What if the major stock market averages
were to trade in a wide range over the next 15 to 20 years, between
6000 and 12000ish on the Dow
for instance? Could you name that tune?
We can. It's the seventies theme
where the 1966 top at 990 proved to be the secular bull market top
capping the prior 20-year bull market cycle that began arguably
after WWII. Although it was
challenged three more times before finally giving way to the bulls
in 1983 (it was briefly pierced when bulls printed the Dow at 1051.70
at the beginning of 1973), it's hard to argue that the 1966 top
wasn't the most important one for long term investors (see chart
The 15-year periods between 1966
to 1981 and from 1931 to 1946 are the only two in the 20th century
where the averages are recorded to have traded in a wide sideways
range for as long. In the thirties this action occurred well below
its peak 1929 levels, so we can't really say the prior bull market
ended in a long term sideways range. For instance, from 1934 to
1946 this range could be defined between 100 and 200 (DJIA values).
But the Dow's peak value in 1929 was 381. In the period from 1966
to 1981, this range is most commonly defined to be between 535 and
about 1051. The top end of the range thus matched the prior bull
market top. In both instances the bottom of the range was about
a 50% retracement from the top of the range. Only, in the thirties,
the top of the range was half its best prior bull market values.
In other words, to translate that
into what it means today, if we argued for a seventies style economic
model in our current outlook, as opposed to the earlier one where
a gold standard was involved up until 1933, we might hastily conclude
the Dow would trade between
about 6000 and 12000 for the next 15 years or so.
Since we're further away from 12000
today than 6000, this increasingly becomes the bullish argument,
or so it seems by the flocking of bulls to this camp where the outlook
for a sideways trading range is simply a lowering of long term bullish
expectations, an understandable psychological phenomenon at this
stage of the bear. This way they may figure that a long term approach
is still more sound, if only because of the semi-bullish risk-reward
appearance of an arbitrarily chosen 6000 point range (from here
the downside would be 2400 points and the upside would be 3600 points...
It's nice to see the bulls lower
their long-term expectations a wee, but let's give them a few more
things to consider.
First, before we go on it may be
noteworthy to mention we've argued for a seventies style inflationary
environment for some time and still do. However, I'd like to think
our arguments go beyond simply fitting the data so that the result
is identical to that period's market outcomes, and thus convenient
to our arguments.
At any rate, as you can see in the
chart, the 15-year period after 1966 is marked by several bear market
legs; each was worse than the other at least until the 1974 bottom.
Although the 1974 bottom proved to
be the Dow's ultimate secular bottom, the time between 1975 and
1982 wasn't rewarding for the bulls that stuck to the tech stocks,
or the nifty fifty issues. That breed was decimated, and in light
of the extent of the dollar devaluation during the period, even
the bulls buying gold and oil stocks after 1975 were having difficulty
beating the inflation.
Nonetheless, gold and oil stocks
dominated the latter half of the long 15-year stretch, and if that
weren't the case, it would be hard to argue the market could have
held its 1974 bottom.
Yet those are the kinds of inflations
less developed economies such as Brazil like to practice, where
the currency devaluation becomes impetus to a gain in real prices,
and thus, a different character of nominal profits than when
inflation policy is aimed at maximizing the value (or purchasing
power) of the currency.
The point is that the "sideways"
market during the seventies appears a lot less injurious on the
chart than was probably the case, and it appears so because stocks
were priced in devaluing dollars, which isn't accounted for in the
chart. Against Gold and the CRB, for instance, the dollar fell 70%
and 40% respectively from 1975 to 1981, while the Dow gained 66%.
So at the end of that period, the Dow bought less real things than
it did in 1974/75 where on the chart it made a price bottom.
the risk-reward argument as a reason for staying bullish on the
stock market for the long run may prove a costly mistake, particularly
if by staying bullish that means owning a stake in the currently
broader conceptual strata of the economy.
