often seems hostile to private enterprise. When businesses do not invest in employees or capital equipment, it is because they believe the risks of doing so outweigh the likely benefits. The extraordinary length of the current period of high unemployment shows that businesses believe the risks to be substantial. John Hussman56 has observed that economic expansions are emphatically not driven by a consumer recovery. They are invariably driven by swings in gross domestic investment capital spending, autos, housing, factories, and other outlays that are heavily reliant on debt financing. The debt financing needed for economic recovery is being choked by three factors. First, economic uncertainty and fear of inflation and higher taxes makes business unwilling or unable to spend as much on capital investments (or on employing workers) as they would in a less erratic economic environment. Second, banks and other lenders are skittish about lending for capital expenditure because they were burned in the recent crisis, making it hard for companies to renew current debt and very difficult to secure new debt needed for expansion. The destruction of General Motors bondholders claims, for example, makes such lending less desirable. And third, and probably the greatest problem, is that most available credit is being consumed by record Federal deficits57. Consumers and businesses are in a protracted period of deleveraging from the excesses of the past decade of easy credit. Until government at all levels goes through the same deleveraging, it is hard to see how the economic environment can improve. And until the average investor perceives that that improvement is coming, there will be no end to the current bear. On the other hand a well-constructed long-term plan for alleviating the debt burden and the even more oppressive burden of unfunded liabilities in public pensions, Medicare, and Social Security, and a political will to implement that plan, may be the trigger needed to restore the optimism of the American people and usher in a new bull market.


Individuals appear to be getting their debt under control. Indeed the rate of increase in overall debt including government debt has been declining. This sudden rediscovery of frugality on the part of consumers may explain why the overall money supply has not risen more than it has and also why the economy is still under considerable strain.

Quoted in Secular Bear Markets and the Volatility of Inflation, Hester, William, June, 2009.


There is one more pernicious effect of the current borrowings by the Federal Government: they are financed by relatively short-term instruments. Ignoring the sale of Treasury notes (of sub-one-year duration), the average duration of longer-term debt is just about eight years. Over the next five years or so (counting from the start of the current surge in deficit spending) the Government will need to refinance this debt. Because a bear market in Treasury securities and therefore higher interest rates are very likely to materialize in that period, that debt may be refinanced at considerably higher interest rates. The resulting interest payments will not be available for social programs to the truly needy or will have to be collected in additional taxes, thus removing monies otherwise available for expansion.

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Barring disastrous intervention on the part of the Federal Government or strong economic stress such as a terrorist attack or great natural disaster, the current secular bear market should end in the next five years. To do so requires a further drop in stock prices, with the extent of those drops dependent on when the current market ends. The sooner the market ends, the lower prices will have to go. Paradoxically, therefore, the more the government employs methods such as Quantitative Easing to prop up stock and bond prices, the longer this bear market will last. The more economic uncertainty is injected into the system and the more fiscal policy dominates monetary policy, the lower the ending PE Ratio of this market, the deeper the fall in stock prices, and the longer the bear market will last. For investors, particularly passive investors, the continuing bear market is bad news. If previous patterns hold, bond prices will begin to fall prior to the end of the bear market in stock prices. This means that investors will face a bear market for both stocks and bonds, a set of adverse investing conditions not seen in two generations. As a result, a passive investor has few opportunities other than commodities. It is likely that commodities will continue to outperform stocks and (once the bond bear market begins) bonds as well. This is, of course, just another way of saying inflation is liable to rise. The real lesson is that passive investing will not work58 until the current secular bear market comes to an end. A well-thought out, consistent, active management program can ameliorate the gloom of the remaining bear years because although the general direction of the market will be downward for the next few years, there will be many ups and downs along the way where a good active management program can provide investors with positive returns and protection against some of the drops. The ride will be on the wild side, but there is money to be made.


Passive investing never works in a bear market because prices are volatile and downward-trending.

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Appendix A: PE Ratio versus Inflation Rate and Interest Rate

Chart A-1 combines the information presented previously on the effects of the inflation rate and the mid-duration interest rate on the Shiller PE Ratio. The chart provides considerable insight on the evolution of the current bear market both to date and in prospect compared with average historical PE Ratios. The horizontal axis is the year-over-year inflation rate in percent. The vertical axis is the mid-duration interest rate, also in percent. The color bands represent the average59 PE Ratio across the period 1871 to present when those inflation rate and interest rates obtained60.
PE Ratio in Current Secular Bear Market

Average PE Ratio

Inflation Rate Year-over-Year %

Chart A-1: PE Ratio in the Current Bear Market


It is important to note that the color bands are the average PE Ratios for those interest and inflation rates. They are not necessarily what the PE Ratio was when the orange, black, and red lines passed through that region. For example, the current PE Ratio is approximately 23 (blue dot) which resides in a region with an average PE Ratio of about 17.

