Long Valuation Waves 3

Adam Hamilton
Archives
Aug 17, 2007

Just one month after the US stock markets achieved new all-time highs, today's fear-stricken equity landscape looks radically different. Investors and speculators alike are frantically dumping everything with reckless abandon, regardless of fundamental merit. The resulting carnage is impressive to behold.

Such episodes of wanton fear, though painful, are very healthy for the markets. They are necessary from time to time. In fundamentally-weak sectors, they force leveraged speculators to rein in their leverage and reduce their risk. In fundamentally-strong sectors, they shake out the weak hands who lack the courage to ignore their emotions and lack the faith to ride secular bulls through turbulent spells.

Market chaos also opens up rare opportunities for traders to rethink their paradigms, the strategic ideas underlying their deployment of capital. When people get scared, they are much more receptive to different ideas than when they are complacent near interim highs. Thus today is a great time to revisit a little-understood yet immensely-important secular driver of the stock markets, the Long Valuation Waves.

Like the slowly undulating waves of the open oceans, the LVWs are great stock-market cycles that run about a third of a century each. They are measured by valuations, or the prices at which the stock markets are trading relative to their underlying earnings. For long-term stock investors, nothing is more important than understanding where the markets are in their current LVW. Today's position within the LVW really governs probable returns over the coming decade.

Before we delve into the wave mechanics though, it is useful to consider why such important forces aren't widely known. If LVWs truly have such a deep impact on the markets, then why aren't they common knowledge? The answer is their multi-decade wavelength. When financial cycles meander at such glacial paces, they escape detection by all but dedicated students of the markets.

It is really just human nature to ignore cyclical behavior below the threshold of easy detection. While short cycles are easy to understand since we have lived through many of them, long cycles can only be perceived with a solid foundation of market history. An astronomy example illustrates this phenomenon.

The very definition of a "year" is the period of time it takes the Earth to complete a full circuit through the heavens and revolve around the sun. And since our planet's vertical axis is tilted, varying amounts of sunlight reach us throughout the year as the relative angle of the sun hitting the ground changes.

This phenomenon leads to the seasons. Since a full seasonal cycle only takes one year and we've all lived through dozens of these cycles, we know exactly what to expect. We look forward to, and predict in advance, spring, summer, autumn, and winter year after year without fail. 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. We know better because we have experienced so many seasonal cycles in our lifetimes.

But imagine if we lived on an outer planet where the seasons were longer, such as Saturn if it didn't have such a wickedly hostile environment and actually had solid ground. If we had grown up under the stunningly beautiful rings of that planet, our seasonal perceptions would be radically different. This is because Saturn, since it is so far away from the sun, takes a whopping 29 Earth years to complete one revolution around the star!

Interestingly Saturn's axial tilt is very similar to Earth's, so an inhabitable Saturn would also have four seasons. But with a 29-year orbit, each season would run over 7 Earth years in duration. If you were born in the beginning of spring, then you would be 21 years old by the time your first winter arrived. Imagine how difficult it would be for your parents to explain the concept of winter to you if you had never experienced it after two decades of life. You might even suspect they were senile for predicting such a strange and hostile season.

Yet they'd be proven right. Like on Earth, the Saturnian seasons would be as inevitable as clockwork. But since even the most robust human would only witness three at best over an entire lifetime, they would be much harder for an average person to perceive. Young people, or folks new to Saturn, would have no reason to expect such seasons unless they had truly studied the past and used this knowledge to frame the present.

This is why the Long Valuation Waves are not widely perceived. With a wavelength running about 34 years, an LVW takes even longer than a full revolution of Saturn. And we do not even watch for LVWs over our entire lifespans, compounding the difficulties of understanding them. If an average person starts investing at 25 and retires at 65, then he only has 40 years over which to perceive a 34-year cycle. Obviously this will not happen casually and requires intense study.

The best place to start is with a conceptual rendering of a Long Valuation Wave. They look like great sine waves echoing through stock-market history. The red line below is a stylized LVW, showing the general path over which stock-market valuations tread. The blue line shows a more realistic LVW, with valuations oscillating around their primary sine-wave trend. The horizontal axis measures years while the vertical one defines valuation multiples.

