Curse of the Trading Range 3
Propelled by the recent massive spikes in the metals as well as the persistently strong energy prices, the 2006 markets have been very much dominated by commodities. Contrarian investors and speculators have naturally gravitated towards these hot commodities markets to ride the early second stage of this global raw-materials boom.
While we are being blessed with huge profits in elite commodities stocks, the progress of the general stock markets never ventures too far from the contrarian mind. Back in the early 2000s before this great commodities bull launched, many of the same speculators trading commodities stocks today were short the general stock markets. I am part of this crowd too and think it is always important to keep an eye on stocks.
And from a contrarian perspective, May has been one of the most interesting general-stock episodes of the past several years. After powering higher relentlessly since October, by May 10th the mighty Dow 30 had come within striking distance of achieving a new all-time nominal high. In January 2000 the Dow had closed at 11723, so it is not surprising the bulls were really excited a couple weeks ago to see an 11643 close.
But before old record levels could be exceeded, the Dow 30 started falling rather rapidly, down 4.7% in just 9 trading days. With the Dow's market capitalization near $3.8t, such a fast decline is not a trivial event since it erases around $180b of equity. While such sharp pullbacks are not particularly rare, I can quickly count about 8 more of them on the Dow chart in the last several years, they do tend to spawn widespread reflection.
The US stock markets have been generally either powering or grinding higher since March 2003, when the war rally launched the day Washington started bombing Baghdad. What was initially a sharp relief surge has blossomed into a full-blown cyclical bull market since. While very profitable for those who have been long, the recent sharp decline is causing growing concerns about what is likely to come next.
Since investors are far more likely to consider controversial market theses after a fast decline shakes their confidence, I'd like to revisit the contrarian view of the US stock markets. Even though the Dow 30 is up a very impressive 55% since March 2003, like most contrarian students of market history I believe we are actually languishing in a secular bear market today. Hogwash you say? Perhaps, but please read on.
Stock markets move in great cycles throughout history. Sometimes stocks are universally loved as in early 2000 while at other times they are universally loathed as in 1982. These cycles are extraordinarily important for long-term stock investors to understand. They are most readily evident when viewing the stock markets in valuation terms, how much investors are paying for stocks relative to those stocks' underlying earnings power.
When investors are discouraged about stocks as they were in the early 1980s, stocks fall to very low levels relative to the earnings they can spin off. The general stock markets typically have a price-to-earnings ratio near 7.0x at these major secular bottoms. Conversely when investors grow euphoric about stocks as in the late 1990s, they can rapidly bid up market P/Es above 28x earnings. This slowly oscillating psychology dynamic creates the great cycles dominating market history.
Never much for fancy academic titles, I call these long valuation waves simply Long Valuation Waves. An entire valuation wave generally runs for a third of a century or so. So about every 33 to 34 years, stocks can move from undervalued to overvalued and back again or vice versa. Each one of these waves can be split in half too, yielding 17-year great bull markets as we saw from 1982 to 2000 and their subsequent 17-year great bears.
Now if you are a stock investor and you haven't yet studied Long Valuation Waves, you are putting yourself at an almost insurmountable disadvantage relative to someone who has. If this concept isn't familiar to you, I strongly urge you to read an overview essay on this crucial topic I wrote last August called "Long Valuation Waves 2." Out of all my voluminous research work, I believe this is easily the single most important topic for investors to understand and internalize.
Like great ocean waves, valuation waves run sequentially. After a valuation trough, like 1982, the main valuation wave starts sweeping into shore over the next 17 years or so and ultimately drives stock prices to very high levels relative to their earnings, the valuation crest like we saw in early 2000. But after this valuation crest passes, the valuation wave continues on and valuations relentlessly fall for 17 years or so down its backface until the next valuation trough. It is these receding valuation waves that create secular bear markets.
If we are indeed in a receding valuation wave, then stock investors are facing another decade or so of declining valuations and flat-to-declining stock prices. A decade! Since the average person's useful investing life is probably only about 40 years from initial investments to retirement and investment drawdown, the consequences of a long-term flat-to-declining stock market are staggering. Investors with only a decade or so left before retirement will not have a chance to recover from another decade-long grind.
