 Valuation Wave Reversion 4
Adam Hamilton
Archives
October 29, 2004
Seventy-five years ago to this very day one of the worst
financial calamities in financial history rocked the world markets.
On Black Tuesday, October 29th, 1929, the US stock markets plummeted
by 12% after a record 13% drop the day before. This single day
of infamy is now universally recognized as the de facto boundary
between the boom days of the Roaring 20s and the overwhelming
bleakness of the Great Depression.
Today we peer back through
history, all smug in our modern sophistication and high technology,
and wonder how investors could have been so naïve.
Didn't they know irrational exuberance was multiplying exponentially
before the crash? Why didn't they sell when the Dow rallied back
up to 274 a couple days later on Halloween 1929 rather than ride
it all the way down to its brutal July 1932 bottom of 41?
Well dear friends, I fear the
trick is on us as we plunge into Halloween 2004 exactly three-quarters
of a century later. It is depressing to ponder, but for all of
our vast knowledge, all of our unprecedented computing power,
and all of our lightning-fast telecommunications networks, collectively
we are making the very same mistakes of our American investing
forefathers. In analogous historical terms, we are probably somewhere
between 1930 and 1932 in today's US stock markets.
How can I dare make a statement
like this that seems so blatantly absurd at face value? The ominous
answer is found in the Long Valuation Waves.
Stock markets historically
move through great cycles lasting about one-third of a century
each. During these periods of time, massive valuation waves crest
and crash like great ocean waves. Valuations, which describe
how high or low stocks are trading relative to their underlying
earnings power, start low as each new wave begins building. Over
many years valuations are bid up high enough to eventually reach
unsustainable extremes. Finally valuations crash and mean revert
and the whole cycle begins anew.
If you are an investor and
haven't yet studied these all-important valuation waves, I have
written earlier essays explaining this phenomenon in depth. You
may wish to check out 2002's Long
Valuation Waves and the original Valuation
Wave Reversion essays to dig into the full background. Personally
I believe these waves are the single most important macro
force for long-term stock investors to understand.
Like the unstoppable great
ocean waves, these valuation waves are relentless and immensely
powerful. No government or central bank in world history has
ever been able to stem their flow. Individual investors who are
brazen enough to trade against these mighty waves may as well
stand up on some island beach and shake their fist in defiance
at an approaching tsunami. Fighting valuation waves is foolish
at best, suicidal at worst. Resistance is futile.
Unfortunately these valuation
waves are not widely understood, primarily because their wavelengths
are so long. With each one of these waves running a third of
a century or so, they cannot be casually perceived. If the average
investor finally starts getting seriously into investing in their
30s and they retire in their 60s, then they only have a few decades
at best in which to invest. Thus, theoretically a single valuation
wave can encompass the entire functional investing life
of a typical investor.
I often use a seasonal analogy
to illustrate this concept. If you live far enough away from
the equator and oceans, there are four distinct seasons each
year. Since this seasonal wavelength is so short, 1 year, we
have ample time in our lives to come to expect the predictable
flow and ebb of the seasons. If you experience a glorious sunny
60-degree day in April you know summer is coming and plan accordingly,
but if you experience an absolutely identical 60-degree
day in October you know from years of experience that winter
is still relentlessly approaching despite this beautiful day.
Investing for "summer"
valuation wave conditions in a valuation wave "October" is a great way to send your hard-earned
capital to its slaughter. Just like the season winter comes whether
you believe in it or not, whether you know it or not, and whether
you care or not, the valuation waves will march right on through
whether or not you believe, know, or care. If you invest with
these waves over the long-term you will earn a fortune, but if
you fight them they will crush you like a bug, as if you didn't
even exist.
Our first graph updates my
earlier Long
Valuation Wave work, comparing the valuation waves with the flagship
Dow Jones Industrial Average over the past century or so. The
left axis graphs valuation, both general stock market price-to-earnings
ratios and dividend yields. It is actually the blue P/E ratio
line for the markets that forms the valuation waves, as you can
see by its lazy undulations through time. The Dow is rendered
in red on the right axis, on a logarithmic scale so its percentage
gains are constant over an entire century.
We also updated our large high-resolution
valuation charts on our
website if you are interested. In addition to bigger versions
of the four charts in this essay, four other large valuation
charts from other essays are also included.
The Long Valuation Wave theory
is crystal clear when you examine this chart. Stock markets,
for herd psychology
reasons, tend to gradually oscillate between low valuations and
high valuations and back again. A full valuation wave, measured
either trough to trough or peak to peak, tends to run a third
of a century or so. Long-term equity investing earns investors
fortunes when these waves are marching from trough to peak, but
kills investors when they are collapsing from peak to trough.
Just like speculation, timing is crucial in long-term
investing too.
