[2006] Is the Fourth Year a Charm for the Bull Market?# Stock
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By PAUL J. LIM
Published: January 22, 2006
SO far, this bull market appears to be sticking to the traditional script.
But investors who have made money in domestic stocks in each of the last
three years shouldn't bank on a happy ending just yet.
Bull markets often follow a predictable pattern. In the first year of a
rally, bulls tend to charge out of the gate: the Standard & Poor's 500-stock
index has posted rip-snorting price gains of 38 percent, on average, in the
initial year of bull markets since 1942, according to a recent study by S.&
P.
This is typically followed by a more subdued second year, with the S.& P.
500 up around 12 percent, on average. And in the third year, the rally
starts to sputter, with average gains of just 3 percent.
This is close to the way the last three years have unfolded - with the S.& P
. up more than 26 percent in 2003, 9 percent in 2004 and 3 percent last year.
So how do stocks perform once bulls like this one enter their fourth year?
The short answer is that they tend "to catch a second wind," said Sam
Stovall, S.& P.'s chief investment strategist. Over the last 63 years, the S
.& P. 500 has soared 14 percent, on average, in the fourth year of a bull
market.
There are a number of possible explanations for this late-stage surge. For
example, investors who lack conviction may see the lackluster gains - or, in
some cases, losses - generated in the third year of bull markets as a
reason to head for the exits. In that way, Mr. Stovall said, third years
tend to "shake off all the loose hands" just in time for the fourth, leaving
the most persistent investors to give the market another boost.
Investors may not know what to think this year. While the Dow is down nearly
half a percent, the S.& P. 500 is up more than 1 percent, the Nasdaq
composite index is up 2 percent and the Russell 2000 index of small stocks
is up nearly 5 percent.
"That's the good news," said James Stack, editor of InvesTech Market Analyst
, a newsletter published in Whitefish, Mont. "But there's also bad news." In
four of the last seven fourth years of bull markets, stocks disappointed:
in one of those instances, they lost value, and three times they posted only
modest single-digit gains.
In the overall averages, however, such duds have been masked by three
spectacular fourth years in which gains were about 30 percent. The most
recent was the fourth year of the bull market that began in August 1982.
What type of year is in store for the market now? Mr. Stovall, for one,
predicts a somewhat below-average year, with single-digit gains.
Note that the current bull market started on Oct. 10, 2002, the day after
the S.& P. 500 sank to 776.76. So the fourth year technically started on Oct
. 10, 2005, not the beginning of 2006. Use the October starting point, and
you find that the S.& P. has already surged more than 6 percent. How much
farther can this bull run?
Mr. Stack says that better-than-average fourth years of bull markets have
tended to have something in common: "There was either a recession or a
significant market correction in the prior three years," he said, "that
helped ease some of the imbalances that develop in an aging bull market."
As long as they don't set off new bear markets, such midcycle setbacks can
help bulls recharge their batteries, he said. But because the current bull
market hasn't faced such a correction - despite geopolitical uncertainties,
natural disasters and record energy prices - big risks remain.
This is true of most bull markets: as they age, risks increase for investors
. Jeffrey N. Kleintop, chief investment strategist at PNC Advisors in
Philadelphia, warned that market blowups "are common in the second half of a
cycle."
That would explain why many bulls don't survive through a fourth year. In
the last 75 years, the average length of a bull market has been 3.7 years,
according to InvesTech Research. The median is even shorter, at 3.2 years.
How can stock investors reduce risk in the fourth year of this bull market?
Here are some ideas:
FOCUS ON HIGH-QUALITY, DIVIDEND-PAYING STOCKS Typically, bull markets begin
with investors betting on big gains in speculative stocks. But as bulls
mature, attention shifts to shares of higher-quality companies.
A study of bull markets going back to 1900 by Ned Davis Research, an
investment research and advisory firm in Venice, Fla., seems to bear this
out. An index constructed for the study showed that in the first third of
bull markets, stocks that pay dividends tend to trail those that don't pay
them. In the middle third, the dividend payers lead slightly, but in the
final third, dividend payers, on average, win handily.
Alan F. Skrainka, chief market strategist at Edward Jones, the brokerage
firm based in St. Louis, says that "you should not own investments today
that you would not want to own in a recession tomorrow." And while "quality
bounces back," he said, "speculative investments fall and sometimes never
recover."
DON'T FORGET THE BLUE CHIPS It's true that small-capitalization stocks tend
to beat large caps in all phases of bull markets. But Ned Davis Research
found that the outperformance of small stocks tended to wane in the final
stage of a bull market. For instance, small caps have historically beaten
large caps by a significant margin in the first third of a rally; by the
final stage, that lead shrinks by two-thirds.
This time around, Mr. Kleintop says he thinks that large caps can wrestle
away market leadership from smaller stocks. For starters, small caps have
beaten large caps for more than five years. And large caps are cheaper than
small caps on a price-to-earnings basis, even though blue-chip earnings grew
faster than small-company profits last year.
PLAY A LITTLE DEFENSE Two sectors that tend to excel during fourth years of
bull markets, Mr. Stovall said, are health care and consumer staples.
Neither depends on robust consumer spending in order to prosper.
Since 1942, the consumer-staples sector has shot up 26 percent, on average,
in fourth years, while health care has jumped 31 percent.
A third sector that typically does well late in bull markets is technology.
But strategists say investors may want to focus on tech stocks trading at
lower P/E ratios, in case stocks pull back in the middle of the year. "The
time to swing for the fences is in the first year of a bull market," Mr.
Stack said. But "when you get to the fourth years, it's time to settle for
singles."
Paul J. Lim is a financial writer at U.S. News & World Report. E-mail: [email protected]
nytimes.com.
