In 1952, Harry Markowitz published his work on portfolio selection titled “Modern Portfolio Theory.” His paper was concerned with the second of two stages. According to Markowitz, the first stage starts with “observation and experience and ends with beliefs about the future of performances of available securities.” As a revered “Father of Asset Allocation,” Markowitz presented his thinking that the wire house complex now distributes as the efficient frontier.

My question is, “What happened to stage one of this financial strategy?” What happened to starting with observation and experience that ends with beliefs about the future of performances of available securities? I believe that a good financial strategy begins with reflection.

Reflection is the first stage.

John Hussman wrote on April 20th about his Observations and Experience to calculate the future performances of available securities. Ed Easterling, Crestmont Research published Secular Bull & Bear Markets Profile, which states that 83% of years have positive performance during bull markets, while only 42% of years have positive returns during bear markets. Furthermore, the average gain is similar between bull and bear markets at 19% and 21% respectively. But the average loss during bull and bear markets is -5% and -18% respectively. Easterling presents that the average bull market ends with PE Ratio’s at 25x or so and the average bear market ends with PE ratio’s at 8x or so. Total cumulative performance of the Dow Jones during bull markets since 1900 is 810% and over the same time bear markets have lost -14% cumulatively.

The last secular bear market occurred between 1966 and 1982, and the Dow Jones lost -10% over 16 years while the PE ratio declined from 21x and ended at 8x. So far, this secular bear market can arguably be traced back to 2000 when the PE ratio was 40x and today we still sit at 31x. Certainly not close to single digit.

The context of the market matters.

Our observations and experience are the first of two stages that Markowitz wrote about. My current concern is that the previous secular stock market P/E ended with valuations at levels twice as high as all previous secular bulls. That means that the secular bear has twice as much ground to cover and the market remains at or above levels consistent with bear starts. That fact alone makes it exceedingly difficult to prove the thesis we are at the beginning or middle of a bull market. And, if that is true, we need to assume we are in a secular bear market.

That does not mean to sell your U.S. stocks, it does mean that you need a robust set of risk metrics that allow you to adapt when prices trade lower. “Buy and hold” during previous secular bear markets has not been a good financial strategy. Risk metrics can and must support your strategic ownership of not just U.S. stocks, but real estate, debt, restricted stock units in your company, liquidity, lifestyle — it’s all tied together. Break down the silos. Establish risk metrics, and make some observations. Use your experience to determine the future performance of available securities. Now may be a prudent time to reflect on the tough questions.

We live in a world built on economic structures that are now unsustainable. That which cannot be sustained will not be sustained. We are here to manage the transition.

Any opinions are those of John Pulliam and not necessarily those of Raymond James. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Past performance does not guarantee future results. Keep in mind that individuals cannot invest directly in any index. The Dow Jones Industrial Average (DJIA), commonly known as “The Dow” is an index representing 30 stock of companies maintained and reviewed by the editors of the Wall Street Journal.

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