The centuries-old average fair
valuation for stocks is 14x earnings, meaning that a market is
fairly priced if it takes 14 years after you buy it to earn back
your entire purchase price in profits. A market is cheap when
its P/E is cut in half, when prices get so low relative to earning
power that it trades at 7x earnings. A market is dangerously
expensive when its P/E doubles to 28x earnings in a bubble, when
investors grow so euphoric that they bid up stock prices far
beyond what the underlying fundamental realities can realistically
support.
As a long-term investor, it
is crucial to buy stocks when they are cheap in valuation terms
and sell them when they are expensive. In the chart above, look
at the red Dow line every time the blue market P/E line traded
near 7x earnings, in the early 1920s, early 1930s, early 1940s,
and early 1980s. In each case in the following decade or two
investors reaped magnificent gains by buying stocks when they
were absolutely cheap by historical standards.
Each of the three greatest
bull markets in the last century, the 1920s, the 1950s
and 1960s, and the 1980s and 1990s all erupted out of valuation
wave troughs. If you are wise enough to buy stocks after long
bears when virtually everyone hates them and valuations are very
low like in 1982, then you are virtually guaranteed to win enormous
long-term profits. This critically important concept forms the
very foundation of long-term contrarian investing.
Conversely look at the horrible
Dow performance in the decades after 1929 and 1966, when stocks
were very expensive and the valuation waves were peaking. In
both the 1930s and the 1970s stock valuations ground relentlessly
lower, driven by plummeting stock prices in the first case and
a seemingly endless
sideways grind allowing earnings to gradually catch up in
the second case. Investors going long near valuation wave tops
inevitably suffer though decade-plus wastelands devoid of any
gains at all at best and wickedly brutal losses at worst.
Now the moral of these valuation
waves is certainly easy to understand. If you are wise enough
to only buy stocks for long-term investing when they are historically
undervalued, when a long valuation wave trough has just past,
you are probably going to grow rich. But if you are careless
enough to buy stocks for long-term investing when they are historically
overvalued, you are not going to make any money at all if you
are lucky and will very probably throw away most of your capital
if you are not.
It is ironic though that these
simple truths like buying cheap and selling dear often prove
so hard to apply. You and I and everyone else understand that
all we need to do to achieve our dream physiques is to eat less
and exercise more, to burn more calories a day than we consume.
Simple right? Yet, like actually buying low and selling high
in valuation terms, it is far easier to talk about running a
calorie deficit than actually pulling it off.
Please take another look at
this century-long chart and carefully note the current stock-market
P/E ratio. It is near 28x earnings, official bubble territory,
and still almost as high as the infamous 1929 valuation
wave peak! This is flabbergasting because, before last
year, no one dared dispute that we were sojourning through the
worst bear market in at least a third of a century. Thus, even
in light of the brutal bear since 2000 US stocks are still
extremely overvalued by all historical standards!
Yet, few investors seem to
even care. Wall Street has been hyper-bullish all the way down
from March 2000 to today, as the entire reason for its existence
is to unload companies' stocks on an unsuspecting public regardless
of prevailing market conditions. Thanks to the powerful war rally
unleashed last year, even mainstream investors are buying into
these new-bull-market theories today, a terrible tragedy. Long-term
secular bulls never, ever erupt from valuations as excessively
high as last March's or today's!
In valuation wave terms, today
we are mean reverting back down from a 33-year peak to a 33-year
trough at some point in the coming decade or so. The 2000 valuation
wave crest shown above looks very similar to 1929's, only much
larger. The next major inflection point for the US markets is
not the far higher valuations that a major bull would bring,
but far lower valuations.
There are only two feasible
paths to far lower valuations, and neither is particularly pleasant.
In the early 1930s stock prices collapsed much faster than earnings
so P/Es plummeted in a relatively short period of only a few
years. While extraordinarily painful and costly for those who
naïvely believed in "investing
for the long-term" at all costs during all valuation
seasons, at least the valuation wave reversion in the early 1930s
was relatively fast so other more rational investors could get
on with investing at the valuation wave bottom in 1932.
The second path was followed
in the late 1960s and 1970s. Stock prices didn't fall dramatically,
instead they ground miserably sideways for the better part of
two decades until corporate earnings caught up enough to lower
P/Es to the necessary 7x valuation trough level from which mega-bulls
launch. This catching-up process took 17 excruciating years!
While seemingly less painful
on the surface than the early 1930s, the ugly 1970s market was
far worse in my opinion since it totally exhausted the majority
of existing investors' total time. If we mere mortals only have
a few great decades in which to seriously invest, from our 30s
to 60s, and a market trades sideways for 17 years of this
precious time like it did from 1966 to 1982, then our individual
opportunities for fortune are irretrievably squandered by such
a catastrophic event.