One LVW is rendered here, but stock-market history bears witness to an endless series of these waves connected end-to-end. While each wave runs about a third of a century in duration, for investors it is far more meaningful to split these waves in half. The 17 years from trough to peak coincide with the great secular bulls of history. And the second 17 years from peak to trough represent the great secular bears.

It is crucial to understand that the medium through which these waves travel is not stock prices, but stock valuations. These valuations expand during booms, peak during bubbles, start contracting when bubbles burst, and continue contracting down to troughs during busts. Investors can use LVWs to buy low in busts, hold for massive gains in booms, sell in bubbles, and preserve their gains to the next bust buying opportunity.

But in order for investors to utilize our position within the LVW cycle as a powerful strategic planning tool, understanding the "valuation" component of these waves is even more important than internalizing their "long" nature. Though valuation is probably the single-most-important concept for long-term investors to understand deeply, sadly the vast majority of investors today seldom consider it for the markets as a whole.

Ultimately stock investing, when you strip away all the glamour and emotion, is about owning a fractional share in the future earnings of publicly-traded companies. Naturally investors want to earn the highest possible returns on their capital. Over the long run, the highest returns arise from the companies with the highest consistent profits. So investors naturally gravitate to these companies over time.

Now the truly wise veteran investors are sector-agnostic. They invest in the sectors likely to see the greatest increases in profits over the longest period of time without concern about what particular businesses these high-potential sectors are involved in. The core mission of investing is to find those companies that will earn the most profits per dollar invested over the lifetime of the investment.

But buying future earnings streams through fractional ownership of companies has a price. Due to the emotional nature of the markets, companies' stock prices are far more volatile than their underlying profits. When the markets are fearful, stock prices fall making future earnings streams cheaper to buy. When the markets get euphoric, stock prices rise making future earnings streams more expensive. Obviously investors want to buy earnings when they are too cheap and sell them when they get too expensive. Buy low sell high.

This is accomplished by monitoring valuations, which are simply the relationship between companies' stock prices and earnings streams. The most venerable measure of valuation is the price-to-earnings ratio. P/E ratios are calculated by dividing a company's stock price "P" by its latest annual earnings "E". Wall Street commonly calls this number a company's "multiple". Valuations are expressed as P/E ratios that tell investors how many times higher stock prices are than their underlying earnings streams.

Stocks are cheap, and great long-term bargains, when their P/E ratios are low. If a stock is trading at a P/E of 7, or a multiple of "seven times earnings", then it only costs $7 to buy each $1 of annual profits. But if a stock is trading at 28x earnings, it costs $28 in stock-price terms to buy $1 of annual profits. Obviously the first stock is a far better deal for investors. Why pay $28 for an identical $1 of earnings that you could buy for just $7? Investors want to buy cheap, so they look for sound and strong low-P/E companies to buy.

But what is cheap? And what is expensive? Thankfully market history is very clear on this. Over centuries all over the world, stock markets have had average P/E ratios running near 14x earnings. This is considered fair value, kind of like sea level, in Long Valuation Wave studies. When prevailing market valuations are under 14x for years at a time the LVW is in a trough. And when they trade over 14x for years the LVW is in a peak. This 14x fair-value line is the center around which the LVWs oscillate.

Besides being the long-term average, what makes 14x so special? It happens to be a very logical fair-value point too. The financial markets exist so savers and debtors can make deals. Savers, or investors, consume less than they earn so they build up surplus capital. Naturally the savers want to invest this capital for a return. Debtors consume more than they earn so they run capital deficits. So they come to savers to borrow capital to use to build the debtors' businesses. While stock investing is technically not debt investing, the stock markets are still primarily a mechanism to direct capital surpluses to fill capital deficits.

