In recent
weeks a major secular milestone was
achieved in the US
stock markets. But because of all
the distracting market turbulence, very few investors are even aware it
happened. And truth be told, even
if the markets weren’t plunging I still suspect only the most diligent
students of the markets would have any inkling.
The
venerable Dow Jones Industrial Average, or Dow 30, finally returned to fair
value as measured by its price-to-earnings ratio. This is major secular milestone
because it marks the halfway point
in the 17-year secular bear in which the Dow 30, and the broader US
stock markets, have been mired since early 2000. Understanding the implications of this
milestone is exceedingly important for all stock investors.
Some
background is in order.
Throughout history, the stock markets oscillate in great cycles
running a third of a century each.
These cycles are defined by prevailing valuations, the P/E ratios of
the broader US
stock markets. The stock markets
go from undervalued, to overvalued, and back again over a 34-year span. I call these Long Valuation Waves and
you can read all about them in another essay.
The first
half of any LVW is a 17-year great bull market, like we saw from 1982 to
2000. Valuations go from deeply
undervalued levels at its start to extremely overvalued levels at its
apex. Once the great bull peaks,
though, the 17-year great bear emerges for the second half of the LVW. Valuations are gradually whittled away
from extremely overvalued levels to deeply undervalued levels. And then like a phoenix this cycle
begins anew.
Now today,
since the US
stock markets have essentially drifted sideways for 8 years, a decent fraction of contrarian investors are aware of
valuation-wave theory. But back
in the early 2000s, it was long-forgotten by nearly all. To establish my bona fides in this
line of research, I wrote my initial essays on this in December 2001,
March 2002, and October 2002 back when
thinking this way was heretical and ridiculed.
Within the
second half of an LVW that witnesses a 17-year great bear, the defining
characteristic is contracting valuations. The first half of this 17-year period
is a mean reversion of index P/E ratios.
Valuations go from extremely overvalued levels back down to fair
value, reverting to their centuries-old average. With the Dow 30 hitting fair value,
this mean-reversion stage of the secular bear is now complete.
This chart,
updated from my October 2002 original one,
shows this process visually. It
looks complicated, but it is straightforward. The pair of blue lines is the index
P/E ratio for the Dow 30. At Zeal
we compute these critical numbers, along with the S&P 500’s and
NASDAQ 100’s P/Es, once a month and publish them in our monthly
newsletter. Watching index
valuations is incredibly important for all long-term investors.
The light
blue line is the Dow 30’s simple average P/E ratio. Individual P/E ratios for all 30
component companies are gathered and then averaged. But this measure can be skewed by a
relatively small component experiencing a wild valuation anomaly driven by
some non-recurring one-time earnings event. Thus I prefer weighting the individual
component P/E ratios by each component’s market capitalization.
The dark
blue line is the market-capitalization-weighted-average (MCWA) P/E. The bigger any component company, the
more weight its P/E ratio is given.
This measure is much harder to skew since earnings anomalies are much
less common in the largest components compared to the smallest ones. For the rest of this essay, whenever I
discuss P/E ratios they will be MCWA trailing (past 12 months, not estimated future) earnings.
The red line
is the headline Dow 30 itself that you watch every day. The white line is where the Dow 30
would hypothetically be if it traded at fair value, or 14x (pronounced
“fourteen times”) earnings. I’ll discuss this fair-value
concept in more depth below.
Finally the yellow line is the Dow 30’s dividend yield. Slaved to the right axis, 3000 means
3%. Dividend yields are an
important secondary measure
of stock-market valuations.
Back in
early 2000, the Dow 30 traded deep into bubble territory at a stupendously
rich 45x earnings! But since then
valuations have been gradually contracting, as they always do in secular
bears, while the index itself has largely remained flat. By grinding sideways, the markets
effectively grant time for corporate earnings to catch up with prevailing stock
prices. This drives the valuation
mean reversion.
As
valuations contracted over the past 8 years, the fair-value Dow rose. Since the index’s P/E ratio
finally hit 14x fair value at the end of June, the fair-value Dow has
converged with the actual Dow.
Back in 2000, bulls foolishly believed that P/E ratios could stay high
forever because we had to be in “A New Era”. But this chart shows how silly it was
to believe the bubble hype then and ignore stock-market history. Mania valuations never last.
This
fair-value concept is very important to understand. Why 14x earnings? Over centuries, across many stock
markets in many great nations, 14x earnings has simply been the long-term
average valuation for common stocks.
Sometimes valuations are higher, sometimes lower, but they always
oscillate around a secular mathematical average of 14x. While long-established historical
validity is enough proof, this number is quite logical too.
