by Adam Hamilton
August 05, 2005
Just this week the US stock markets blasted up to impressive new four-year highs, continuing the bull market that launched back in March 2003. Since those dark days the mighty S&P 500 has soared 55% higher! This is an absolutely glorious run by any standards.
In light of this powerful cyclical bull in stocks we have witnessed in the past two years and five months, many investors understandably wonder how on earth anyone could be bearish today. Indeed, the shorts have been beaten within an inch of their lives in recent years and bears have been relentlessly hunted to the verge of extinction.
Despite the scorn heaped on the stalwart remaining bears, I still find myself sojourning in this very politically-incorrect camp. It is certainly not that I want the markets to go down, I do not. But as a lifelong student of the markets and speculator I know that the markets are the world's ultimate probabilities game. To me it makes little sense betting against fundamental probabilities no matter how powerful technical momentum may seem.
And today, whether we love it or hate it, probabilities are conspiring against the bulls. It is for these bulls, including my own dear friends and family members, that I am penning this essay today. People work hard over a lifetime to save capital and provide for their families and it breaks my heart to see investors risking their precious capital while naïve of the great risks weighing on the markets today.
Thus, for the first time in nearly three years, I want to delve into the Long Valuation Waves again. These waves, like ocean waves, are great valuation cycles that run about a third of a century or so each. Depending on where in the wave cycle one happens to be, investment strategies vary tremendously. Investors not aware of these cycles face anything from zero returns over a decade at best to catastrophic losses at worst.
Since these fascinating long market cycles meander so gradually that they tend to escape detection, to understand them it is useful to venture into astronomy to put them into perspective.
Once each year, our celestial rock known as Earth completes a full circuit through the heavens and revolves around the sun. And since our planet is tilted on its vertical axis, the angle of the sunlight reaching us changes throughout the year and causes the seasons. And because a full seasonal cycle only takes one year, we are all very familiar with what to expect. We know, look forward to, and predict spring, summer, autumn, and winter year after year without fail.
Therefore if June is hot, July is hotter, and August is steaming, none of us will extrapolate this trend into the future and predict a broiling December. Since we have all lived through dozens of complete seasonal cycles we absolutely know what to expect. In any cycle studies, including financial, the more cycles that one witnesses the easier it is to understand the nature of those cycles.
Now imagine that we all lived on Saturn and grew up gazing at its stunningly beautiful rings in our skies. Assuming it didn't have such a wickedly hostile environment and was a rocky planet instead of a gas giant, our perception of the seasons would be vastly different. Saturn, since it is so far away from the sun, takes a whopping 29 years to complete an orbit.
The seasons on Saturn would each run one quarter of this, or a little over 7 years each. If you were born on Saturn at the beginning of spring, as I was on Earth, then you would be over 20 years old by the time your first winter arrived. Imagine how hard it would be for your parents to explain the concept of winter to you when you had never even witnessed it after two decades of life! You might even think they were old-fashioned or senile to dare predict such a strange season.
But these seasons on our hypothetically pleasant Saturn, despite their far longer duration, are as inevitable and move with the same clockwork precision of those on Earth. Yet, since they take 29x longer for a full seasonal cycle to be completed, they would be vastly harder to perceive. Even the most robust human would only witness three of them at best in his entire lifetime.
Well, the Long Valuation Waves have long wavelengths similar to the revolution of Saturn. These mighty market waves tend to run a third of a century or so each, even longer than a Saturnian year. Compounding the difficultly of perceiving these long cycles, our time to watch them is even less than our lifespans. If the average investor today starts investing at 25 and retires at 65, he only has 40 years to perceive a 34-year cycle! This cannot happen casually but rather requires intense study.
Keeping the foundational concept of long Saturnian seasons in mind, here is a hypothetical rendering of long valuation waves. At the simplest level they are like great sine waves echoing through financial market history with a 34-year wavelength. Just as an ocean surfer has to be careful what part of the wave he tries to catch, so should investors be wary of where we happen to be in our current Long Valuation Wave.
The red line above represents a stylized rendering of a Long Valuation Wave, while the blue one shows a more realistic wave based on market history. While only one wavelength is shown above, the history of the stock markets is represented by an endless series of these connected end-to-end like saw teeth. They are not all identical in magnitude, slope, and duration, but over time they average out to look like the blue line above over about 34 years.
