Are We Entering a "Super-Bear Market Through 2014?
(This introduction has been written early in 2002)
    2001 was an exciting year. It began with a deepening of the dot.com bust, followed by at least two quarters of unabashed recession. And then came 9/11...
    The economy is showing signs of recovery, with the stock market slowly climbing. After the S&P 500 peaked at 1,580 in March, 2000, and bottomed at 968 on September 22, 2001, it rose to 1,160 on December 31, 2001. The Dow Jones Industrial Average topped out at 11,720 in January, 2000, fell to 8,250 on September 22nd, and then rebounded to 10,135 on 12/31/2001. The forecast, from the January, 2002 issue of Money Magazine, is for a recovery during the second half of 2002, with the stock market climbing even as you read this in anticipation of this recovery. However, Money Magazine is also flogging concerns about a 14-year super-bear market, as we enter the down phase of this latest of the 32-year market cycles that have characterized the U. S. stock market since at least 1871. (The chart below is from "Forecast 2000", by Michael Sivy, in the January, 2002, issue of Money Magazine.) (For comic relief, see "Nightmare in Netland".)


    The long, flat stretch in this chart from 1966 to 1982 is misleading. This was a period of rampant inflation (shown in the chart as 7%) during which, by August of 1982, the inflation-adjusted stock market had dropped to about a third of its peak value in 1966. (See Figure 1 below for an inflation-adjusted plot of the Dow Jones index, and Figure 2 below for an inflation-adjusted plot of the S&P 500 index.) Money Magazine has drawn this chart to cover a 52-year period, but the pattern can be found unaltered back as far as 1871 (Figures 1 and 2 below). The bottom line is that, since 1871, the U. S. stock market has gone through three "super-cycles" lasting of the order of 32 years apiece, and it appears as though we might be playing out a fourth such super-cycle. 
    I was first introduced to this startling eclaircissement in 1997 at the Capitol PC Users Group, Inc. (CPCUG), website at http://cpcug.org/user/invest/bigpic2.html. At this website, Harry Rood, of Harry Rood Consultants, presents a stunning exposition of the long term behavior of the stock market that achieves its exegesis through plots of major stock market measures back through 1871. 
    The other insights that I'm about to share, I've had to work out for myself. In my 32 years of investing, I've never seen the mechanisms of the stock market explained. (This may not be an accident. Investing is a competitive game, and if everyone knew how the system worked, it would reduce the competitive advantages of those expert investors who do.)

I.   How the Stock Market Really Works:

A. Total Stock Market Returns
    The grand total output of all the companies in the U. S. is essentially the gross domestic product.
     The total value of all the stocks of all the companies in the U. S. is basically the sum of the prices of all the stocks of all U. S. companies.
    The total annual average rate of return on all U. S. stocks consists of:

    Of these, only the first two represent real gains in stock valuesThe latter two are distracters that tend to obscure what's really going on

1. Dividend Yields
    The first of the real gains  (dividends) varies from 7% of the values of the associated stocks at the bottom of a stock market trough, when stocks are undervalued, to about 2.8% at a stock market crest, when stocks are overpriced. (During this last bull market, the average dividend yield on the S&P 500 set a new all-time record low in early 2000 by dropping to 1.4%.) To say that in a more meaningful way, in absolute dollar values, dividends don't vary much except to slowly rise. It's the stock prices that vary, partially because of stock price inflation and deflation, causing the dividend yields to vary.
    Over the long haul, dividend yields, rather than capital gains, are the principal source of stock-market returns!
    That's not what we want to believe. We want to believe that we--or the investment advisors, mutual funds, etc., that we choose as our proxies---can find hot  little companies that will transform us into millionaires within a few short years. And as a matter of fact, it sometimes happens. My next-door neighbor invested, I'm guessing, perhaps $10,000 in Intergraph Corporation in the 1970's, and sold his stake in 1992 for $1,600,000.
    How could dividend yields have gotten so low? One possible reason might be low inflation and interest yields from competing financial instruments. Investors are willing to accept dividend yields from stocks that are lower than interest yields on bonds because dividends tend to rise over time as stock dividends rise, whereas bonds have traditionally offered a fixed rate of return. (Inflation-adjusted bonds offer protection against rising rates of inflation, but unlike stock dividends, which generally go up but not down, interest rate yields from bonds can drop if the rate of inflation drops.) Another reason might be that during the nineties, the word was put out that by retaining more of their earnings for reinvestment, corporations could boost their rate of capital growth. 

