or the End?
by David Stanowski
22 January 2008
Now that the DJIA, and most major stock market indexes, have smashed through their 16 August 2007 lows, the debate has begun about what will happen next. Are we near the beginning or the end of this new leg down? This article updates my remarks from 30 August 2007. The data used herein is current through Friday, 18 January 2008.
The permanently-bullish Wall Street crowd has confined their discussion to picking a bottom that will set up a new advance for a move above the 11 October 2007 high at 14198.10. Their optimism, or more accurately, wishful thinking, is not based on anything more substantial than the belief that the U.S. economy is "in good shape", and that the FED will save the day with lower interest rates.
However, there are two measures of stock market value that can lend some clarity to this debate:
The classic way to compare today's stock prices with levels of known value is to compute a P/E ratio. Investors always look to invest their money in things with low P/E ratios, because it represents how many dollars that they have to pay to receive one dollar in earnings. Speculators ignore high P/E ratios, because they are betting on price appreciation instead of looking for income. However, when prices stall in their upward movement, speculators usually bail out, and prices collapse to levels that bring the P/Es in line with historical norms.
The Dividend Yield is another way to measure values in the stock market. This is the total dollar amount of the dividends paid on the DJIA stocks divided by the value of the DJIA.
Looking back at over 100 years of data for the Dow Jones Industrial Average (DJIA), it is clear that stocks become over valued, i.e. too expensive, when their P/E ratios exceed 21, and they are under valued, i.e. cheap, around 7. Fair value is about 14.
While it is possible for a major top to form before the P/E ratio exceeds 19-21, history says that stocks can not be considered under valued at these levels.
Looking back at over 100 years of data for the DJIA, it is clear that stocks become over valued, i.e. too expensive, when their Dividend Yields are less than 4%, and they are under valued, i.e. cheap, around 7%. Fair value is about 5.5%.
The 1901 high lead to a 2-year bear market that saw the DJIA lose 46% of its value.
The 1919 high was an anomaly, because earnings rose dramatically which dropped the P/E, and increased the dividends paid out, even at a top. From 1919-1921 the DJIA lost 46% of its value.
The 1929 high lead to a 3-year bear market that saw the DJIA lose 89% of its value.
The 1966 high lead to a 4-year bear market that saw the DJIA lose 37% of its value.
The 1973 high lead to a 2-year bear market that saw the DJIA lose 45% of it value.
The 2000 high lead to 3-year bear market that saw the DJIA lose 39% of it value.
Will the October 2007 high lead to a 3-4 year bear market which will see the DJIA lose more than 45% of its value?
The message from over 100 years of data on P/E ratios and Dividend Yields is clear: The 11 October 2007 high was made at levels which are signaling that it is likely a major top! The P/E of 19 was not excessive but the DY 2.0% certainly was. Furthermore, the duration of this over valuation should be considered, as well as the extent. The P/E ratio of the DJIA has been above the average level of 14 since 1995. Likewise, the DY fell below 3% in 1992, and has remained there for the last 15 years! In 1929, the DY was below 3% for only 2 months and the market crashed.
The current situation is very similar to 1966-1973. The DJIA made a major top at 995.15 on 9 February 1966, with a P/E of 24, dropped 37% into 1970, and then hit a new high of 1051.70 on 11 January 1973, with a lower P/E of 19. All through out this seven year period the DY was at an over valued level of 3%. After the second top, in 1973, the DJIA plunged 45%.
The DJIA made a major top at 11908.50 on 14 January 2000, with its highest P/E in history (44), dropped 39% into 2002, and then hit a new high at 14279.96 on 11 October 2007, with a lower P/E of 19. All through out this seven year period the DY was very over valued, at less than 3%. Since this pair of tops is two orders of magnitude greater than in 1966-1973, a major bear market, with a decline of at least 45% should be in the offing.
Mutual Fund Cash:
When stock mutual funds take in money to invest in stocks, they invest most of it, and keep a portion in cash reserves. When managers are very bullish, they keep less money in their cash reserves. Major tops are formed with cash reserves of less than 5%, and bull moves begin with cash at conservative levels near 10-11%.
In the graph below, notice how stock-mutual-fund managers briefly dropped their cash reserves to less than 5% at the 1966 top (shown as 5 circled). Then they let their cash drop as low as 3.9% at the 1973 top (shown as D circled), and also kept their reserves below 5% much longer than in 1966.
Then compare it to 2000 (shown as V) when their cash dropped below 5% again, but the amount of time that their cash reserves were below 5%, during the 2002-2007 rally (shown as b) far exceeds that leading up to 2000, and managers hit an all-time low of 3.5% cash reserves in July 2007!
This pattern seems to confirm the idea that the seven year 2000-2007 pattern is similar to the one in 1966-1973, and that there is a very high probability that a major bear market is just beginning.
There is a lot of talk about how worried investors are about the stock market, which is a bullish sign, but the other data do not confirm this. Investors are worried about their stock portfolios, but they haven't unloaded much of their holdings, which betrays their underlying bullishness. Most long-term measures of sentiment have remained bullish for years. For example: there have been more bulls than bears, among investment advisers, for 457 out of the last 466 weeks, i.e. nine years!
In addition, note that last week's action broke a 25-year uptrend line for the DJIA!
The Real DJIA, i.e. the DJIA/Gold, just broke to a new low this month, so it is now down 67% from its high in 1999. This is a more accurate picture of the Dow's performance, than the nominal Dow, because it removes the portion of the gains that are just due to the decline in the U.S. Dollar.
One side of this argument is relying on their belief that the U.S. economy is strong, and that the Fed can prevent a bear market by lowering interest rates. Lowering rates did not reverse bear markets in 1929-1932, 2000-2002, or in Japan, in the 1990s; and it is unlikely to work at the present time. This side claims that the indicators cited in this article are no longer valid, because "things are different this time"! They're right; things are different this time. It is not difficult to make the case that the economic and financial conditions in this country are much worse than they have been since 1929! Hardly a good reason to believe that stocks will advance from here.
If you believe that these indicators are not outmoded relics from the past, then you should pay attention to their message! They are saying that this is just the beginning of a new leg down in the stock market that will not end anytime soon!
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