Thanks to Jason for passing this along.
We also believe, the past two years of stock market recovery notwithstanding, that the market probably remains in a long term bear phase, which began in the second quarter of 2000 and which is likely to persist until the combination of slower than historical economic growth, rising inflation, and event risk compress market valuation to a typical bear market trough (a multi‐year price‐earnings ratio under 10). Granted, we at D3 do not invest in the broad market, nor do we attempt to be market timers, but the extraordinary volatility of 2008‐09 convinced us that investors must be mindful of broad market trends.
Giving credit where credit is due, market analyst Ed Easterling’s recent book, Probable Outcomes, is the source of our bear market hypothesis. Easterling demonstrates that two macro‐economic factors drive the long term valuation cycles of the stock market: the rate of economic growth and the rate of inflation. He is pessimistic about both and so are we. American economic growth averaged 3.3% annually from 1900‐2009. Unfortunately, as Carmen Reinhart and Kenneth Rogoff demonstrated in their recent book, This Time is Different, high sovereign debt reduces economic growth. We believe that debt service and debt reduction are likely to reduce developed country economic growth to no more than 2% for the rest of the decade. Easterling shows that this will reduce market valuations. Also reducing valuations will be rising inflation. The low 1% inflation rate of 2010 is not sustainable. From 1900‐2009 inflation averaged 3.3% annually. Easterling’s market model suggests that rising inflation and slowing growth is likely to cause nominal stock market returns to decline 2% per year until the market bottoms. He adds that bear market cycles are dangerous because of their volatility.