2. Inflation-Corrected Gains in U. S. Productivity
    The inflation-corrected gains in per capita output underpin the real gains in standards-of-living of a population. In the U. S., over the past 126 years, this inflation-corrected, per capita gain has averaged out to about 1.5% per year.

3. Monetary Inflation
    In the shell game that is the stock market, inflation provides a wonderful way to bamfoozle the investor. The popular stock indices remained unchanged from a high in 1966 of almost 961 on the Dow to a high of just over 1,051 on the Dow in June, 1981. In the meantime, the galloping inflation over that 15-year period meant that the June, 1981, Dow Jones high of 1051, after correcting for inflation, was really about 375 in 1966 dollars. In other words, the stock market lost nearly 2/3rds of its value between 1966 and 1981, even though its absolute level of 1051 before correcting for inflation was slightly greater than the 961 it had been 15 years earlier.
    Although the value of the average stock declined by a factor of nearly three-to-one over the 15 years between 1966 and 1981, there would have been a stream of dividend income that would at least partially have offset the decline in capital value of stocks. In 1966, that dividend income would have been near the 2.8% dividend yield that is found at market tops; by August, 1982, when the stock market bottomed at 777, that rate of return had risen above 7% because the valuation of the average stock had fallen so significantly.
    Any meaningful discussion of stock market values must draw upon numbers that have been corrected for inflation.

4. Stock Price Inflation and Deflation
    Stocks are sold at auction in accordance with the law of supply and demand. In bad times, when the economy is in recession, stocks become relatively cheap  Then once the economy is rolling along again, stock prices are bid up and up, with everyone eager to buy them, until the next downturn occurs and the stock market suddenly dives again. The range of stock-price inflation is about 7/2.8 or about 2.5 to 1. At a stock market peak (which typically occurs when the economy is in its best form and everyone's optimistic), a "market-basket" full of big-name stocks will usually sell for about 2.5 times what that same market basket of stocks would fetch at a stock market bottom (which typically occurs at the darkest, scariest hour of a recession). In other words, stock prices have been "bid up" until they're relatively expensive.
    Obviously, the time to buy stocks is when they're deflated, but at those times, fear gets in the way.
    Obviously, the time to sell stocks is when they're inflated, but at those times, greed gets in the way.
    In addition to real gains in the values of stocks, inflation also raises stock prices by a few percent per year, although this doesn't represent any real gain in buying power.

I.   Stock Market Super-Cycles
    A few years ago, on the Internet, I came upon a stunning exposition of the long-term behavior of the stock market at http://cpcug.org/user/invest/bigpic2.html, written by "Harry Rood". At the time he wrote this (1997), the stock market was overvalued. From there, it proceeded to continue to engorge further until it became a bubble that was only pricked last year (2000).
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    Now for a shocker! The average inflation-adjusted rate of rise in stock values over the period from 1870 to the present is only 1.5% to 2% per year! Some years have seen larger gains than this, but during recessions, these rates of rise can actually go slightly negative.
    To this may be added the average dividend, which, as stated above, is anywhere from 2.8% a year to 7% a year. Add to this the 1.5% to 2% rise per capita productivity and 3% for inflation and you arrive at an average, annual stock market rise of about 7.3% to 12% a year. "Whoa!", you say. "What about the last few years, when the stock market has risen 25%, 30%, or 40% a year?"
    Two factors have made possible the extraordinary stock market gains of the past few years:

(1)  Real productivity gains in the upper single digits have seemed to have been taking place. (These gains are now being questioned, and perhaps, retroactively downsized.), and
(2)  Stock prices have set new records for price inflation.
    I mentioned above that dividend yields can get as low as 2.8% when stock prices have hit a cyclic peak. Last year, dividend yields hit an all-time low of 1.4%. In other words, stocks have never been so overpriced... so expensive for what you got... as they were in early 2000 just before the dot.com bubble burst.

    1929 was the year of a super-bull-market peak. From there, prices dropped like a runaway elevator from 400 on the Dow in 1929 to 40 on the Dow in 1932. Thereafter, prices languished for another 15 years until 1949. In 1949, prices began a slow climb, peaking in 1966. 1966 was the year of a super-bull-market top in a euphoric mood of irrational exuberance. (37 years after the 1929 crash). After 1966, prices dropped again for the next 16 years, rallying in the presidential election years of 1968, 1972, and 1976, but (after correcting for inflation) working their way steadily lower. Stock prices finally bottomed 16 years later, in August, 1982, at a value in inflation-adjusted dollars, that was less than one-third that of their peak in 1966. Then they began a long climb, punctuated by major corrections and the stock market crash of 1987. 1998 was the year when they should have hit a 16-year super-bull-market peak, but everybody was having too much fun at the party, and the downturn didn't occur until the year 2000.

Stock Market Super-Cycles (continued)   (Written in 2001)   Now the question of the hour is: are we heading into a 16-year super-bear-market (known in the trade as a secular bear market) that will last until 2014? If so, the stock market might be expected to reach bottom next year (2002), and to peak during the presidential election year of 2004. However, through 2014, succeeding peaks would be comparable to, or less  than the peaks in the various market indices reached in 2000. If so, the next stock market rise through 2004 would be a good time to liquidate one's equities, and to invest one's money in short-term money market instruments. On the other hand, there are some indications that the market will recuperate by next year. However, the stock market is a major leading indicator that usually begins a meteoric rise about 6 months before the economy actually turns up. So far, that hasn't happened. In the meantime, layoffs are continuing around the world. Of course, Uncle Sam is usually the locomotive that pulls the rest of the world back to prosperity, and it may work the same way again this time. Just because things have worked in such-and-such a way in the past doesn't guarantee that they'll continue to work that same way in the future. On the other hand, this time it was going to be different. This time, the baby-boomers were saving for their retirements, and their money flowed automatically into mutual funds each month. Awash in a steady influx of funds, the stock market was going to go up and up and up, inflating stock prices without regard to the usual standards of prudent investing. Besides, productivity was increasing at an upper-single-digit rate, so that one could make a case for such lofty stock valuations. Guess what? In 2000, the music stopped, and showed us once again that the stock market tricks even the experts.
    I don't mean to alarm anyone with this 16-years-of-bad-luck scenario. If it happens, we'll have a good chance to exit the game between now and January, 2005, after recovering at least part of what we had in early 2000. It would still be possible to make money by selling stocks at market highs and buying them back at market lows, although a better strategy might be to invest in short-term interest-bearing instruments, since stocks would have a bumpy ride.
    (For those who have money to invest and who want to put that money in equities, now might be a suitable time to pick up some "fallen angels" off the bargain table. Just as everyone wanted well-run dot.com companies a year ago, now, no one wants them, making it a good time to act contrary to the crowd.)

    Below is a paper that I wrote for my family in 1991, updated in 1997.


HOW TO LOSE MONEY IN THE STOCK MARKET WITHOUT REALLY TRYING

Just kidding!

