Look, Ma! The Emperor Has No Clothes!


Last Night's Question: Why Did the Stock Market Double After It Had Already Reached a Normal Peak?  
    Last night's discussion centered around the anomalous surge beginning about 1996 (actually, maybe about 1997) from the highest levels ever seen in the past to twice the highest levels ever seen in the past. The inflation-adjusted Dow should have "bounced" off its upper trend line and headed down when it hit about 6000. Instead, it promptly doubled to 12000.) Last night, I was asking, "What happened?". Today I found out.

The Answer
    The 9-year boom that lasted from 1991 through 1999 (and actually, through 2000) was one of the longest continuous expansions in U. S. history. Earnings in 1996 were about $41 a share on the S&P 500. They rose to about $52 a share in 1999, and to about $57 a share in 2000. By 1999, the conversation had turned to "forward earnings growth"... to what next year's earnings would be. (I recall hearing the term "earnings momentum"). These weren't new ideas , but I think that, in the midst of euphoria, there might have been a switch from this year's news to next year's news. Dividing 52 by 41 gives an earnings  growth factor of about 1.27. Stock prices could rise by 27% through 1999 without raising the price-to-earnings ratio on the Dow stocks (although it would take the price-to-book ratio and the dividend yield out of bounds). Dividing 57 by 41 yields a growth factor of about 1.39, which would have allowed a rise of about 39% without incresing the P/E ratio. Then I went to the price-to-earnings (P/E) ratios listed in the Dow Jones price table. Here, I found that the P/E ratios had marched from 16.45 in 1995 to almost 26 in 1999. Bingo! This was the smoking gun!  The proximal cause wasn't the shifting of U. S. production to foreign shores or the transition to a service economy. Instead, it was a combination of an unusually prolonged series of back-to-back earnings increases, combined with new highs in boom-time price-to-earnings inflation. This latter factor was just like the other markers of price inflation only it wasn't as pronounced.   Figure 1 below shows a plot of the price-to-earnings ratios from 1929 to 2002 (estimated). Price-to-earnings ratios spike at the bottoms of recessions, when earnings drop extremely low (low divisor). They rise more smoothly coming up to a stock market top, when earnings rise, but stock prices rise faster. Their maximum values at stock market tops are generally less than 22:1. The P/E ratio in October, 1929 was, as I recall, about 21:1. As you can see, their values in the late 90's set new records for PE ratios during an expansion.

    If you multiply 1.27 times 26/16.5, you get 2.00. This is consistent with a doubling of the Dow from 1996 through 1999.
    This is not good news. What it suggests is that the final run-up in the Dow was a feeding frenzy for stocks... what's known in the trade as a "final blow-off:.. masked by an unusual run-up in earnings. (The mania in technology stocks is dramatically revealed by last night's chart of the Pilgrim Baxter Technology and Communications Fund, reproduced below. Between December of '98 and March of 2000, it went from about 18 to about 118, and then back to about 13 today.)

The Meaning of This Answer
    If this is the case--if there's no sea change in the way the world does business--then what goes up must come down, and sooner or later, the piper must be paid for the tune he played. Presumably, this market must eventually work its way down to a more sustainable level.

Can It Continue?
    Another important fact about this situation is that this was a one-time move that boosted the stock market to 6-to-1 price-to-book ratio, a 76-to-1 price-to-dividend ratio (the previous record was 38:1), and a 26:1 price-to earnings ratio. The stock market can only stay that high if retains these lofty valuations. (Let's see. With a long-term rate of rise of 1.2% a year, it would take the Dow 60 years to grow enough to return to the upper edge of its normal envelope if it merely kept up with inflation over the next 60 years.)
    Could this inflation become even greater? If it could go this far, I suppose it could farther, but it seems to me to be at enormous risk of deflation. I think it got to the point where everyone said, "The stock market is climbing. If I don't buy with the crowd, I'll be left behind." That's the classic mindset that empowers a mania.
    An important point about the stock market is that it depends for its continued popularity upon moving to continually higher levels. On the other hand, rises in book value and in dividend yields occur glacially slowly, and even earnings don't rise terribly fast. Earnings will surge after a slowdown. Money Magazine forecasts a 27% increase in earnings this year, followed by 12% next year. But the long-term average even in the best of times averages 6% or 7% a year. The stock market can only beat that rate of rise by becoming more bloated.  Financial advisors are all trying to get across to the investing public is that this marvelous bull market is going to slow down to a more sustainable pace. What they're not saying, in my  opinion, is just how much risk is inherent in the stock market at its current levels.

The Next Question
    The next question is: how come no one else seems to be saying anything about this? The U. S. (and the rest of the world) abounds with experts in this area. How come no one is speaking out? Am I wrong somewhere? I'll certainly try to ferret out an answer to this.

Should This Be Told?
    After thinking about the implications of this knowledge, I'm wondering if it's in the investing public's best interest to be aware of this at this time. It will certainly be helpful to have this information for my own personal investing plans. But would it be better to wait until the stock market, hopefully, recovers in 2004? If everyone listened to this and sold their stocks at once, think what that would do! Fortunately, a decision doesn't have to be right now, and I would certainly want to check my facts and my interpretations before shouting that the sky is falling!
    For us, there are a few small-cap stocks that have done well over the past year, and have worked their way back up to where they were in early 2000. I'm going to sell these and keep the money in cash. I own the Fidelity Select Home Finance Fund, which has recovered the price at which I bought it. It's doing great with interest rates low. Once interest rates start to rise... One disappointing ace-in-the-hole is the Fidelity Freedom Income Fund. I thought that, with its low exposure to stocks and income-producing holdings, it wouldn't drop during a market pullback. It hasn't dropped much--about 6%--but I had hoped that it would have pulled back out by now. We have about a fifth of our money in it, so it will be a good source of money market cash reserves.
    So these I'm going to convert to cash right now. Some funds, such as the PBHG Technology and Communications Fund displayed above, have sunk so far that they have nowhere to go but up. I won't change what's in these. If I have any reason to put money back into the stock market, I would probably put it into such "fallen angels". The question of what to do about in-between funds is one I'll address after I've gotten a reading or two from financial experts about just what this is all about.