The medium through which these waves travel is not stock prices, but stock valuations. Valuation describes what a stock is worth, how high or low its price happens to be relative to the underlying profits it generates for its shareholders. After understanding the "long" part of these waves, internalizing the "valuation" part is the next key to this critically important puzzle.
Stock investing, when you strip away all the glamour and sandblast out the emotion, is ultimately about owning a fractional share in the future earnings power of publicly-traded companies. For every dollar invested, investors want their companies to earn the highest percentage of profits possible each year. A company earning 20% profits on your dollar is superior to those only earning 10% profits.
Honest investors will readily admit that they could not care less about what sectors in which they invest, they just want the best returns. And over the long run the best returns always emerge from the most profitable companies. Therefore, the essence of investment is about finding the companies that are earning the most profits, and are likely to continue to, per dollar invested.
These profits come at a price. Companies' stock prices are far more volatile than their underlying profits. Because of this, there are times when future profit streams are cheap to buy and times when they are expensive. The financial metric used to measure the relative cheapness or dearness of profits is the venerable price-to-earnings ratio, or P/E.
Stocks are cheap, and great long-term bargains, when P/E ratios are low. For example, in a stock trading at a P/E of 7, or 7x earnings as we say in the industry, it only costs $7 to buy $1 worth of annual profits. An expensive stock, in contrast, can trade above 28x earnings. Thus it would cost $28 to buy $1 worth of annual profits. Which stock is the better deal? Obviously the 7x earnings one. Why pay $28 for the same dollar of profits you can buy for $7?
Now over centuries these P/E ratios have had an average of 14x earnings, investors were paying $14 for each $1 worth of annual profits. This is considered fair value in Long Valuation Wave studies, the horizontal center around which the waves lazily oscillate through time. Consider it like "sea level". When valuations are lower than 14x the waves are in a trough and when they are over 14x they are in a crest. The fair-value line above represents this P/E 14 long-term valuation baseline.
And if you think carefully about it, 14x earnings makes great logical sense too. The financial markets exist so savers, people who consume less than they earn, and debtors, people who consume more than they earn, can get together. Savers (investors) effectively loan their capital surplus to debtors in order to earn a return on their capital, and the debtors in turn use this capital to build businesses. Even stock investing, while not technically debt, is a mechanism to move capital surpluses to fill capital deficits.
All these capital transactions are two-sided. Obviously the saver wants to earn the highest return possible on his capital. But the debtor running a deficit wants to pay the lowest rate possible to use the saver's capital. This fundamental conflict of interests is resolved by the free markets. 14x earnings is a happy medium that gives savers a fair return and debtors a fair price. Its reciprocal yield is 7.1%.
If you save a capital surplus, you could probably be persuaded to offer it up to a company that needs it for a 7% projected return. Similarly if you needed to borrow capital for business reasons, you have to admit that 7% is not an exorbitant rate. Across centuries, cultures, markets, and countries, 14x earnings, or 7% earnings yields, just seems to be the most natural fair-market price for balancing markets' capital surpluses and deficits.
If 14x earnings is the long-term base fair-market valuation, it provides a stable central reference point off of which we can define cheap and expensive. After my own extensive studies of market history, my inner mathematician likes to deal in multiples. With vast databases to back up this assertion, I consider half of fair-value, or 7x earnings, to be cheap, a great bargain.
Conversely 21x earnings is moving into the realm of expensive valuations. And double fair value, or 28x earnings, is bubble territory. Try to keep dwelling on the fact that $1 of earnings is $1 of earnings, totally fungible. So paying only $7 for that dollar of earnings is vastly superior than paying $28 for that same dollar. For long-term investors, the valuations at which they choose to buy is the single most important factor guiding the long-term success of their investments.
Hopefully the concept of Long Valuation Waves is starting to make sense now. They are called long because they have wavelengths running a third of a century or so, like a Saturnian year. And they are valuation waves because they track the price that investors are generally paying for $1 of earnings at different points in these long cycles. On top of these core foundations we need to then add psychology.
There are periods of history when investors can't get enough stocks and are willing to buy at any price, regardless of valuations. Thankfully 1999 was not too long ago so we all remember well what these mania periods are like. And there are other periods when investors won't touch stocks with ten-foot poles. Like a 20-year old trying to imagine the Saturnian winter, unless you were actively investing from 1974 to 1982 you have never experienced one of these.