Now all of these capital transactions are two-sided. Obviously the saver wants to earn as high of return as possible on his painstakingly-saved capital. But meanwhile the debtor 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 happens to be the long-term happy medium between the investors with capital to invest and the companies that need this capital. Interestingly the reciprocal yield of 14x earnings is 7.1%.

If you are an investor with a capital surplus, you would probably consider offering it to a company that needs it for an expected 7% return. Similarly if you have a company that needs capital, you have to admit that 7% is not an exorbitant rate. Thus across centuries, cultures, markets, and countries 14x earnings just seems to be the most natural fair-market clearing price for balancing capital surpluses and deficits.

Since 14x earnings is the base long-term fair-market valuation, it provides a stable reference point off of which we can define cheap and expensive. Just as market history has shown 14x to be the center reference point around which the LVWs oscillate, it has defined earnings extremes too. When stocks are trading at half fair value, or 7x earnings, they are very cheap. When they are trading at twice fair value, or 28x earnings, they are very expensive. Obviously investors want to buy the former and sell the latter.

With this historical knowledge we can really define a Long Valuation Wave. It is a third-of-a-century cycle where the general stock markets start out cheap at 7x earnings. Stock prices rise faster than earnings in the 17-year secular bull that follows this LVW trough, increasing valuations. Eventually stock prices approach or exceed 28x near the LVW peak, usually a bubble, and then a 17-year secular bear sets in. In this valuation reversion, earnings rise faster than stock prices driving down valuations. Then this whole cycle begins anew like a phoenix from its ashes.

Once you understand what an LVW is conceptually, it is easy to see them meandering through the markets in long-term valuation charts. Out of the big three US stock indexes, only the Dow 30 has been around long enough to chart sequential valuation waves through history. While the Dow was born in 1896, the S&P 500 didn't arrive until 1957 and the NASDAQ Composite until 1971. So the Dow remains the king of ultra-long-term charts.

It is rendered below in red, on a logarithmic scale. This scale helps the index's percentage gains and losses look much more visually comparable over time. The general stock-market P/E ratio, the LVW measurement of choice, is shown in blue. A secondary valuation measure, the dividend yield, is drawn in yellow. As a valuation indicator it works opposite to P/E ratios, with high dividend yields representing cheap stocks and low ones representing expensive stocks.

The blue P/E-ratio line meandering higher and lower over the last century is the Long Valuation Wave. It shows general stock-market valuations gradually climbing higher and grinding lower depending on where they happen to be within the wave. Like long seasons in a Saturnian year, LVWs are easy to see if you consider enough history but virtually impossible to perceive if you only live in the present like most investors today.

Like all waves, LVWs are easiest to measure from peak to peak or trough to trough. The distance between the first two peaks rendered above is 37 years and the second two 34 years, for an average of 35 years. The wavelengths between the troughs ranged from 29 to 33 years, with an average of 31 years. All four wavelength measurements together average out to 33 years, right in line with the conceptual LVW model.

The last three LVW peaks rolled through in 1929, 1966, and 2000. They averaged general-market P/E ratios of a staggering 34x earnings. This is considerably in excess of the twice-fair-value 28x level that marks classic bubbles. While the latest 2000 valuation peak looks a lot like the 1929 peak in symmetry terms, 2000 was at a far larger scale. General-stock valuations soared to 44x in early 2000, a bubble unprecedented in US history. This most-recent valuation peak dwarfed the one witnessed in the late 1920s.

This yields a provocative point to ponder. If the long-term average stock-market valuation is 14x earnings, but the late-1990s boom pushed valuations up to never-before-witnessed extremes, then the coming LVW trough will need to be lower and/or longer than usual to restore balance to the long-term valuation averages. Stock investors need to be aware of this ominous possibility in this receding LVW.

The last three LVW troughs occurred in 1920, 1949, and 1982. The latter, of course, marked the humble beginnings of the biggest bull market in US history. All three of these troughs averaged general-market valuations of 7x earnings, right in line with half historical fair value. Since our latest LVW peak was so incredibly extreme, I strongly suspect we'll see valuations under 7x before this LVW fully runs its course.