1997

  I. A STOCK MARKET PRIMER
      Stock Market Indices
      There are several indices which are used to track the performance of the stock market. Among them are the "blue chip" indices which follow the country's largest stocks, and the growth fund indices which monitor smaller-capitalization stocks.
    The best known blue chip indicator is the Dow Jones Index which tracks the sum of the stock prices of the 31 largest companies in the U. S. Figure 1 shows how the Dow Jones index has fluctuated over the past ? years. The Dow Jones Index indicator is a surprisingly good average-stock-price barometer considering the small number of corporations which it encompasses. Another blue chip index, the Standard & Poors (S&P) 500, follows the 500 largest U. S. corporations while the New York Stock Exchange (NYSE) Composite tracks all the stocks on the New York Stock Exchange. In practice, the Dow Jones Index and S&P 500 Index have run fairly close together, and I will be using them more or less interchangeably throughout the rest of this discussion (because I don't always have independent data for each of them).


Figure 1 - 102 Years of Inflation-Corrected DJIA Srock Market Levels


Figure 2 - 125 Years of Inflation-Corrected S&P Stock Market 500 Levels



The smaller-capitalization fund indices such as the NASDAQ composite, the Russell 2000 Index, the Wilshire 4500 Index and the Hambrecht & Quist Technology Index measure the pulses of small-company stocks. As we will see in Section II, these indices and the prices of the stocks which they represent can move quite differently from the prices of the country's blue-chip stocks.
    These indices are not inflation-adjusted. A part of their rise over time is the result of inflation and not of any meaningful rise in corporate stock prices or values. Also, they don't include the effects of dividends, so the total rate of return on stocks is higher than the rising indices would indicate.

    The rest of this discussion (below) was written in 1991, just after the close of the Gulf War.

Price-to-Earnings Ratio  
    The price-to-earnings (P/E) ratio of a company's stock is the ratio of its per-share price to its trailing 12-month earnings per share. The average P/E ratio for all the stocks on the New York Stock Exchange ranges from about 7:1 at a bear market bottom to 22:1 at a bull market high. For example, the average price-to-earnings ratio of the Standard and Poor's (S&P) 500 stocks hit a low of about 7:1 in August of 1982 a few days before the great bull market of the 80's took off. The average P/E ratio of the S&P 500 hit a high of 22:1 in August of 1987 just before the October, 1987, crash. The median (or neutral) value of the S&P 500 average P/E ratio is 14:1.
    When the economy is in recession in the middle of Presidential terms, corporate earnings drop, thereby raising the price-to-earnings ratios of stocks. As a consequence, stock prices also decline, generally in advance of earnings retrenchments. Generally, the stock market anticipates a recovery before there are any glimmers of recovery and rises about six months before the first signs of spring. As a result, P/E ratios increase in the early stages of a recovery and then either fall back as earnings pick up, or stay at their elevated levels as the stock market rises on rising earnings.
    The average S&P P/E ratio right now with the Dow Jones Index at 3000 is about 18:1, but earnings are expected to grow by about 25% over the next year from their current, depressed levels as we emerge from the current recession, which would support an increase in the Dow Jones Index to about 3750 if the P/E ratio stayed at its current value of 18:1.
    Another rule of thumb about stock prices is that a stock's P/E ratio should be about equal to its expected rate of growth, in percent. For example, if the company's earnings and its stock price have been increasing at a rate of 25% a year and can be expected to increase at a rate of 25% during the next few years, than its P/E ratio can be as high as 25:1.

Price to Dividend Ratio
    Most large companies that are no longer growing rapidly give their shareholders a share of their earnings (a dividend). The average dividend rate ranges from about 2.1% of the price of the stock to about 6.7% of its price per share. The price-to-dividend (P/D) ratio is the reciprocal of this dividend rate and ranges from about 16:1 in 1982 to 38:1 in 1987. Right now, the average price-to-dividend ratio of the S&P 500 stocks is 32:1 which is on the high side.
    Generally, anything over 30:1 is considered to mean that stocks are relatively expensive and that the stock market indices are in the "danger zone". However, right now, we are coming out of a recession, which means that dividends will probably increase over the next year, reducing the P/D ratio or permitting a higher stock market valuation.