As an investor I can't imagine
a greater financial curse
than being hoodwinked into investing in an overvalued market
and then watch my investments gain no value for nearly two
decades. This curse is compounded tremendously because during
those two decades fiat-currency
inflation erodes away the purchasing power of capital so
in real inflation-adjusted terms serious losses are actually
being accrued.
With the Long Valuation Waves
unstoppable, far lower valuations are almost certainly coming,
either by brutal plummeting over a few years or an endless demoralizing
grind over a couple decades. General stock-market valuations
oscillate between undervalued and overvalued levels and back
again throughout history without fail, and unfortunately we are
on the "back again"
valuation mean reversion following a massive peak in early 2000.
If you are a long-term investor
not versed in contrarian thought or have never been exposed to
valuation waves, you probably either feel like I am kicking you
in the teeth right now or that I am a lunatic, totally wrong.
Actually, I would not mind being proven wrong one bit on this
one since neither valuation mean reversion alternative appeals
to me either. Like you I have worked unbelievably hard all my
life to earn my capital and it pains me to realize that I face
investing in a valuation mean reversion where all market forces
conspire against me and other investors.
Nevertheless, my personal feelings
and yours are totally irrelevant. The markets couldn't care less
about you or me as a person. The valuation waves flow and ebb
whether you and I like them or not, and putting our heads in
the sand and hoping for the best is a pathetic way to address
a threatening situation. Strong evidence continues to accrue
that a valuation wave mean reversion is already underway, and
no force on earth can stand in its way if history is a valid
guide.
Our final three graphs detail
this mean reversion evidence in the three major US stock indices.
These charts were explained in detail in prior
essays, but for now please just focus on the blue P/E ratio
valuation lines and the yellow dividend
yield valuation lines. Like it or not, they are mean
reverting.
Since the last valuation wave
peaked in early 2000, general market P/Es are shrinking while
dividend yields are rising. Last year's spectacular war rally
temporarily slowed this inevitable process, but it certainly
didn't end it. Massive bear-market rallies sometimes running
a year or more were witnessed after 1929 and 1966 too, but those
prior valuation wave mean reversions ultimately won in the end,
as will today's.
The legendary Dow 30's valuation
wave mean reversion chart is very revealing. After trading above
42x earnings in early 2000, crazy levels never before
witnessed in its entire 107-year history, the Dow is still trading
around 21x earnings today! Realize that in all of Dow history,
a major bull market has never, ever launched from such expensive
levels, 50% above historical fair value. Never!
Now if you, your broker, or
your financial advisors believe that the Dow is going to rally
significantly higher from here in the immediate years ahead,
say up 40% or more to 14,000 or higher, then you are betting
for higher valuations. Higher prices mean higher P/E ratios because
ultimately underlying corporate earnings cannot grow faster than
the underlying US economy. The P in the P/E ratio can certainly
be bid higher, but the E is not going to miraculously jump ahead
of general economic growth.
Thus, please realize that a
bet today that blue chips are going lots higher in the coming
few years ahead is a bet for something that has never happened
before in market history. Not only is it a bet that an already-in-progress
valuation wave mean reversion can somehow be short-circuited,
but it is a bet that a secular bull will launch from 21x earnings
for the first time ever.
Back to our seasonal analogy,
this is like witnessing a glorious 60-degree day (the 2003 war
rally) in valuation October and betting that winter must therefore
miraculously vanish to immediately make way for summer again.
Just as winter inevitably follows October in our 1-year seasonal
cycle, so does a valuation wave trough near 7x earnings inevitably
follow a valuation wave peak in the 33-year Long Valuation Wave
cycle.
If you are long-term long on
US stocks at this stage in the valuation waves, then you are
making a conscious and willful decision to spit in the face of
market history as well as declare that you are somehow exempt
from the timeless laws of the markets. Please realize that betting
for something that has never happened before is not a
high-probability-for-success gamble.
The mighty S&P 500, which
contains the entire Dow 30 and much of the NASDAQ 100 companies
within its elite ranks, is faring even worse than the Dow. The
SPX is now trading above 21x earnings with a dividend yield under
2%. At the past century's greatest buying opportunities, the
valuation wave troughs, the SPX traded near 7x earnings while
yielding over 7% in dividends. Thus, in pure historical valuation
terms, the S&P 500 remains far over fair value and roughly
triple what it would read at a 33-year valuation wave
trough.
One of the greatest things
about investing and speculating is the fact that the markets
are a limitless environment. You can take your capital and bet
any amount of it on any market outcome at any time you want.
No one can stop you. But even though you can allocate your funds
in any way you wish, that doesn't mean that the laws of the markets
will spare you from your own folly.