Stock
markets exist solely to facilitate capital transfers between those with
surplus capital (savers, investors) and those who need capital (debtors in a
loose sense, companies). In order
to transfer this capital, both sides of the deal need a fair and
mutually-beneficial exchange. If
capital is too cheap, investors won’t offer it up for investment. If it is too expensive, companies
won’t want to “borrow” it. 14x is just right for both parties.
Interestingly
the inverse of 14x earnings is a 7.1% yield. If an investor buys stock at a 14x
P/E, it will take the company 14 years to fully earn back the price he
paid. Without compounding, this
translates to 7% or so. 7% is
both a fair rate of return for investors’ hard-earned capital and a
fair price to pay by companies who need this capital. All over the world for at least
hundreds of years, capital has flowed freely at 14x and 7%.
Stock
markets oscillate around this 14x fair-value level because this is where the
markets clear, all investors with surplus capital have the opportunity to
invest it and all companies that want surplus capital have the opportunity to
procure it. So this fair-value
concept for stocks is not only historically verifiable, but it is eminently
logical too. After 8 long years
of mean reverting, it is exciting to see the Dow fairly valued again.
This 14x
fair-value point is also the anchor from which undervaluation and
overvaluation are objectively measured.
At half fair value, 7x earnings, stocks are very cheap historically. As soon as you see 7x earnings in the
major stock indexes, it is time to throw every dollar you’ve got at the
deeply undervalued stock markets.
Such levels are only seen at the end of 17-year secular bears, like
1982.
Conversely
double fair value, 28x, is classical bubble levels. Once the major stock indexes trade
above 28x earnings, it is time to think about exiting investments and
preparing for the end of the 17-year secular bull. If you look at a Long Valuation Wave chart
over the last century or so, the importance of 7x, 14x, and 28x index P/E
ratios is readily apparent.
Stock-market history is crystal clear regarding valuation ranges.
The
implications of the Dow once again hitting 14x earnings today, for the first
time since the late 1980s, are profound. Seeing fair value again validates the
thesis that we are in a secular bear, where stocks at best trade sideways for 17 years! Since 17 years is such a huge chunk of
any investor’s investing lifespan, it is absolutely devastating for
wealth creation to be trapped unaware within one of these secular bears.
And if you
add 17 years to the top of the last LVW in early 2000, you get out to 2016 or
so for the projected end of this bear.
We are only halfway through temporally and even more importantly in
valuation terms. Bear markets
don’t end at fair value, they continue their relentless
valuation-mauling work until the general stock markets hit 7x earnings. Odds are very high that the Dow will
still be trading near today’s
levels in 2016 but with valuations cut in half again from today!
Going from
the bubble top to 14x is the mean reversion, which is now complete for the
Dow 30. But just as the crests of
LVWs witness extreme overvaluations, their troughs see extreme
undervaluations. The second half
of the great bear ushers in the dreaded LVW trough, where investors’
morale is crushed and an entire generation completely gives up on stock
investing. Sadly the worst is yet
to come.
For a rough
road map of how the Dow 30 is likely to trade sideways and how its valuations
are likely to evolve between now and 2016, we can consider the last LVW
trough approach in the 1970s. The
second half of that decade saw the same LVW section roll though that we face
today. This next chart shows,
very clearly, that secular bears do not conveniently end at fair value. They linger on until 7x is seen.
Although
this is a chart of the S&P 500, conceptually it is the same for the Dow
30. In fact, over 6 years ago
when I first did this long-trading-range analysis
I used the Dow 30. All 30 of the
elite blue-chip Dow components are also in the S&P 500 (SPX). And these Dow components dominate it
too, representing 32% of the entire SPX’s market capitalization but
just 6% of its components!
While these are
SPX P/E ratios in this chart, they approximate the Dow 30’s pretty
well. Since the Dow has much
higher quality components on average than the SPX, the Dow’s P/E is
usually a bit lower. For example,
at the end of June when the Dow’s P/E hit 14.0x, the SPX’s was
running at 18.1x. Nevertheless,
the general P/E progression lower during secular bears certainly still applies
to both indexes.
As you can
see here in the SPX, the US stock markets continued drifting sideways on
balance throughout the rest of the last secular bear for over 8 years after fair value was
reached! 14x in 1974 wasn’t
the end, under 7x in 1982 was.
While there were big cyclical bulls and bears within this period of time, when all was said and done the
markets were dead flat. This gave
earnings time to catch up with stock prices and the entire 34-year LVW cycle
time to fully run its course.
Since the
LVWs slowly oscillate from undervalued levels to overvalued levels and back
again, merely hitting fair value isn’t the end. It is only the halfway point in secular bears. This is crucial for investors to know
because Wall Street is increasingly claiming that stocks are the cheapest
today that they’ve been in decades. While true, this is very misleading
and is going to hurt a lot of naïve investors.