With valuations already contracting from 44x in 2000 to 23x today, the fact that we are now in a receding Long Valuation Wave is unassailable. Long-term stock investors really need to understand this. The peak-to-trough phase of an LVW tends to run for 17 years. If you add 17 years to the 2000 valuation peak, we are not looking at the next trough until 2017 or so. This means we probably face another decade of contracting valuations. These reversions are challenging and risky times for investors.

The prospect of the US stock markets continuing to see valuation multiples contract for another decade ought to be very sobering. Valuation contractions in this peak-to-trough phase generally happen in one of two ways. Either stock prices fall until earnings are high enough to lower valuations to the 7x region or stock prices meander sideways until earnings rise enough to lower valuations to 7x. In both cases, in LVW ebbings investors face 17 years of sideways-to-down markets.

This can be illustrated by looking at actual stock-market performance during the past century's LVWs. During the 17-year periods when the waves were flowing in, stocks saw awesome performance in powerful secular bulls. But during the subsequent 17-year periods when the waves were flowing out, stocks performed terribly in secular bears. Investors deploying capital in the former made fortunes while those foolishly buying and holding through the latter suffered crushing and irreparable long-term losses.

This final chart compares the nominal Dow 30 with its log-scale variant to analyze LVW returns. The returns shown are trough-to-peak and peak-to-trough within the LVWs, so they are not always the best or worst possible returns over intra-LVW spans of time. They are also capital gains only, excluding dividends.

Since long-term investors aren't traders, these absolute returns over half LVWs represent the kind of general-market returns actually earned. They really highlight the critical importance of understanding and heeding Long Valuation Waves.

Even though the LVWs strictly measure valuations, actual stock-market performance during their flowings and ebbings mirrors the valuations well. From 1914 to 1929 in an incoming LVW, the Dow 30 climbed 629%. In the next LVW flowing in from 1949 to 1966, the index powered 516% higher. And in the latest from 1982 to 2000, this venerable blue-chip stock index soared a mind-boggling 1409%!

The very best time to be a long-term investor is when the first half of an LVW is rolling in, when it is pushing valuations higher by driving up stock prices. This is the time when it makes great sense to buy and hold, when the patient and prudent earn fortunes simply by buying in at LVW troughs and watching their stocks rise on balance for the next 17 years. It is an investor's dream.

But there is a cost to pay for such long bull markets. They push valuations so out of whack compared to underlying fundamental realities that equally long adjustment periods are needed to restore valuations to more reasonable levels. These subsequent LVW ebbings are the great bears we've seen throughout market history. Stock prices decline on balance, or at best trade sideways on balance, for 17 years until valuations are once again very cheap.

The first LVW-driven secular bear shown above ran from 1929 to 1949. Over 20 years investors buying and holding the very best elite stocks in America would have lost 58%! The second secular bear ran from 1966 to 1982 and yielded a 22% loss. The third started in 2000 and is still ongoing, but it is likely to have similar results by 2017 because nothing can short-circuit the relentless and unstoppable LVW cycle.

The very worst time to be a long-term investor is when the second half of the LVW is rolling out. Valuations are being driven lower by a combination of flatlined or falling stock prices and rising earnings. Investors who try to buy and hold through these great bears get slaughtered. Even if a market is flat for 17 years, which is about the best-case scenario during an LVW ebbing, it still has catastrophic consequences.

If an average investor only has 40 years in which to build his fortune, between the ages of 25 and 65, then losing 17 years to an LVW-driven secular bear is crippling. Even if the investor gets lucky and the bear just grinds sideways rather than falling, he loses purchasing power every year at the real rate of inflation. On top of that he suffers staggering opportunity costs, 17 years of watching his capital do nothing while other contrarian sectors are rising. He also loses crucial decades for compound interest to multiply his gains.

Now the current LVW ebbing since 2000 is particularly interesting. Valuations have already been roughly cut in half since 2000, so there is no doubt we are in the secular-bear phase of the current wave. Despite this, as of the middle of July the Dow 30 and S&P 500 were higher than their early-2000 bull-market tops. The former was 19.4% higher and the latter 1.7% higher last month than near the last LVW peak in 2000. Does this negate the LVW thesis? Not at all.