This herd psychology moves in great waves too, and is actually the underlying driver of the Long Valuation Waves. Early in the 34-year cycles investors are fairly neutral about stocks, but gradually they get interested and a Boom ignites. After maybe a decade of booming, greed festers and a Bubble spawns, pushing prices up far faster than earnings and sending valuations spiraling heavenwards.
Sooner or later this mania psychology fails when all the capital that can be enticed in has been sucked in. Without any new buyers mania prices collapse in the Burst phase. And then over the next half wavelength the Bust manifests itself. The financial markets are perpetually experiencing these Boom Bubble Burst Bust cycles, driven by investor psychology, and empirically measurable by the Long Valuation Waves. These specific seasons within Long Valuation Waves are rendered above.
The ultimate goal of investing is to Buy Low Sell High, and if we rewrite this core equation in psychology terms it can be stated as Buy Fear Sell Greed. Prices are lowest when investors are generally scared making that the best time to buy. And prices are highest when investors wax the greediest so that is the best time to sell. In Long Valuation Wave terms these opportunities manifest themselves at the peaks and troughs of the waves.
If you understand this discussion to this point you are doing great. We've finally made it through the underlying theory on my Long Valuation Waves thesis. I fully understand this is intense. It took me many years of relentless and painstaking historical market studies for all of this to coalesce in my head so please don't feel bad if it seems overwhelming in one big gulp. It will become much clearer as we use this theoretical foundation to explain the market reality below.
This next chart is where the rubber hits the road. It distills over a century of stock-market prices and market valuations. The stock index used is the Dow 30, since it is the only major American index today with enough history to run this long of a study. It is rendered on the right axis in red, on a logarithmic scale so percentage gains are constant over time. Long-term index charts are greatly distorted with conventional linear axes.
The valuation data, including both the price-to-earnings ratios discussed above as well as dividend yields, are slaved to the left axis. Dividend yields are another key valuation metric that I don't have room to discuss today unfortunately, but they work similarly but inverted to P/E ratios. As you ponder this chart, keep the blue wave rendering from above in mind. Enter the actual Long Valuation Waves!
Fleshed in with actual data the Long Valuation Wave theory becomes far more concrete. The blue P/E ratio line above is the actual Long Valuation Wave meandering through the past century. The labels on the left axis for price zones correspond with the discussion earlier on 7x cheap, 14x fair-value, 21x expensive, and 28x bubble earnings multiples. Over time general market valuations meander from cheap to expensive and back again with all the regularity of the seasons.
Major valuation peaks and troughs above are labeled with the prevailing market P/E ratios at the time. Note that stocks were always cheap (near or under 7x earnings) near secular valuation bottoms and always expensive (above 21x earnings) near secular valuation tops. While you can't tell as much from this chart, our final chart below will illuminate the actual returns for investors if they bought near these major tops and bottoms.
Before we dive into returns though, there is much to learn here. Note the periods of time. From the 1929 top to the 1966 top, one full Long Valuation Wave marched through. It ran 36.3 years in duration. The next wave started immediately after and ran from 1966 to the blisteringly high 2000 top. It, rather uncannily, weighed in at exactly 33.9 years, a perfect match with our conceptual 34-year valuation cycle.
These waves are symmetrical when measured trough-to-trough as well, just as they ought to be. From the 1949 bottom to the 1982 bottom the full wave ran 33.1 years, a third of a century. As you digest this chart and ponder the blue waves above, realize that these Long Valuation Waves are real. They are not mere vain academic babblings like the goofy Efficient Market Hypothesis, these are real forces driving real markets. Investors only ignore them at their own great peril.
With a full wavelength running about 34 years, a half wavelength is, amazingly enough, about 17 years. These half wavelengths are rendered above and the most recent three since 1949 have been right on target in duration. These half-waves represent major secular trends in stocks, bull markets if the valuation-wave crest is approaching and bear markets if the valuation-wave trough is approaching. The Great Bull in US stocks from 1982 to 2000 was a 17.4-year secular bull riding an incoming Long Valuation Wave.
