Investment Update
Thursday, July 18, 2002


    The Dow-Jones Industrial Average topped out at 11720 in January, 2000, and the S&P 500 peaked at 1527.46 in March, 2000. Today, the Dow closed at about 8019, while the S&P 500 ended the day at approximately 847. The Dow is at about 68.4% of its peak value (meaning that it will have to rise by about 46% to get back where it was when it maxed out two and a half years ago). The S&P 500 is an even paler shadow of its former self, at 55.4% of its March, 2000, value. It will have to rise 80% to attain its prior perch. And interestingly enough, that places it a little below the upper end of the range of its long-term trend line (after correcting for inflation). (I'm guesstimating that the long-term upper trend line for the S&P 500 in July, 2002, is about 875.) A similar situation exists for the Dow-Jones Industrial Average, for which I'm guesstimating an inflation-corrected, upper-trend-line value of about 9500 for July, 2002. In other words, the popular market indices are back within (though near the top of) their normal trend channels.
    By the standards of the Fed's fair-market-value formula, they're within buying range. The interest rate on 10-year Treasury bonds closed today at about a 4.6% interest rate. The "earnings yield" on the S&P 500 (as nearly as I can determine) is something like 7%, so stocks are significantly under-priced compared to bonds.
    Projected operating earnings for 2004 (actually, the year-ahead operating earnings for 2005) should be something like $72 a share, leading to a 2004 S&P index of 1540, giving an earnings yield of 4.6% (Friday's value for the yield on 10-year Treasury bonds), and corresponding to a price-to-earnings ratio of 22-to-1. This is the kind of P/E ratio that appears at normal market tops. The economy is in good shape, and should support such a P/E ratio for a market peak.
    In short, it looks to me as though the stock market will support at least a partial retrenchment of its bear market decline. Three months ago, when the Dow stood at 10200, it was already 56% of the way up from its 9/19/2001 low of 8200 to its March, 2000, peak of 11800. But now that it's moved back to 8000, we're being given a second chance. I think it's time to buy. And certainly, no one should sell right now!
    Bear markets end when the bulls capitulate. When the bulls say, "I've been waiting around here for 2½ years and the stock market is only getting worse. It looks like it's going to really cave in! I'd better  sell," then it's time for the stock market to turn around. There's crisis in the air when the bear market makes its last frightening plunge, shaking off the more tenacious amateur investors, who have finally  decided to cut their losses and cash in their chips. Then, when they've sold at fire-sale prices to the pros, who've been coolly waiting for this moment all along, the bear market turns into a bull market. During the bear market, there have been previous rallies that fizzled out, so when the stock market rises 350 points the first day, the amateur investors, who have just sold, aren't ready to jump back in. They did that three months ago, and were caught in a bear trap. It isn't until a month or two later, after the market has risen 2000 points, that the outsmarted amateur investors begin to realize that this is the real thing.
    This feels to me the way it did in the summer of 1982, or December, 1974, with small investors capitulating and selling their investments at precisely the time when they should be buying. If you're thinking of selling stocks right now, don't do it! The stock market still isn't cheap, but it has dropped far enough now to be in safe territory. I can't say that it won't go lower, but I'm sure that it will get back to where it is now. It's no longer twice as inflated as it's ever been in the history of the stock market, the way it was in March, 2000 (partially because 847 today is equivalent to about 706 in March, 2000, dollars, or less than half its peak value of 1527).
    I'm not ruling out the idea of a long-term (secular) super-bear market through 2014, but if that happens, I think the market will inflate and deflate in four-year cycles. For example, if that scenario occurs, the S&P 500 might rebound to 1400 or 1500 in 2004, and then, in 2006, sink back to a somewhat lower level than it's at now. But there would be bounces along the way. The stock market never goes down for 14 years at a slow but constant rate. That would put brokerage houses and investment magazines out of business. (A great deal of the lure of the stock market is the excitement it creates, and the possibility of winning big. So it swoops and soars and sidles and slides, giving everyone the thrill of the chase, like playing tug-of-war with a puppy and a dishtowel.)
    This is the point when the seasoned investor rubs his hands gleefully together, loads up on whatever funds he wants (generally, those that have been hit the hardest), and sits back to wait for the impending bull market.
    At least for the S&P 500, the deflation by a factor of two that was worrying me has already taken place. Allowing for recovering earnings, the slow workings of modest inflation, and a percent or two a year of underlying real gain over a four-year period, an S&P index of 1527 in December, 2004 would be equivalent to an S&P index of about 1200 in March, 2000. An S&P index of 1350 in December, 2004, would be equivalent to an index of 1080 in March, 2000--temporarily overpriced, as befits bull market tops, but not like the manic high of March, 2000. And an S&P index of 847 in December, 2004 would be equivalent to an S&P index of about 672 in March, 2000. With a recovery on tap and low interest rates in the near-term, there's no reason to expect stock prices to fall much below the tops of their trend channels.
    To me, things are looking much safer and better.