While the Long Valuation Waves are indisputably real, the important question today is determining where we are currently likely at in these great third-of-a-century cycles. Our two charts this week, updated from earlier iterations of this line of research, make a crystal-clear case of where we are right now in valuation wave terms. The first compares the last two now legendary great bulls while the second compares the market action since 2000 with the last brutal great bear.
The latest great bull run from 1982 to 2000 is legendary and remains well known by the vast majority of today's stock investors since they lived through it. But only a few old timers and students of the markets remember the nearly equally mighty great bull that preceded it, from 1949 to 1966. In this chart both axes are zeroed so the true magnitude of each great bull is readily apparent and not distorted. These great bulls were twins in many regards.
Over the course of each great bull, Dow 30 P/E ratios and dividend yields are noted at key technical points. In P/E ratio terms, 14x earnings is the average historical fair value for stock markets. The reciprocal of 14x earnings is a 7.1% earnings yield. 7% is a fair level for both sides of a capital transaction. It is reasonable for savers to earn 7% to lend the capital they haven't consumed and borrowers to pay 7% to borrow the capital they haven't earned.
14x earnings is the long-term average clearing price for capital transactions in the stock markets. One half these fair-value levels, or 7x earnings, is the general level witnessed during Long Valuation Wave troughs when stocks are dirt cheap and likely to rise tremendously in the coming 17 years. Twice fair-value levels, or 28x earnings and higher, is the general level witnessed during Long Valuation Wave crests when stocks are likely to languish in the coming 17 years.
The single most critical factor for long-term investment success in the stock markets is not which stocks you pick, but where the markets happen to be in their latest Long Valuation Wave when you commit your capital. If you buy at a valuation trough you won't have to do anything because the valuation wave washing in will lift virtually all stocks. But if you instead buy at a valuation crest, the same buy-and-hold strategy will lead to no nominal gains and considerable inflation-adjusted losses. Valuation timing is everything for investment.
So where are we today in Long Valuation Wave terms? I think the best way to discern this is to view our last two great stock bulls superimposed. As you can see above, stocks were cheap in both 1949 and 1982, the last two major valuation wave troughs. In both cases valuations were down near 7x earnings and dividend yields were high, over 6%. Over the next 17 years in each case, stocks climbed relentlessly on balance driving P/E ratios much higher and dividend yields much lower.
By 1966 the Dow 30 was trading at 24.1x earnings and only yielding 2.9% in dividends, the highest valuations it had seen since the late summer of 1929. At the time investors were euphoric though, believing they were traveling in a brave New Era where valuation no longer mattered. The market darling stocks at the time were the "Nifty 50", they were giant American companies with consistent earnings growth and high P/E ratios. This should sound familiar because the market darling stocks in the late 1990s had very similar attributes.
But all great bulls must come to an end, and without warning in early 1966 the Long Valuation Wave crest was reached and the long 17-year journey began down the other side of this wave to its trough. While the Dow fell initially investors were not worried, just as they weren't in the early 2000s, because they figured that "This Time It Is Different". These are the five most dangerous words an investor can ever utter and they have cost investors trillions of dollars of capital in just the past half century alone.
While our next chart gets into the resulting great bear starting after the 1966 valuation wave crest, first carefully ponder the uncanny similarities between the last two great bulls. By early 2000 the Dow 30 was trading at 44.7x earnings and yielding just 1.0% in dividends, its highest valuations by far in history. Even back in 1929 on the eve of the Great Crash the general-stock-market valuation was "only" running 32.6x. Our latest valuation crest drove the markets to the highest valuation extremes they had seen in at least a century, and probably ever.
While the 1960s great bull was up roughly 10x, from around 100 to 1000 over 17 years, the 1990s great bull handily exceeded these gains. It was up about 15x in nominal terms from 1982 to 2000, a stupendous bull run by any standards. As you ponder these statistical similarities, carefully examine the chart above as well. In pure price-pattern terms the last two great bulls had a great deal in common in their ascents. In both cases investors increasingly poured capital into stocks driving their valuations well above fair value to overvalued levels.