Now if you didn't have me droning on, and just had these charts, I suspect you would independently arrive at the same morose conclusion I have. First, valuations flow and ebb throughout market history, and these flowings and ebbings tend to run 17 years in duration each. Second, if these cycles are so steadfast in history and tend to run with such regularity, the outlook for the US stock markets in the next decade can't be good.
A magnificent 17-year secular bull market ended in 2000 that rode an incoming valuation wave just as the 1920s and 1960s bull markets did. But what happens when that same valuation wave passes us by and starts heading back out to the seas of time? Each time that such an event transpired in history valuations started falling from expensive levels back down to cheap levels.
And indeed the chart above clearly shows the current Long Valuation Wave already well into ebbing. Valuations in 2000 at the end of the greatest bull market in US history were the highest in US history at an utterly mind-exploding 44x earnings. Investors were willingly, and foolishly, paying $44 for $1 of profits! Even in 1929 they "only" paid $33 at the top!
In the past five years valuations have fallen dramatically yet are still above 21x earnings, very expensive in historical context. Today's valuations are actually right in line with the 1966 valuation top! This is not a good omen!
The reality of this analysis presents a very uncomfortable conclusion for today's long-term investors to ponder. If full valuation waves tend to run 34 years in duration, and major secular bulls and bears tend to run 17 years or so each, then odds are the US stock markets will face tough sailing until 2017! That is 12 more years friends, not fun! And since we each only have about 40 investing years in which to build our fortunes, we cannot afford to be wrong on the next 12.
This is why I am bearish on the US stock markets, because the Long Valuation Wave that lifted us until 2000 has been relentlessly ebbing since then. Believe me I am not happy about this and don't like it one bit. I would love to be in a place in history today like 1982 or 1949 where stocks are loathed and cheap and a new valuation wave is starting to crash into shore. But regardless of what you or I wish, the reality is our Long Valuation Wave is leaving us and heading back out to sea.
Long-term investors long the US stock markets today are facing a valuation winter, when valuations gradually march back down from expensive levels to cheap levels. The same dollar of profits that sells for $21 in stock price today will almost certainly go for under $7 before this current Long Valuation Wave ebbing fully runs its course.
Unfortunately, and you really ought to share this with anyone you love with heavy long US stock exposure, investors in the past who ignored these Long Valuation Wave ebbings were slaughtered like sheep. The best time for long-term investors to buy is at valuation-wave troughs while the worst time is at the valuation-wave peaks. While today is not quite as bad of a time as at the 2000 top, we are probably still only 5/17ths of the way through this 17-year valuation ebbing.
Our final chart shows the actual returns investors could have earned by buying at Long Valuation Wave peaks and troughs. These periods of time, which go back to 1914, have an average duration of 17.1 years. Thus, from a probabilities standpoint the wise bet to make is that our current secular trend will last somewhere around 17 years as well, not just merely the 3 from 2000 to the latest 2003 stock-index bottoms.
The Dow 30 is graphed on both axes of this chart, the normal nominal index on the left and the logarithmic version where percentage gains are constant on the right. Note that the nominal version really distorts reality implying that virtually all the stock gains of the last century were in the past few decades. In reality there have been three major secular bull periods and two secular bears.
The bull periods rendered above represent Long Valuation Waves coming in, like a valuation summer. The bear periods between the bulls represent the waves moving past, like a valuation winter. Success as a long-term investor is heavily dependent on where in these valuation-wave cycles stock purchases are made. If investors buy when valuations are low they make fortunes but if they buy when valuations are high they lose big.
Investors buying in 1914, 1949, or 1982, near the valuation-wave troughs where everyone hated stocks, could have reaped magnificent secular gains of 629%, 516%, and 1409% on the Dow 30 over these 17-year bulls. These are the stories, especially since 1982, that inculcate market lore today and make stock investing for the long term seem so romantic and foolproof.
But the dark side of investing, the stuff that Wall Street never talks about in public, is represented by the secular bears between every secular bull. Long-term investors buying in 1929 would have waited 19.8 years for a 58% loss! Can you imagine losing 58% of your precious long-term capital as well as wasting half of your 40-year investing life? Yet countless investors did just that, buying in 1929 as the mania hype seduced them in.