Let me put it this way. The investors
that bought a mutual fund in 1966 were no more likely to have broken
even by 1982 than slick Willy could turn down a good cigar.
Have Yet to Factor Dollar Devaluation
What's more, the seventies model only applies at all if the analyst's
outlook includes scope for enormous dollar devaluation, and continuing
inflation policies by the Federal Reserve System.
We'll contend that the so called
sideways manifestation of values in the major stock market averages
from 1966 - 1981 wouldn't have been possible at all without those
factors, and indeed, the prior experience of the thirties suggests
But there's also another really important
point to make here. Interest rates haven't been as low in the United
States as they are today since the early sixties.
In fact, somewhere in the sixties
the bond markets began a primary bear market. By 1966, yields on
the 10-year bond rose to 6%, and then 8% by 1970. From 1970 to 1975
they fluctuated between about six and eight percent. Today, yields
have yet to rise.
Why is this important to our outlook
today? Because it's some evidence that by the time the 1975 bottom
in the Dow came around, the US dollar had already undergone a significant
devaluation (75% relative to gold and 50% to the CRB) and so had
Note that the bottom in the Dow during
1974 coincided with a plateau in the dollar, commodity values as
well as yields. Since we know bubble markets are better at factoring
the past than the future, and these variables began to plateau,
we can conclude that stock values reflected the prior movements.
In other words, the variables had already
impacted on stock values.
Thus, the Dow's value factored those
events. We know that because those events are recorded and preceded
the 74 bottom. We won't really know where the bottom is today until
years from now when it becomes academic, but we're speculating that
it can't come until investors factor these problems for the dollar.
The alternative is to apply a different model. Perhaps Greenspan's
productivity model would fit nicely.
But if we want to apply the seventies
model to our current economic outlook in order to determine a comparable
bottom value for the Dow today, I think first we need to determine
a reasonable valuation for the Dow assuming yields would rise at
least to 6%, and the dollar will devalue at least by another 30%
relative to the CRB. Those are the conditions that preceded the
1974 selling climax after all.
So is Dow 6000 fair value if bond
yields were at such levels, and if the dollar was in decline as
it was during the period 1971 to 1974?
The main answer to that question
depends on what happens to the dollar next. Is it going to fall
precipitously so we can confirm the application of the seventies
model, or is it going to rise so that we can finally be proven wrong
about the whole darn thing?
Since our outlook for the dollar
is bearish, our outlook for
the next ten years or so indeed does mirror the period between 1970
and 1980 which is also marked by
a meaningful devaluation in the dollar. To make the comparison between
then and now without including what happened to the US dollar is
erroneous, since it was the main economic problem of the day.
So if we're going to see a seventies
style inflation and dollar devaluation then today's dollar weakening
is only the beginning, and markets have yet to factor appropriate
equity valuations. Can you see where we're going with this?
My guess, if we were to try and superimpose the current period onto
the seventies era in most markets, is we are at about 1971. By 1971,
the Dow was rallying off a second bear market bottom, made
the prior year, and the dollar was beginning to come apart.
Commodity prices just began to turn up by the end of the
year, and interest rates bottomed after falling in sympathy
with the prior year's Dow slide that ended 40% off its prior high.
The main difference between then
and now, at least in these particular markets, was that interest
rates (10-year yields) bottomed at a higher level (6%), when today
they are still at 4%. The bull market in bonds ended before the
1966 stock market top.
We consider it proof that bond markets
haven't considered dollar devaluation yet today. And so, stock market
valuations are probably due for further setbacks until at least
market participants adjust their outlooks more in line with the
reality of current circumstances, whose inflationary chalk marks
are already all over the tape.
Of course, reality is something the
Fed is able to change while it's still able to lower interest rates.
I suppose we could discuss the various
reasons that enabled the Fed to sustain a low interest rate policy
since the summer of '01 in the face of the inflationary factors
we routinely discuss as becoming increasingly evident. However,
I think we'd agree that 9-11 allowed further cuts that may not have
been executed as effectively without a so-called "gentlemen's agreement"
in favor of the dollar that lasted all about six months.