Price-to-Book-Value
    The book (P/B) value of a stock is estimated liquidation value if the company were "sold for parts". Its price-to-book value is the ratio of the total price of all of its stock divided by its estimated liquidation value. The problem with P/B values is that they are very difficult to estimate. Some assets that are carried on the books as very valuable may be obsolete and wouldn't bring much on the auction block. Other assets such as land may be carried on the books at its purchase price 30 or 50 years ago and may be worth much more than its book value would imply.
    With these caveats in mind, P/B values for the S&P 500 average range from about 1:1 in 1982 to more than 3:1 in 1987. Right now, they are running 2.6:1, which is very pricey. Book value is not apt to change rapidly as we go into and out of recession.

The Four-Year Economic Cycle
    Any perusal of economic history in the United States reveals that the U. S. has a four-year economic cycle in which the economy is prospering and inflation is low during Presidential election years, and the economy is foundering and inflation is elevated at the midpoint of the current President's four-year term. The reason for this is that no one seems to have yet found a way to manipulate the U.S. economy so that efficiency can remain at a peak while growth remains steady. During fat, dumb, and happy times of prosperity, companies loosen up and efficiency gradually declines. Unions demand more money for their members, corporations begin to do the things they "should" do, and the economy overheats. Inflation begins to accelerate as prosperity creates higher levels of demand which breed higher prices, typically during an election year. At this point, the Federal Reserve must step in and raise interest rates. At first, this has no apparent effect upon the economy. Generally, the Federal Reserve must raise the discount rate it charges to banks three times ("two steps and a stumble") before the first hints of a recession appear. Since no Presidential party wants bad news just before election, the country is generally given its bitter medicine just after a Presidential election occurs, although the Federal Reserve often has to raise interest rates and begin cooling the economy just before the election—i.e., during the election year. Usually, though, there's no visible damage or obvious signs that a recession is coming until after the November elections. The first hint is generally a decline in the stock market, which typically anticipates changing economic conditions by 6 to 9 months[1], during the year following a Presidential election year. Then the Federal Reserve continues to tighten the spigot during that post-Presidential-election year, usually with protestations that its going to be different this time—that there will be a soft landing and no recession[2]. The economy begins to slow down. By the second-year between Presidential elections, the economy is at least stagnating, and is usually in a recession. Marginal workers are laid off, unemployment rises, unions temper their demands, and companies look for ways to lower their costs and raise their productivities. Toward the end of this year and in the early part of the third year, the Federal Reserve steps in and, in effect, prints up more money. This increases the money supply and lubricates the wheels of commerce, although with inflationary consequences[3]. Then in the latter part of the third year, the economy begins to recover so that everything looks rosy again the following year (fourth year) for the next election.  
   