Gray regions are places where the combination of interest rate and inflation rate never occurred in the past 140 years.

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The lines of different colors in Chart A-1 show the progress of the current secular bear market from its inception at the end of 1999 to the present. The orange dot was the situation at the end of 1999 when the inflation rate was at 2.7% and the mid-duration interest rate was 6.3%. The inflation rate and interest rate then traced the meandering orange line generally down-hill (i.e. to lower PE Ratios) until the bottom of the market in 2003 (the black dot) when the inflation rate was 3.0% and the interest rate was 3.9%. From there, it traced the black line as the cyclic 2003-2007 bull market unfolded. When the financial crisis began in 2007, the economy was at the point shown by the red dot when the inflation rate was 2.7% and the interest rate 4.8%. The red line traces the progress since then. Current conditions are shown by the blue dot, with both the inflation rate and the interest rate at 3.5%. The large blue arrow approximates the predicted path of the PE Ratio during the remainder of the current secular bear market. One interesting exercise is to compare the actual PE values with the average PE values at the orange, red, black, and blue dots. As discussed in the body of the paper, we expect the PE Ratios at each phase of this current market to be higher than under the same conditions in previous markets due to the increased stability achieved through control of the interest rates. The orange dot sits at a PE Ratio of about 27 (fairly typical of the ending PE of secular bull markets), but the actual PE Ratio then was over 44. This divergence should have flashed significant warning signs, regardless of the increased market stability. At the end of the tech crash in 2003, the actual PE Ratio was at 21. The average conditions at that part of the chart (black dot) are just above 18, much closer to what we would expect. As the market recovered and climbed up toward its 2007 highs, the PE Ratio reached a local maximum of 27. The red dot sits at a PE of approximately 24, again slightly above the historical average. Finally, current conditions (blue dot) put the PE Ratio at 23. The average in this region is about 17, indicating that current conditions significantly exceed the average even taking increased stability into account. The wide blue arrow shows a possible path from current conditions to the end of the secular bear market. Predicted conditions at the end of the current market are a PE Ratio of 15, an inflation rate of 5%, and an intermediate-duration interest rate of 6.8%. The region around the tip of the blue arrow indeed has an average PE of 15. In summary, this chart shows the unfolding of the current secular bear market and a possible path toward its conclusion. If the predicted path is followed, the PE Ratio will go up and down along the way, but considerably more down than up until the bear market finally ends.

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Appendix B: The Wheelock Principle in Finance

In Biology the Wheelock Principle, named for the population biologist Heather Wheelock, states that if you breed for anything, you get stupid as a side effect. This means that if the breeding of a species is directed to producing some purported benefit other than intelligence, all the effort will be deleterious to the intelligence of the species, regardless of whether the actual goals of the breeding program are met. There is a straightforward corollary of the Wheelock Principle in finance: any government intervention to produce a goal other than improved economic conditions will, as a side effect, have a deleterious effect on the economy and, by extension, the stock market. In general, the Federal Reserve addresses economic conditions without regard (at least in theory) to political considerations. It sets the ground rules but does not choose winners and losers under those ground rules. As a result, its policies are more directly aimed (and as history since 1982 shows, more effectively aimed) at improving the economy. Fiscal policy, the policy of the Congress and the White House, is, on the other hand, primarily driven by political considerations. The Wheelock Principle therefore predicts damage to the economy in direct proportion to the strength of fiscal intervention61. As an example, higher interest rates and higher taxes on business directly lower earnings by increasing borrowing costs and lowering after-tax monies. They also lower discounted projected earnings (and hence the current price) by increasing the rate by which future earnings are discounted. Lower earnings require lower stock prices for the same PE Ratio. Higher taxes, interest rates, and inflation all increase the perceived risk in the markets. As was shown in this paper, higher perceived risk results directly in lower ending PE Ratios for the current market. Thus intervention such as higher taxes and borrowinginduced inflation will, following the Wheelock Principle, extend the current bear market. By increasing economic volatility, it may also deepen it.


