Secular Market Indicator¶
The Secular Market Indicator (SMI) is an objective metric for identifying long-term economic cycles using a modified Shiller CAPE ratio referenced against gold. Published in The Journal of Wealth Management in 2018, the research demonstrates that a portfolio which dynamically alternates between equities and gold based on the SMI outperforms static buy-and-hold strategies over ten-year periods approximately 70% of the time, with superior risk-adjusted performance about 80% of the time.
The Secular Cycle Problem¶
Secular market trends last 5 to 25 years and consist of dominant long-term expansions or contractions within which shorter cyclical bull and bear markets occur. While cyclical markets have objective definitions -- Ned Davis Research uses a 13% change in approximately 150 days, Standard and Poor's uses a 20% move -- secular markets have lacked a consistent and objective definitional framework applicable to portfolio management.
Secular cycles are marked by warfare and peace, financial crises, prolonged deflation and reflation, technological innovation, and demographic change. Prior research identified market turbulence, inflation, and economic growth as regime-shift factors. The problem was that investors recognized the existence of these long-term cycles but had no reliable signal to identify when one was beginning or ending.
Shiller's CAPE Ratio and Its Limitations¶
Robert Shiller's Cyclically-Adjusted Price-Earnings ratio, which averages inflation-adjusted earnings over ten years, demonstrated strong predictive power for decades. It correctly signaled the dot-com bubble (NASDAQ fell 78% after the March 2000 peak) and was updated to cover the housing bubble (Case-Shiller Home Price Index fell 27% after July 2006).
However, since about 1990, the CAPE ratio has remained largely above its historical average, failing to provide timely signals for secular market reversals. The ratio predicted the 1999 technology crash but underperformed a simple yield-plus-growth model in three of the last four decades before the study. Critics advocated for revision or abandonment of the model.
The fundamental problem was one of reference. A current CAPE value compared against a historical average suffers from endpoint dependence and assumes all periods are homogeneous -- assumptions known to be false. Absent a consistent definition of "high" or "low," investors could not determine when to act.
Gold as the Reference Asset¶
The solution was to reference the CAPE ratio against a real asset. Gold was selected for several reasons: it serves as a diversifying agent and hedge, its inflation-adjusted price mean-reverts over ten-year periods (matching Shiller's ten-year averaging window), and increases in economic policy uncertainty drive increases in gold prices. Since inflation is a defining characteristic of secular cycles, gold captures the economic uncertainty that the equity-only CAPE ratio misses.
The SMI divides the CAPE ratio by the natural logarithm of the nominal gold price. The numerator reflects economic strength and confidence; the denominator reflects economic weakness and uncertainty. Using nominal rather than inflation-adjusted gold prices preserves gold's role as an investment of last resort during periods of economic stagnation.
The Decision Rule¶
When the SMI crosses above +1, the economy enters a secular bear phase -- overweight gold. When the SMI crosses below -1, the economy enters a secular bull phase -- overweight equities. Maintain each posture until the opposite signal occurs.
Using over 100 years of annual data, the SMI identified secular cycles with remarkable clarity. The resulting ten-year forward equity returns corresponding to "high" and "low" signals were almost entirely mutually exclusive -- there were either winning decades or losing decades with virtually no overlap. The only false positives occurred during the Great Depression when fiscal and monetary policies were erratic.
Portfolio Results¶
A portfolio alternating between 100% equities and 100% gold based on the SMI signal dominated both a buy-and-hold equity portfolio and a buy-and-hold gold portfolio. Key findings:
- Outperformance frequency: Approximately 70% of ten-year periods
- Average annual real outperformance: 3% over equities, 8% over gold
- Risk-adjusted outperformance: Approximately 80% of the time
- Number of trades over 40 years: As few as eight (one entry, three switches, one exit)
The model underperformed during secular bear cycles because equity bear markets tend to be volatile sideways trends rather than continuous declines. However, by avoiding the deep drawdowns within secular bear cycles, the portfolio captured the magnitude of gain earned relative to the magnitude of loss avoided.
Implications¶
The research reinforced several conclusions for long-term investors. Participation in secular bull markets through equities is critical because the magnitude and consistency of returns are exceptional. Gold may be a safe haven in secular bear markets but is not necessarily the optimal risk-off choice; it is, however, substantially better than holding passive equity during prolonged contractions.
Investment time horizon takes on different meaning depending on where one enters the secular cycle. When entering a secular bear market, 12 years has historically been too short to achieve the long-term average equity return. When entering a secular bull market, 12 years is sufficient.
The elegance of the approach lies in its simplicity: "If the economy is strong, hold stocks. If the economy is weak, hold gold." But that statement is only actionable with a consistent and objective definition of "strong" and "weak" -- which the SMI provides.