I only use such an improvable concept
to explain a short-term phenomenon, and in hindsight, since the
dollar first peaked during July 2001, and went off to lower lows
in 2002, perhaps it is a relatively correct diagnosis of the interceding
rally. However, the decline in bond yields since the beginning of
the second quarter (2002) is harder to explain.
2002, commodity prices have risen sharply; at a faster pace than
at any time since 1983 reportedly. This has continued right into
September, and its pace has picked up since summer.
Although the Fed slashed the Fed
Funds rate significantly in the third quarter of 2001, the decline
in bond yields since April 2002 has been steeper than their decline
immediately after the 9-11 Fed rate cuts. This latter steep decline
in yield coincided with a 2000-point drop in the Dow from April
to July, so it's somewhat explainable; and it coincides with a heightened
sense of anxiety about the war on terror, so it's further explainable.
But this all meets with a 20% gain
in the CRB, a 10% decline in the US dollar index, and a boom in
both housing as well as the profitless boom in consumption. Oops,
did we forget to mention a deteriorating government budget.
It looks like we may have a little
bond bubble on our hands!
Theoretically, the Fed must be hoping
its inflation is feeding through enough to boost specific prices
so that when interest rates inevitably reverse course, profits will
be seen to be rising too.
So the third quarter is important
for the bulls in determining whether they'll have the legs to run
the Dow up on a commodity bull run. Or in other words, it's important
for them to determine whether the inflation has seeped through to
profits yet. So far the news hasn't been good, but that's typical
since it's still profit warning season.
Whether the earnings are nominal
or not wouldn't matter to the mass of investors who think inflation
is the rate of change in the CPI.
The question is whether they are
seeping through to the right prices, as opposed to squeezing margins.
The evidence has been suggesting the latter, so if the bubble in
bond prices implodes, because of rising prices of course, and even
as margins erode, there'll be more trouble in paper paradise for
the Tom Galvin's of the world to explain away, at what are still
historically high stock market valuations.
Bottom Is A Long Way Off
When interest rates were last as
low as they are today (1960's), the S&P 500 traded at a trailing
PE ratio of between 15 and 20 times earnings as you can see on the
above graph. Today the S&P trades at 34 times earnings and the
Dow we estimate at about 23 times trailing earnings - the only kind
that are historically reliable by the way. Of
course the spike after 2001 was due to a collapse in profits, but
that's precisely the point. Profits haven't fallen as fast as they
have in this cycle for about 50 years.
Besides, the PE ratio made new records during the expansion phase
right up until 2000, while earnings were apparently rising.
The excess was obviously greater
in the latest cycle if we're correct about productivity and inflation.
But that's not really the point. The main point is understanding
the psychology of the transition from high multiples to low multiples.
We argue that because the inflation increasingly manifested in real
values, it became harder to fool investors. In other words, it became
easier for them to discern the difference between real and nominal
profits, and since they were
increasingly perceived to be nominal, earnings multiples declined.
The bottom in valuations during the
latter half of the seventies thus represented a deteriorated outlook,
and consequently, a decline in expectations for stock returns. Nobody
cared about forward earnings we can assure you.
The equity risk premium skyrocketed
so that by 1974, earning yields
for the S&P exceeded the 10-year bond yield by almost 50% (dividends
excluded). In 1971, for comparison,
this premium was actually a slight discount, as earnings yields
averaged a little better than 5% while bond yields averaged a little
better than 6%.
If we were to include dividends on
the S&P 500 in our calculation, in 1971 stocks offered about a 9%
yield (50% premium) and in 1974 they offered a 14% (combined earnings
and dividend) yield, which represented a
100% premium to the 7 percent 10-year government bond yield during
the same year (1974).