Why is this comparison so important? If we can establish, beyond any reasonable doubt, that 1982 to 2000 was a period when the Long Valuation Wave was coming in and ultimately crested, then we are now in the subsequent period where this same Long Valuation Wave is going back out and dragging valuations back down into a trough. In the vernacular this part of the valuation wave cycles is known as a secular bear, the most dangerous time possible for long-term buy-and-hold investors.
And if the 1982 to 2000 great bull matches up so well in valuation and price terms with the 1949 to 1966 great bull, isn't it at least prudent to consider that perhaps this 2000 to 2017 period through which we now sojourn will match up with the brutal 1966 to 1982 great bear? As a contrarian and student of market history I obviously think the answer is yes, but even if you disagree on a logical basis the following chart ought to terrify you.
Great bear markets can unfold in two ways, either via a wicked fast decline as from 1929 to 1932 or a long excruciating sideways trading range. The latter, which I call the Curse of the Trading Range, is far more deadly because it eliminates long-term investors' chances to win any gains for the better part of two decades, nearly half their investing lifespans. If you have 40 years to invest and lose 17, you may as well just give up.
This chart overlays the market action since the recent 2000 valuation wave crest with the great bear that unfolded from 1966 to 1982. While the main chart does not have zeroed axes, the inset chart on the lower right does so you can view this troubling comparison without any axial distortion. Love it or loathe it, the price action we have seen since 2000 is textbook Curse-of-the-Trading-Range stuff. Buy-and-hold stock investors really need to carefully consider the obviously bearish implications here.
The red line shows the Dow 30 during its last great bear. I've found that a lot of people I've discussed this with, if they haven't studied market history, believe that prices just fall in secular bear markets. This is not necessarily true. In reality the last great bear was an immensely volatile trading range that lasted for 17 years or so with zero net gain from the 1966 top. There were unbelievably brutal declines on the order of 45% and exhilarating rallies near 75%!
Such hyper-volatile conditions are not a problem for speculators, who can buy the sentiment bottoms and sell the sentiment tops, but for investors who like orderly stock-price growth they can be psychologically devastating. Investors who bought in 1966 when conditions looked awesome had no capital gains yet in 1982, 17 years later!
And in reality, once adjusted for inflation, they had a considerable real loss. My studies on this 1966 to 1982 period in capital-gains terms adjusted for inflation show investors lost an unbelievable two-thirds of their purchasing power by buying and holding stocks, a 64% real loss excluding any dividends they received. Talk about a kick in the teeth!
This history is frightening enough alone, but the current progress of the US stock markets since 2000 has been mirroring that of the first 6 years or so of the last great bear to a remarkable degree. Just as in the last great bear, we have seen brutal downlegs like the one that ended in late 2002 and awesome rallies, or cyclical bull markets, like the one we've seen since early 2003. As this chart shows, even on the zeroed-axis inset version, the magnitude of recent Dow 30 moves is exactly on target with those of the early 1970s.
This secular sideways grind, the Curse of the Trading Range, happens because stock valuations were far too high to be sustained at the last valuation crest so they need to drop back to fair levels. The long way to do this is to have stocks slowly move sideways over many years until earnings can catch up with high stock prices. But Valuation Wave Reversions are problematic because they don't conveniently stop at 14x fair value. They overshoot on the downside and ultimately end near 7x earnings at the next valuation wave trough.
The Dow 30 interim top P/E ratios since 2000 that are shown above in yellow drive home this point. At its 2000 peak the Dow traded at an absolutely unsustainable 44.7x earnings! By May 2001 it was again near 11350 on the index, but its valuation had dropped dramatically to 27.6x earnings. By March 2004 after the initial war rally upleg it was back near 26.1x earnings, but by March 2005 at even higher index levels valuations had again dropped considerably to 21.4x.