14x earnings
is definitely cheap compared to the Dow’s 45x in early 2000. But it is still very expensive
compared to the 7x seen at the ends of secular bears manifesting in the
second half of LVWs. Investors
who watch their elite blue-chip stocks drift sideways on balance for 8 more
years, taking real losses
after inflation, will be devastated.
Their portfolios will only be worth a modest fraction of what they
could have been if they had understood the LVWs.
So
what’s a besieged stock investor to do? Sitting in cash or bonds certainly
isn’t the answer. With the
Fed doing everything in its power to destroy the US dollar,
inflation is only going to accelerate.
And with interest rates still not too far above half-century lows,
longer-term bonds are going to take a beating as long rates inevitably
rise. Odds are the coming 8 years
won’t be kind to cash or longer bonds either.
8 years ago
I faced this same quandary regarding my own investment capital. I wanted to invest and speculate
through the coming secular stock bear.
So I studied market history and looked for sectors that performed well
in such an environment. The most
promising one by far was commodities and the companies that bring them to
market. Commodities tend to
thrive during secular stock bears, as I wrote way back in April 2001.
Just as
these secular stock bears tend to run for 17 years, so do the concurrent
secular commodities bulls. While
Wall Street loves to call today’s great commodities bull over the moment commodities start
pulling back, the probabilities are very high that commodities will continue
rallying on balance for another 8 years or so. And elite commodities stocks, with
their high profits leverage
to commodities prices, should see phenomenal gains.
Although
there are times within secular bears when most large commodities stocks get
sucked down with general stocks, particularly during the vicious cyclical
bears like we’re in today, most of the time they
thrive. Investors can not only
weather the general stock bear, but earn fortunes to boot, by prudently
deploying capital in elite commodities stocks.
And
interestingly, it is actually the stock-market LVWs that really help drive
these concurrent but inverse cycles in the commodities markets. During great bull markets in stocks,
stocks become so sexy that virtually all investment capital gravitates toward
stock markets. This starves other
realms of much-needed investment.
For example back in the late 1990s, everyone wanted to buy junk tech
stocks but no one would touch oil producers.
So by the
end of the great bull in stocks, the first half of the LVW, commodities
infrastructure has been starved of capital investment for at least a
decade. Global capacity for
producing raw materials is rusting away and not keeping pace with growing
global demand. Raw materials just
can’t compete for investors’ attention when the general stock
markets are hot, leaving inadequate capital investment to handle world demand
growth.
By the time
the great bear in stocks arrives, the second half of the LVW, commodities
prices are gradually starting to rise simply because long-neglected supplies
are inadequate. Then contrarian
investors, looking for alternatives to thrive through a general-stock bear,
start investing in this beaten-down sector. Commodities stocks are driven higher
and even commodities themselves eventually become investment destinations.
So the great
valuation cycles in the stock markets, by virtue of so powerfully shaping
global investment capital flows, heavily influence commodities too. Commodities infrastructure is
neglected and left to rust when stocks are sexy. But when stocks start drifting sideways
for 17 years, commodities regain favor as an alternative investment and
capacity is rebuilt. Everything
in the capital markets is interrelated.
At Zeal, we
started investing and speculating in commodities and commodities stocks back
in 2000 when they were universally loathed. We’ve been blessed with
tremendous returns over the years since.
We relentlessly study the stock markets, the commodities markets, and
individual stocks in order to know when probabilities favor deploying
capital. And when they do, we
pull the trigger and add investments and/or speculations.
We are going
to continue this approach we’ve used so successfully over the last 8
years of this secular bear to thrive in the next 8 years. If you want to get world-famous
cutting-edge analysis on the stock markets and commodities, along with
real-world trading recommendations based off of it, subscribe today
to our acclaimed monthly newsletter. In our current July letter I discussed
neat new bear-market trading strategies in short-oriented stock ETFs.
The bottom
line is even though the Dow 30 just hit fair value, the secular bear is not
over. Wall Street will tell you
stocks are the cheapest they’ve been in decades, which is true. Nevertheless, valuations still remain
twice as high as they ultimately travel at the ends of secular bears. Odds are the stock markets will
continue drifting sideways on balance for the next 8 years or so until the
Dow 30 actually retreats to 7x earnings.
This is
certainly depressing if you are a long-term investor. Watching the markets trade sideways,
and taking real losses due to inflation, is no fun at all. Thankfully a secular commodities bull
is running concurrently with the secular stock bear. So opportunities to profit abound,
both on the long-term investment side and short-term speculation side. There’s no need to totally sit
out a secular stock bear.
Adam Hamilton, CPA
Zealllc.com
July 18, 2008
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for Adam? I would be more
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information.
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comments, or flames? Fire away at
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