So the equity risk premium, calculated
this way, doubled from 50% to 100% during the period from 1971 to
1974 - the stock market's ultimate bottom in the 15-year period
Today, using a 23 multiple for the
Dow (derived by the average current trailing PE ratios of the 27
Dow components that have recorded a positive profit at the time
of writing) instead of the astronomical one in the S&P 500, the
combined profits and dividend yield works out to be about 6% at
current values (4% for the S&P 500).
This works out to a 50% premium over
the 10-year US government bond yield today (no premium if we use
the S&P 500 figures). If we're heading towards the bottom end
of a long-term sideways range, similar to the one in 1974, this
risk premium could double in a transition period that resulted in
lowered expectations for stock returns.
So what value would the Dow trade
at if bond yields rose to the 6%-8% range (in order to factor in
the conspicuously accelerating inflationary variables), and the
equity risk premium rose to 100% over those levels? Earnings yields
plus dividend yields would have to rise to somewhere in the neighborhood
of 12 to 16 percent, in order to validate a 1974 type model that
would result in similar valuation outcomes. That's more than double
today's stock yields.
It would put the Dow at between 3000
and 4000, assuming profits neither grew nor declined materially
from current levels (200 to 300 for the S&P 500). This is well
below our intermediate outlook, which calls for Dow 6000 this year;
it is below Bill Gross' longer term outlook for Dow 5000; it meets
David Tice's ultimate target for Dow 3000; and it approaches my
partner's Dow 2000 target. It
could very well take another few years to define this extreme a
contraction in market confidence, but maybe not. The divergence
between interest rates and reality is a factor that could reverse
sharply, and accelerate the prognosis.
In any case, while the least of the
bullish forecasts now call for a long-term bottom at 6000, that
is our medium term target (by yearend, maybe even by October).
As we near that point we'll evaluate
the extent of any serious bear market rally, but not until then,
for lots can and probably will still change.
Attempt Comeback on Yen Pessimism
our outlook thus remains bullish for gold in the medium and long
term. As for the short term, this week gold bulls have to contend
with a recovery in the dollar against the yen we're sorry to have
to tell you.
The story here seems to be renewed
pressure by Japanese-US politicians on the BOJ to endorse yen devaluation
as the means to stimulating the Japanese economy.
Every once in a while this pressure
emerges, usually when the dollar is weak. Each time it does, it
does so near a Bank of Japan monetary policy meeting, as is the
case this week.
But outside of reducing interest
rates, the bank has been loath to endorse direct yen intervention.
This of course is sound policy, but since it is a central bank,
which is a political tool, sooner or later if it is satisfied the
public believes it is independent, it'll probably give in to the
reformist pressures in government and allow prices to rise even
if through currency devaluation.
I don't really think it could work
since the imbalances are piled up on the US dollar's side, but if
it did, it would have to be bullish for the Nikkei, which it could
only if the stronger dollar stimulated US import demand, which meant
stocks couldn't really go down as much as we expect in the US. Otherwise,
a weak yen would only spur more gold demand from an already leery
Japanese investment community. That said, a strong dollar could
help the Fed sustain an accomodative rate policy.
The pessimism about Japan's economy,
however, is a red herring for the yen because Japanese assets are
still underweight in most international portfolios and besides,
the bad market news largely emanates from the United States these
But if it were possible for US-Japanese
authorities to sustain a cheap yen and a strong dollar,
while simultaneously boosting equity values, the gold trade would
have to key off of the trade in commodities, generally. If inflation
continues to be the solution, which policymakers prefer to employ,
commodity and gold values could easily still rise even while the
The exception is if the policies
are so successful they engender another paper bubble powerful enough
a force in the dollar's favor that commodity values actually decline
as they did during the late nineties.
Anything is possible of course, but
if we're right about the similarities between today and 1971, as
well as our assessment for the dollar in general, then we're only
at the beginning of a large move in gold that may eventually fuel
a recovery in the US stock market averages as that sector's inflation
ultimately seeps into overall market capitalizations.
But we're so far away from that
point, it's still exciting to think about!