And as of early May, the Dow 30's P/E has dropped to 18.7x, not too far above fair value, even though it was once again challenging all-time nominal highs. The markets are definitely valuation mean reverting! While I am happy to see the stock markets a lot less overvalued than they were in 2000, extreme caution is still in order here. When a valuation wave is receding, it never stops at fair value. The Dow is not just going to 14x and then a new bull erupts. It is almost certainly going far lower to 7x earnings.
A perfect example of the reason stock investors today should not be anywhere close to being smug and complacent happened during the last great bear. In early 1973, roughly just 6 months ahead in comparable trading-range-time terms of our latest peak last month, the Dow 30 was trading at just 18.7x earnings and yielding 2.7% in dividends. But even though these valuations were getting reasonable, over the next two years into the end of 1974 the Dow 30 plunged.
The unbelievably vicious cyclical bear market that ignited in 1973 and 1974 was one of the most psychologically devastating episodes in market history. The Dow went from roughly 1050 to 575 in two years, about a 45% loss. For the majority of buy-and-hold investors, this was the key psychological turning point that shattered their resolve. Late 1974 is when investors started to hate stocks. If you are a long-term investor in general US stocks, imagine how you would feel two years from now if the Dow 30 is back under 7000.
Well, ominously if the US stock markets continue following the last great bear's script today, we are now at the highest risk yet of seeing a multi-year cyclical bear ending in a sub-7000 Dow. Visually above, note the amazing similarities between the awesome cyclical bull from 1970 to the end of 1972 and the equally magnificent last several years in the US markets. If the modern date scale was shifted six months to the right, this comparison would be even more uncanny.
Also note that just before the brutal mid-1970s cyclical bear started prowling, the Dow was trading at 18.7x earnings and yielding 2.7% in dividends in late 1972. These numbers are remarkably similar to what we saw this month, 16.5x and 2.5%. Obviously anything can happen in the markets and today's stock markets don't have to follow the dark mid-1970s course, but investors ought to still take this potential risk very seriously.
Here we are, more than 6 years after the last Long Valuation Wave crest in 2000, and the evidence continues growing that we are in another long-trading-range great-bear scenario. If I was a long-term buy-and-hold general-stock investor, this increasingly ominous trading range would make we want to cry. Thankfully there is a far better alternative than suffering another decade of real losses in a brutal sideways grind.
During these great stock bears in market history, commodities tend to thrive. Commodities also run on third-of-a-century-or-so cycles but they are offset 180 degrees. When stocks are in a secular bull commodities are usually in a secular bear and vice versa. Even during the last long trading range of the 1970s stocks of primary commodities producers soared. Stocks of giant producers often had 10x+ gains during this period and stocks of more speculative smaller commodities producers witnessed plenty of 100x+ gains!
At Zeal we think it is pointless to try and fight a receding Long Valuation Wave so we have focused our research efforts since 2000 on profitably investing and speculating in the unfolding Great Commodities Bull. While the Dow 30 may still be pathetically languishing near 11000 a decade from now, great commodities stocks are almost certainly going to be at least an order of magnitude higher than they are today.
Long-term stock investors can park capital in the stocks of elite commodities producers, earn huge gains while weathering the general-stock secular bear, and have great sums of capital ready to buy general-stock bargains when the next valuation wave trough arrives. If you'd like to learn more about specific commodities stocks opportunities that are likely to thrive as this commodities bull continues to power higher, please subscribe to our acclaimed monthly newsletter today.
The bottom line is the evidence continues to mount that we are now sojourning through another long trading range in the general stock markets. While speculators can capitalize on this and trade the massive cyclical swings inherent in such a sideways valuation reversion, buy-and-hold investors will likely get slaughtered. If you think that buying and holding the biggest and best American companies is always a sure thing, think again. Beware the Curse of the Trading Range!
Thankfully while stock markets are suffering though great bears the commodities are usually surging in their own great bulls. Thus a prudent buy-and-hold investor has a far higher probability of success over the next decade if he deploys his capital in elite major commodities-producer stocks rather than long-range-bound general stocks.
Adam Hamilton, CPA
May 26, 2006
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