Making Money in a Fallen Market


By Any Prior Standards, the Stock Market, Even After Its Pullback, Is Still Unbelievably Overpriced
    Last night's Figure 1, showing as it does the anomalous surge in stock price inflation from the beginning of 1996 through the end of 1999 (to 6:1) to twice the highest level (3:1) ever experienced in the past (and three times the highest precious price-to-book ratio), tosses into a cocked hat what I previously wrote about the three-to-one range in stock price inflation. Obviously, something new has been added to the mix.

    By any yardsticks of the past, today's stock market, even after its pullback, is still fantastically overpriced. The only way the stock market can advance beyond its end-of-1999 level of about 11,500 is if it moves to even more-rarified levels of dividend yields, price-to-book ratios, and returns-on-equity than its unprecedented values at the end of 1999. So the question becomes: what is the cause of these uncanny returns-on-equity? They're the only reason the Dow didn't tank several years ago when the Dow reached about 6000.
    In the meantime, until we know whether these returns-on-equity are based upon substantial foundations, the conservative position would be to assume that current stock prices are exorbitantly risky.
    One interesting observation about the curve in Figure 1 is that it looks as though a switch has been thrown at the beginning of 1996. Also, why is the rise directly proportional to the time? 
    The return-on-equity begins to fluctuate wildly, beginning in 1981. It peaks temporarily in 1988. What's that all about?
    One (legitimate) reason for a rise in return-on-equity could be the switch from a production-based to a service-based economy.

"Don't Settle for a 1,500,000% Profit"
     I read that if you had invested $1 in the stock market at the end of 1899, it would have been worth $15,000 at the end of 2001. Let's take a look at that and see what it really means.
    The consumer price index was 25 in 1899. Because of inflation, twenty-five cents in 1899 was equivalent to $5.37 today. If we deflate the $15,000 to convert it into 1899 dollars, the $15,000 becomes about $700 in 1899 terms.
    In 1899, the DJIA, after correcting for inflation, stood at 1400. My guesstimate is that a market peak in 1899 would have been about 1800.     The DJIA perched just below 12,000 at the end of 1999. This was higher by a factor of two than any previous market peak, so a DJIA of 3600 in 1899 would have corresponded to a DJIA of 12000 in 1999. This means that stock prices at the end of 1999 were inflated by a factor of 3600/1400 (= 2.57) over stock prices in 1899. Dividing $700 by 2.57 so that we're comparing apples and apples, we arrive at an initial investment of $272 1899 dollars to buy our market basket of stocks. (We've now corrected for consumer price inflation and for stock price inflation. If we had happened to be at the bottom of a super-bear market in 1999, the original collection of stocks would have brought only $2,500, or $116 in 1899 dollars.)
    A growth factor of 272:1 is still impressive, though not quite as great as the advertised 15,000:1.
    The ratio 12000/3600 ( = 3.33) is a measure of the true, inflation-adjusted long-term capital gains return on the Dow over this 100-year period. To convert this to an annual percentage, we calculate ln(3.33)/100 = 0.012 = 1.2% per year, agreeing pretty well with Harry Rood's estimate of 1.3% to 1.4% per year.
    If we divide $272 by 3.33, we'll get a remaining growth factor of 82 that derives from dividend income. To convert this to an average annual rate, we compute ln(82)/100  = 4.407% per year, agreeing with the horseback guesstimate I made last night from the chart.
    So there you have it. The 100-year-average real rate of return on equities (above inflation) has been about 5.6% per year.
    Looking now at the return on equities since 1926, the DJIA stood at about 200 in 1926. It towered at about 12000 at the end of 1999, or about 60 times its 1926 value.  So the average annual rate of rise in the DJIA was ln 60/70 = 5.84% per year. Adding to an assumed dividend rate of 4.41% per year gives us 10.25%. But as we've seen above, if you correct this number for consumer price inflation and for stock price inflation, the real rate of return is about 5.6% per year.

Making Money in a Fallen Market
    I don't have time to go into it tonight, but there would seem to be ways to make major gains even in today's market, provided that there's some reason to think that it isn't riding for a crash. One of the ways is to buy the technology sector. This sector was everyone's darling two years ago. Figure 3, below, shows a five-year chart of the Pilgrim-Baxter Technology and Communications Fund that both Tommie and I own. It looks rather as though the fund had a bad-hair year, doesn't it?

Two year ago, when this fund was monstrously overpriced and everyone should have been selling it, investors couldn't buy enough of it. Now, when it's monstrously under-priced and everyone should be buying it, no one wants to touch it with a 10-foot pole. So buying fallen angels, stocks that have been ravaged by the bear, is one way to beat the general market averages. The companies that remain are the survivors. Technology isn't going to go away. It will stage a comeback. So this is one possible ploy.
    There are others that I won't try to discuss tonight. I mention them only to suggest that there is hope, but it requires acting differently from the cut-and-dried.