Where Angels Fear to Tread



    The next move in interest rates is going to be up. The lowering of interest rates over the past two years has made stocks more attractive relative to money market funds and bonds. Bond-owners by now have presumably sold their bonds, having ridden interest rates down from their peak a couple of years ago, with the corresponding increase in the market value of their high-interest bonds.

    At the same time, corporate profits are expected to rise in the second half of this year. However….

    The stock market tulip mania of the last few years outstrips anything previously seen by a factor of about two. Dividend yields normally bottom out at 2.8% to 3%. In early 2000, they must have reached 13% to 1.4%. Price-to-book ratios rarely exceed 3:1. In early 2000, they must have exceeded 6:1. Earnings were still high in 2000, so that price-to-earnings ratios, while high, weren’t in the same league with the other two measures of stock inflation. But earnings can turn on a dime, and they do when the Federal Reserve raises rates to slow the economy.
    In short, stock prices became inflated by a factor of about two above any previous level of overpricing. It became a pyramid club, a Ponzi scheme, in accordance with the “Greater Fool” theory of investing. (“I know I’m a fool to pay you this much for your stock, but I’m counting on finding a greater fool who will pay me more than I paid you to take this stock off my hands.”)

    In the latter “fools rush in… ” stages of great bull market, inexperienced investors throw caution to the wind, investing so they won’t be left behind in this wonderful musical-chairs game.
    The Dow would have to drop to no more than 8000 to reach the upper bound—the turning point—of its range. To deflate to a book value equal to its stock value, as it did in 1982, the Dow would have to drop to about 2000-2500. Of course, given 14 years of high inflation, like the 14 years between 1968 and 1982, the stock market in 2016 could be cheap at 7500 (although its value in today’s dollars would be 2500).
    To say it again, most of the gain in the stock market between 1982 and 2000 was puff. The Consumer Price Index rose by a factor of 1.82 between 1982 and 2000. Multiplying that by the 776 Dow value in August, 1982, gives a value of 1412 for the Dow in year-2000 dollars. Assuming a long-term real rate of rise of stocks of 1.4% per year, we would expect a price of about 1817 for a stock market bottom at which the price-to-book and dividend yields would match those of August, 1982. Then multiply this by a factor of 6 for the price inflation of the 90’s and you have about 10,900 on the Dow, which is close to the 11,000+ that the Dow actually hit before it began its collapse.
    So it all adds up, and it adds up to a glum future for stocks for, probably, the next decade.
    Over the four years between 2000 and 2004, we might see 1.4% a year in real growth. Then again, we may not,. Earnings have fallen, and it may take a couple of more years to see earnings rise above their 1999 levels. If the stock market inflated by 2004 to the level that it reached in 2000, that would only be a 20% rise from present levels. In the meantime, interest rates will rise, and this time, bonds and money market funds may seem more appealing if a substantial fraction of investors realizes that there is a low ceiling on how high the market can go.

    A more reasonable scenario is a drop in the Dow toward more reasonable levels. The Dow is still far above any previous level in its history. Its rise into 2004 depends upon no one recognizing that the emperor has no clothes.

    In retrospect, it appears (at least to me) that the great bull market of the 90’s was made possible by a large number of amateur investors who are being forced to save for their retirements. They can’t afford to be stock market gurus. They’re read many places that stock market total returns since 1926 have averaged 10.6%, so they wanted to invest some or all of their retirement savings in stocks. And there’s no success like success. Watching everyone around them make money in the stock market, it became the “in” thing to do. And nowhere have I been able to find a quantified discussion of what’s driving the market, or of what indicators (like price-to-book and dividend yield) they needed to monitor. As I’ve mentioned, I’ve had to run these calculations for myself.

    In what else could we invest?