The latest Dow 30 highs happened 7.5 years after the 2000 highs. Is a 19% total gain over 7.5 years acceptable to long-term investors? No way. It represents a compound annual gain in the Dow 30 of just 2.4%. A mere 2.4% a year is unacceptable for all the considerable risks inherent in investing in stocks. A bank savings account would have done much better at a fraction of the risk. And 2.4% is well below the real rate of monetary inflation in the US so investors have suffered real purchasing-power losses.

So a 19.4% higher high 7.5 years deep into an LVW ebbing definitely doesn't invalidate this thesis. At best it is a double top representing a trivial rate of return. The S&P 500's 1.7% gain over this same period of time supports this idea of a double top in early 2000 and mid-2007. Marginally-higher highs deep within a secular bear do not change the fact that it is still a secular bear and that an LVW is still flowing out today.

And this fact that valuations are still contracting and our current Long Valuation Wave is still receding down to its next trough is probably the single most important thing for investors to understand today. In most of this year until the past month, the rising stock markets created a deadly sense of complacency. Valuations were still gradually declining on balance, but stock investors believed we were in a secular bull since stocks were rising.

If the average mainstream investor had read this essay in early July, he would have laughed. What an asinine concept! How can we still be in a secular bear when new all-time Dow and S&P highs are being reached? Yet thanks to the general-stock correction in the last month, investors are now more receptive to considering theses like this that Wall Street hates. Investors would do well to carefully consider the LVWs and their implications today while they have the mental opportunity to reflect on contrarian reasoning.

And realize this concept of the Long Valuation Waves is certainly not new. Prudent contrarian students of the markets have always known that stock markets move in great valuation cycles. For this great bear, I've written about these valuation cycles previously in 2001, 2002, and 2005. Yet despite this most investors choose not to study history and doom themselves to suffer the consequences of their willful ignorance.

Every week on CNBC I hear Wall Street "experts" talk about valuations, and they inevitably make comments suggesting how excellent general stock valuations look today. "Stocks are now at their lowest valuations since 1996, a great bargain." "At a 20x multiple investors cannot go wrong buying today." Unfortunately this typical Wall Street view is myopic and it ignores the irresistible force of the Long Valuation Waves.

Once an LVW ebbing gets started, it will run to completion. Nothing can stop it. Periodically governments try to support stock markets, but they never succeed for longer than short periods of time. And the ultimate target of the LVW trough is not 14x fair value, but half fair value at 7x earnings. If the Dow 30 was to trade at 7x earnings today, we'd be looking at 5500! Although the Dow probably won't get that low since earnings will gradually rise over the next decade before the LVW trough arrives, it really illustrates how far away we are from a typical historical great-bear valuation trough.

Thankfully not all stocks tend to decline with the general stock markets over these 17-year secular bears. Commodities, which are neglected during the 17-year stock bulls, tend to thrive on balance when capital returns to rebuild global production capacity during the LVW bears. This is why commodities stocks have been among the world's best-performing investments and speculations since 2000. At Zeal we continue to research and recommend elite commodities stocks at technically opportune times. Subscribe to our acclaimed monthly newsletter today to mirror our trades and thrive during this stock bear!

The bottom line is the Long Valuation Waves are the most important secular driver of the general stock markets. A month ago when the markets were surging, few investors cared. Hopefully today when stocks are bleeding, more will pay attention. Our current LVW ebbing has about a decade to run yet which means general stock performance should be flat or down for another decade. It is a very dangerous environment.

Investors really need to seek alternative investments to ride out this secular bear. Although the prospects for general stocks are dim, commodities stocks should ultimately thrive just as they have during past LVW ebbings. While it is a lot more challenging to multiply capital during a secular bear, it can certainly be done by prudent investors willing to avoid the valuation-contracting mainstream US stocks.

Adam Hamilton, CPA

August 17, 2007

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