Published: January 22, 2006
SO far, this bull market appears to be sticking to the traditional script.
But investors who have made money in domestic stocks in each of the last
three years shouldn't bank on a happy ending just yet.
Bull markets often follow a predictable pattern. In the first year of a
rally, bulls tend to charge out of the gate: the Standard & Poor's 500-stock
index has posted rip-snorting price gains of 38 percent, on average, in the
initial year of bull markets since 1942, according to a recent study by S.&
P.
This is typically followed by a more subdued second year, with the S.& P.
500 up around 12 percent, on average. And in the third year, the rally
starts to sputter, with average gains of just 3 percent.
This is close to the way the last three years have unfolded - with the S.& P
. up more than 26 percent in 2003, 9 percent in 2004 and 3 percent last year.
So how do stocks perform once bulls like this one enter their fourth year?
The short answer is that they tend "to catch a second wind," said Sam
Stovall, S.& P.'s chief investment strategist. Over the last 63 years, the S
.& P. 500 has soared 14 percent, on average, in the fourth year of a bull
market.
There are a number of possible explanations for this late-stage surge. For
example, investors who lack conviction may see the lackluster gains - or, in
some cases, losses - generated in the third year of bull markets as a
reason to head for the exits. In that way, Mr. Stovall said, third years
tend to "shake off all the loose hands" just in time for the fourth, leaving
the most persistent investors to give the market another boost.
Investors may not know what to think this year. While the Dow is down nearly
half a percent, the S.& P. 500 is up more than 1 percent, the Nasdaq
composite index is up 2 percent and the Russell 2000 index of small stocks
is up nearly 5 percent.
"That's the good news," said James Stack, editor of InvesTech Market Analyst
, a newsletter published in Whitefish, Mont. "But there's also bad news." In
four of the last seven fourth years of bull markets, stocks disappointed:
in one of those instances, they lost value, and three times they posted only
modest single-digit gains.
In the overall averages, however, such duds have been masked by three
spectacular fourth years in which gains were about 30 percent. The most
recent was the fourth year of the bull market that began in August 1982.
What type of year is in store for the market now? Mr. Stovall, for one,
predicts a somewhat below-average year, with single-digit gains.
Note that the current bull market started on Oct. 10, 2002, the day after
the S.& P. 500 sank to 776.76. So the fourth year technically started on Oct
. 10, 2005, not the beginning of 2006. Use the October starting point, and
you find that the S.& P. has already surged more than 6 percent. How much
farther can this bull run?
Mr. Stack says that better-than-average fourth years of bull markets have
tended to have something in common: "There was either a recession or a
significant market correction in the prior three years," he said, "that
helped ease some of the imbalances that develop in an aging bull market."
As long as they don't set off new bear markets, such midcycle setbacks can
help bulls recharge their batteries, he said. But because the current bull
market hasn't faced such a correction - despite geopolitical uncertainties,
natural disasters and record energy prices - big risks remain.
This is true of most bull markets: as they age, risks increase for investors
. Jeffrey N. Kleintop, chief investment strategist at PNC Advisors in
Philadelphia, warned that market blowups "are common in the second half of a
cycle."
That would explain why many bulls don't survive through a fourth year. In
the last 75 years, the average length of a bull market has been 3.7 years,
according to InvesTech Research. The median is even shorter, at 3.2 years.
How can stock investors reduce risk in the fourth year of this bull market?
Here are some ideas:
FOCUS ON HIGH-QUALITY, DIVIDEND-PAYING STOCKS Typically, bull markets begin
with investors betting on big gains in speculative stocks. But as bulls
mature, attention shifts to shares of higher-quality companies.
A study of bull markets going back to 1900 by Ned Davis Research, an
investment research and advisory firm in Venice, Fla., seems to bear this
out. An index constructed for the study showed that in the first third of
bull markets, stocks that pay dividends tend to trail those that don't pay
them. In the middle third, the dividend payers lead slightly, but in the
final third, dividend payers, on average, win handily.
Alan F. Skrainka, chief market strategist at Edward Jones, the brokerage
firm based in St. Louis, says that "you should not own investments today
that you would not want to own in a recession tomorrow." And while "quality
bounces back," he said, "speculative investments fall and sometimes never
recover."
DON'T FORGET THE BLUE CHIPS It's true that small-capitalization stocks tend
to beat large caps in all phases of bull markets. But Ned Davis Research
found that the outperformance of small stocks tended to wane in the final
stage of a bull market. For instance, small caps have historically beaten
large caps by a significant margin in the first third of a rally; by the
final stage, that lead shrinks by two-thirds.
This time around, Mr. Kleintop says he thinks that large caps can wrestle
away market leadership from smaller stocks. For starters, small caps have
beaten large caps for more than five years. And large caps are cheaper than
small caps on a price-to-earnings basis, even though blue-chip earnings grew
faster than small-company profits last year.
PLAY A LITTLE DEFENSE Two sectors that tend to excel during fourth years of
bull markets, Mr. Stovall said, are health care and consumer staples.
Neither depends on robust consumer spending in order to prosper.
Since 1942, the consumer-staples sector has shot up 26 percent, on average,
in fourth years, while health care has jumped 31 percent.
A third sector that typically does well late in bull markets is technology.
But strategists say investors may want to focus on tech stocks trading at
lower P/E ratios, in case stocks pull back in the middle of the year. "The
time to swing for the fences is in the first year of a bull market," Mr.
Stack said. But "when you get to the fourth years, it's time to settle for
singles."
Paul J. Lim is a financial writer at U.S. News & World Report. E-mail: [email protected]
nytimes.com.