The dangerous buy-at-any-price-valuations-be-damned mentality returned in 1966 when the Dow 30 first challenged 1000. Everyone thought it was the perfect time to buy and stocks were as popular as they were in 2000. Yet, over the next 16.5 years the Dow didn't break 1000. It actually lost 22%. Can you imagine holding long-term investments for 17 years and losing 20% before inflation? And as you recall the 1970s were not exactly benign on the inflation front.
In real inflation-adjusted terms, general US prices rose 3.1x over this exact valuation-driven secular bear from 1966 to 1982. Thus not only did long-term stock market investors buying in 1966 lose 20% of their precious capital nominally, but the remaining 80% could only buy one third as much in terms of real purchasing power as the original capital deployed. The 1966 investors lost 17 years of their 40-year investment lives as well as 70% of their remaining capital's purchasing power!
Now when we only have 40 years to build our fortunes, such 17-year hits are catastrophic. If you lose capital and purchasing power for 17 years in a Long Valuation Wave ebbing secular bear, you may as well just throw in the towel at that point. The meager capital left over is not likely to be enough to compound into great fortunes in the secular bull that will eventually come when the next Long Valuation Wave starts rolling in.
In 2000 this happened again, stocks were believed to be in a New Era destined to rise eternally and valuations reached all-time highs. Countless investors and the general public were sucked into the mania and bought near the top. While this was 5 years ago, history is very clear in showing that secular bears tend to run 17 years in duration, not just 3 like the period between the 2000 top and the latest 2003 bottoms. Odds are there are 12 more years of secular bear markets ahead.
Now please realize that bear markets are not just falling prices, they are also flatlined prices like the 1966 to 1982 example. But the Federal Reserve's relentless and irresponsible inflation of the US dollar supply ensures that we will continue to lose purchasing power every year without fail. So even if this current bear is the best case and is flat, in real purchasing-power terms it will still decimate investors.
If you are interested in an in-depth comparison of the 1966-1982 secular bear with the 2000-20XX secular bear in valuation terms, please check out my Curse of the Trading Range essays. The parallels are already uncanny and a little disturbing. If this comparison holds, the Dow 30 won't trade materially above 12000 until after 2017 or so. Talk about a kick in the teeth!
I hate bear markets. I live to play the markets, but playing them is infinitely easier in secular bulls where the rising valuation tide lifts all boats. Making money in bear markets is very challenging and takes 10x the work that it takes in bulls. I am not happy at all with the message of the Long Valuation Waves today and truly wish I could tell you that we are due for a secular-bull stage.
Nevertheless, reality is reality regardless of our feelings. If we know a valuation-wave trough is coming we can prepare our capital accordingly and weather the storm elsewhere. There is no need for anyone to fight a secular headwind for 17 years. Right now, sadly, probabilities are in favor of 12 more years of a secular bear, probably endless sideways grinding, before the next Great Bull.
Thankfully the prudent can weather this valuation storm. While stocks wane for 17 years as a valuation wave trough approaches, commodities tend to thrive in these same 17-year periods!
Commodities long waves are almost perfectly offset by one-half wavelength, making them bullish when stocks are bearish. Indeed commodities are now in a secular bull market and are rapidly becoming the best performing sectors in all of the markets. Long-term stock investors can avoid the worst of the Long Valuation Waves by deploying in commodities stocks rather than the general stocks, techs, and financials that were so popular in the last bull market.
At Zeal we continue to look for elite commodities-producing companies to ride this commodities bull and weather this valuation-wave winter. We recommend these companies for purchase in our acclaimed monthly newsletter as we uncover them and the timing seems favorable. Our subscribers also have exclusive Web access to large updated versions of our famous valuation charts to track the Long Valuation Waves. Please join us today!
The bottom line is stock valuations flow and ebb over 34-year periods, Long Valuation Waves. Since the last wave top rolled through in 2000, we are now in the ugly part of the cycle. A 17-year secular bear market is highly likely to run from 2000 to 2017 or so, witnessing an endless trading range under the 2000 highs at best and a much deeper bear market at worst.
I humbly urge all long-term stock investors to carefully study the Long Valuation Waves and fully consider their implications. If my thesis is right we are in for some tough sailing ahead. But for the prudent who understand the times and invest accordingly, there is no need to suffer with the general stock markets.
Adam Hamilton, CPA
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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, http://www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.
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