The much rougher economic sailing prior to the Great Moderation, a period in which most governmental control of the economy was through fiscal activity rather than control of either the money supply or interest rates, supports the conclusions of this section.

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Appendix C: The Money Supply and Inflation

Inflation is always and everywhere a monetary phenomenon62. --Milton Friedman Chart C-1 shows how accurate this statement of Friedmans is, at least on the time scales relevant to the secular markets discussed in this paper. The two curves in the chart show the money per unit of output supply (M2 from 1947 to present, and approximations to it back to 1867, divided by the Real Gross National Product) and the Consumer Price Index. Both have been scaled so that they have an average value of 1.0. Money Supply and CPI

Sources: Money Supply 1871-1907: Friedman and Schwartz, Monetary Statistics of the United States, Table 20, PP340-341. 1907-1959: National Bureau of Economic Research 1959-2011: St. Louis Federal Reserve CPI 1871-1946:Shiller http://www.econ.yale.edu/~shiller/data.htm. 1947-2011: St. Louis Federal Reserve

Chart C-1: The Relationship between Money Supply per unit Output and Inflation

As Friedman observes, there is no particular reason why these two curves should be so similar unless one causes the other or both are caused by the same thing. By plotting them on a log chart, we can see that the slopes are, on the average, very nearly identical, meaning that, say, a 5% rise in the money supply per unit of production is likely to be closely associated with a 5% rise in prices.


Money Mischief: Episodes in Monetary History, Friedman, Milton, 1990, Harvest Books.

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Beyond the close resemblance of the two curves, several other things can be observed. The ratio of the two is proportional63 to the velocity of money (by definition). Thus when the red line is above the black, monetary velocity is high, while when it is below, monetary velocity is low. The three places where the two curves diverge significantly can be attributed to changes in this velocity. Thus during the last years of the 19 th Century the velocity of money was much higher than presently, reflecting the periods less-well developed financial system, greater dependence on immediate cash, and (for much of the period) a higher than average GDP growth rate (which tends to depress the M2/GDP ratio). The divergence from 1930 to the late 1950s actually spans two different periods. The first is the greatly reduced velocity during the Depression which had many causes, particularly bank closings and extreme caution in spending on the part of consumers64. After the Depression, wage and price controls, rationing, and the large percent of the population involved in WW II kept the velocity of money low. Finally, the elevated velocity of money during the Tech Bubble can also be clearly seen, the result in part of the rapid growth in both GDP and stock investments during the period65. It therefore seems probable that the difference between the two curves is caused by economic and societal factors unrelated (to first order) to either the money supply or the inflation rate. It is clear, therefore, that the money supply per unit of output and the inflation rate are closely related, especially over a period of years. But which one causes the other? It is impossible to say from the data behind the chart the corresponding peaks and valleys in both curves match everywhere to within a quarter or two66. One thing, however, that can be said is that prices are not sticky in the sense that they substantially delay their response to changes in the money supply. That is, the absense of any offset in time between the two curves may not establish that changes in the money supply cause changes in the inflation rate, but it certainly establishes

Equal to, if there is no scaling


Note that the ratio of M2 to GDP fell slightly during this period despite a substantial fall in GDP. This means that the money supply contraction was even stronger (at least in the first few years of the Depression) than that of the GDP, reflecting among other things the failure of the Federal Reserve to promptly lower interest rates and, perhaps, Hoovers attempts at balancing the budget, both of which would tend to lower both M2 (by taking money out of circulation for interest and tax payments to the government) and money velocity.

Stock investment lowers the money supply as presented here (M2) because it takes money out of short-term accounts and small time deposits (both of which are counted as part of M2) and puts money into longer-term investments that are not so counted.

It is certainly easier to explain the close correspondence of the two curves if changes in the money supply cause changes in the inflation rate. A simple thought experiment shows why this is so. Imagine that, overnight, all currency, bank deposits, and other immediately-accessible sources of money doubled in nominal amount. It seems fairly clear that the prices of the things that money can buy would also immediately double and then things would be much as they were before. On the other hand, it is hard to see how an immediate doubling of the prices of items would cause a rise in the money supply, especially in the absence of a commodity-based currency (e.g. gold).

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that if the causal relationship is in that direction, then prices respond very quickly to those changes. The purpose of this appendix is not, however, to critique the Quantity Theory of Money. Its purpose is to show that it does not matter if the independent variable used in the main part of the paper is the inflation rate or the money supply per unit output. The near 1:1 correspondence of the two, as shown in Chart C-1, means that either can be used with equal effect to show the effect of both on PE Ratios. Before leaving the topic of the money supply, it is worth debunking some silliness that has been being passed around on the Internet recently. Different versions of Chart C-2 (taken from the St. Louis Federal Reserve web site) have been presented as showing that the Federal Reserve is recklessly increasing the money supply.