It doesn't matter if I believe
in gravity or not, but if I take the risk of jumping out of an
airplane without a parachute I am going to splat into a nice
bloody crater after my 60 seconds of euphoria. There are no parachutes
in the markets either. You can be 100% long-term long after
a valuation wave peak, like today, but history teaches this is
not a prudent risk to take. Maybe "this
time it is different", the same hope that investors had
in 1929, but I really doubt it. As King Solomon wisely said millennia
ago, there is nothing new under the sun.
The NASDAQ truly was the nexus
of speculative excess in the early 2000 valuation wave peak,
and these staggering valuation metrics show it. This mania index
was trading at over 100x earnings and yielding an inconceivably
low 0.0% in dividends at its peak!
These valuations were so absurdly
extreme that they probably haven't been witnessed for centuries,
not since the infamous South Sea Bubble in England of the 1720s
or the Tulipomania in Holland in the 1630s. Every market history
book from now until the end of time will detail the out of control
tech mania of 2000 as one of history's greatest examples of a
popular speculative mania.
It is sobering and frightening
to realize that NASDAQ valuations, after last year's war rally,
are now trading around 42x earnings again. This is three times
fair value and an unfathomable six times historically undervalued
levels near 7x earnings. Remember that historical manias only
need to be trading above 28x earnings to be considered classic
bubbles, so the NASDAQ remains a valuation bubble to this very
day.
Now should mega tech stocks
be immune from the laws of the markets? Are mature giants like
Microsoft still growth companies? Why should investors be forced
to pay 28x+ earnings for a mature tech company when a non-tech
company of comparable size and growth "only" costs 21x earnings today? The still
prevailing tech valuation premium, a bubble residual effect,
is ultimately unsustainable.
Investors seek the greatest
bargains for the highest potential returns at the lowest risk,
and ultimately we couldn't care less whether the companies we
own sell computer code on CDs or raw commodities. The smartest
long-term contrarian investors like Warren Buffett will buy virtually
any business if, and only if, it is cheap relative to its current
and future earnings and it has a historically high dividend yield.
Buying cheap and selling dear ultimately applies to every sector,
and technology has no long-term exemption.
The bottom line is we just
witnessed a 33-year valuation wave peak in early 2000. Like winter
inexorably follows summer, valuation wave troughs inevitably
follow the peaks. Being long-term long the general markets during
these valuation wave mean reversions is suicidal. To do so one
needs to be so overflowing with hubris that they believe that
they are miraculously exempt from all of the hard lessons of
market history.
Equally folly-filled is financial
analysis that neglects to consider the valuation wave season
in which we sojourn. One recent
example involves the famous VIX implied volatility index.
Some folks believe that since the VIX was low in 1994 and the
VIX is low today that we are due to have a massive secular bull
market in stocks like we did from 1995 to 2000.
Comparisons like these certainly
seem seductive and logical on the surface, but does comparing
specialized technical indicators between a valuation wave ascent
to its peak and a valuation wave descent to its trough make much
sense? When valuation waves are rising like from 1982 to 2000,
practically everything is bullish except for short corrections.
But when valuation waves are falling like from 2000 to 20XX,
practically everything is bearish except for periodic bear-market
rallies. Please beware of analysis that crosses valuation wave
seasons without acknowledging this gaping disconnect. It is just
asking for trouble.
If you are interested in our
ongoing valuation studies, please consider subscribing
to our acclaimed monthly Zeal
Intelligence newsletter. Each month end in preparation for
publishing my partners and I painstakingly compute the major
index P/E ratios and dividend yields shown above from the bottom
up. While I live in the realm of financial data constantly, there
is no set of numbers that I look more forward to seeing each
month than these valuation numbers. Like the position of the
sun in the sky, they help us define the major season in which
we invest. The latest numbers will soon be out in our brand new
November letter hot off the presses.
I am going to start seriously
looking for the next valuation wave trough when the S&P 500
P/E ratio falls under 10x earnings and its dividend yield exceeds
6%. Believe me, when this happens I am going to be jumping for
joy and this pivotal event will be discussed extensively in our
newsletters as we look for blue-chip bargains to ride the next
great equity superbull all the way up from the coming valuation
wave trough to its ultimate peak.
While not a pleasant subject
for investors to discuss during a valuation wave mean reversion,
I humbly implore you to consider the sober message of the valuation
waves on this seventy-fifth anniversary of the infamous October
29th, 1929 crash. Had you been living then and understood valuation
waves, you could have sold soon after the crash and avoided the
brutal 85% additional drop to the 1932 bottom.
You and I must choose
whether we will learn and apply the hard lessons learned by our
investing forefathers or whether we will suffer a similar ill
fate. No one can save us from ourselves if we brazenly ignore
market history.
October 29, 2004
Adam Hamilton, CPA
email:
zelotes@zealllc.com
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