Chart C-2: Monetary Base (M0) This shows that M0, the currency supply (whether in peoples pockets or in bank vaults), has indeed risen by about 230% since the middle of the Financial Crisis. This becomes considerably less alarming, however, when one considers where this extra cash has come from. Chart C-3 shows M2 for the same period. The difference between M2 and M0 is that M2 also includes travelers checks of non-bank issuers, demand deposits, other checkable deposits, savings deposits, money market accouts for individuals, and time deposits of less than $100,000.

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Chart C-3: M2 The M2 chart paints a very different picture. While there was a substantial rise in M2 during trhe recession and also during 2011, it has been nowhere near as alarming as implied by considering only Chart C-2. What this means is that the recession has taken money from savings and longer-term deposits and moved it into currency. This movement has nothing to do with changes in M267 (which includes both kinds of money). Indeed, it has no necessary connection to Federal Reserve actions at all.


There are actually two reasons why the dramatic growth in M0 is not reflected in M2: The first is the reason given above, that money has, for the most part, simply moved from one component of M2 (namely the non-M0 components) into currency (M0). The other is that M0 is only a small part of M2 in the first place. At the beginning of the rise in 2009, M0 was at about $870 billion. At the same time, M2 was approximately $7.75 trillion. Thus M0 represented only 11% of M2 at that time. At the end of the period, M0 represented 29% of M2. As a result, even ignoring the compensating changes in non-M0 components of M2, the vastly greater size of M2 means that the M0 changes have only moderate effect on M2.

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Source: St. Louis Federal Reserve

Chart C-3a: Small Denomination Time Deposits

Source: St. Louis Federal Reserve

Chart C-3b: Money Market Mutual Fund Shares Charts 3a and 3b show two examples of such movement from non-M0 components of M2 to M0 (neither small-denomination time deposits nor money market mutual fund shares are a part of M0, but both are components of M2). The approximate 25% reduction in both time deposits and mutal fund shares for both 2010 and 2011 is, by itself, more than enough to explain the increase in M0.

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About Radiant Asset Management, LLC

This paper was written by Radiants Chief Investment Officer, David Ross, who has a background in applied mathematics and investment management with an emphasis on U.S.Treasuries-based stratgies. It was developed both as part of the research effort to understand the events surrounding debt and Radiant enhanced return Treasuries strategy. Mr. Ross previously has run three companies, holds nine patents, received a BS in Physics from Yale University, did his MS and PhD studies in Aeronautics and Astronautics at Stanford University and has an asteroid named after him for his mathematics work at NASAs Jet Propulsion Laboratory in the Advanced Projects Group. Radiant Asset Management is an alternative investment management firm formed on the belief that corporate fundamentals, investor behavior, and market dynamics drive performance. Original research and proprietary analysis set us apart. We seek superior absolute returns in all markets. If you have any comments on the paper, are interested in any further research or speaking engagements please contact: David Ross O: 425.867.0700 dave@radiantasset.com Radiant Asset Management, LLC 15400 NE 90th St. Suite 300 Redmond, WA 98052

Disclosure This material is directed exclusively at investment professionals. The presentation is provided for limited purposes, is not definitive investment, tax, legal or other advice and should not be relied on as such. Investors should consider their investment objectives before investing and may wish to consult other advisors. Any investments to which this material relates are available only to or will be engaged in only with investment professionals. Any person who is not an investment professional should not act or rely on this material. The information presented in this report has been developed internally and/or obtained from resources believed to be reliable; however, Radiant Asset Management does not guarantee the accuracy, adequacy or completeness of such information. References to specific securities, asset classes and/or financial markets are for illustrative purposes only and are not intended to be recommendations. All investments involve risk and investment recommendations will not always be profitable. Radiant Asset Management does not guarantee any minimum level of investment performance or the success of any investment strategy. As with any investment there is a potential for profit and well as the possibility of loss. This material is not an offer to sell nor a solicitation of an offer to purchase any securities of Radiant Asset Management or its affiliates. Radiant Asset Management and its affiliates are under no obligation whatsoever to sell or issue any securities except pursuant to the terms of a duly executed purchase agreement and related documents. Radiant Asset Management, LLC P. 44