Inflation tends to lag whatever the Federal Reserve is doing about it by about two years. This means that during the year after the Presidential election when the Federal Reserve has raised interest rates and tightened up the money supply, inflation continues to rise, peaking about two years after the Fed first begins to tighten up—i.e., in the middle of the recession. Then in the year before the next election, inflation begins to fall, reaching a minimum around the time of the Presidential election, two years after the Fed has squeezed the hardest. In the meantime, the next round of inflation has already been programmed into the system by the Federal Reserve and it is often beginning to fight inflation again even as the general public is rejoicing over prosperity, low unemployment, and low inflation.
    Why do we have inflation? There are arguments that a little inflation, like a little extra fat, is a healthy thing. For example, there could be problems with our trading partners if our interest rates were very low and theirs were high. Investment capital would flow overseas to earn higher rates of return than they could get in the U. S[4] if our interest rates were no longer competitive. Also, inflation is cutting the ratio of the national debt to the gross national product (hopefully, faster than we're running it up). In any case, the Federal Reserve could cut the inflation rate to zero but it would be painful, and with our current level of indebtedness, it could possibly lead to a devastating depression that would further balloon our national debt. For better or for worse, inflation is created and controlled by the federal government. (Two governors of the Federal Reserve Board have recently been quoted in USA Today saying that the Board is aiming for zero inflation. Alan Greenspan has also endorsed zero inflation in his testimony before Congress in 1990. I also saw a remark that the growth of the money supply has been slight recently, which might support the idea of gradually wringing inflation out of the economy. There is a way to estimate future inflation by following the rate of growth of the money supply—the rate at which money is "counterfeited"—using data provided by the St. Louis Federal Reserve Bank. There are plenty of bond traders who know how to use this data to estimate the rate of inflation two years down the road. The fact that long-term interest rates are still high suggests to me that zero inflation isn't in the cards any time soon. However, I don't really know any more than that and I haven't had time to try to find out.)
    A bad recession is like a hard winter which kills off insect larvae and sets the stage for an especially pleasant summer.
    During the Carter years from 1977 to 1980, the Federal Reserve didn't tighten the money supply enough to cause a recession. The result was the runaway double-digit inflation of 1980-1981, which required the harsh 1982 recession to correct.

Indebtedness. 
    The U. S. level of indebtedness, public and private, corporate and individual, is at its highest level in history. Consumer indebtedness has risen from 74% of disposable income in 1976 to 96% of disposable income today. Many families now depend upon two incomes to make payments on their loans. In the meantime, banks have become severely overextended (although they are moving rapidly to try to build their reserves). Any major rise in unemployment could become catastrophic.
    

Super Bull Markets and Super Bear Markets
    There have been three super bull markets in the 20th century. The first of these "super-cycles" began with a deep bear-market low in 1915? Prices hemmed and hawed until 1921 when the first super bull market began, culminating in the stock market crash of 1929 from a high of about 385. There followed a three-year super bear market which bottomed at a low of 40 on the Dow in 1932. From there, the market yoyoed up and down until 1949 when it began the second long super bull market rise that peaked in 1966 at about 1000[5] on the Dow. In 1966, a second super bear market began, with lows in 1970 and 1974 (midpoint-election years). From 1974, the Dow Jones again yoyo-ed up and down in accordance with the four year cycle, peaking in 1976 and 1980, and then a little higher in 1981 at about 1045, only slightly exceeding the high it had established in 1966[6]. Then in 1982, the stock market entered the third super bull market period rise of the 20th century and may now be nearing the end of that phase. The pieces may be falling in place for another super bear market in which excesses are wrung out of the blue chip stock market just as recessions wring excesses out of the economy. I've underscored "blue chip" because what will happen in the blue chip market may not reflect what will happen to small growth stocks. (See "The Two-Tier Market" in Section II for a further discussion of this point.)
    If we accept the rule of thumb that the stock market has yielded a long-term rate of return of about 10% a year of which 4% is returned in the form of dividends, then over the 25 years since the market peaked at 1000 in 1966, the Dow Jones Index should have risen to

1000 X e (25 X .06) = 1000 X e1.5 = 4500

which is not terribly far from where it is now.
    The total return on the S&P 500 stocks for the last 30 years would be about 20:1, and the inflation-adjusted return over that time span would be about 4.5:1. In actual practice, the total return on the S&P 500 stocks over the 31-year period from 1960 to 1991 has been exactly 20:1 and the inflation-adjusted return has been 4.4:1[7].
    Unfortunately, we are not in a period like 1982 when the Dow Jones Index can soar by factors of several. However, we are in a period when small-capitalization growth stocks can roar, and this may in fact happen.

From August of 1982, when the Dow Jones Index bottomed at 776, to April, 1991, when it broke 3000, the Dow Jones Index climbed by a factor of about 3.87. Since the Dow Jones Index reflects the total value of the 31 leading companies in the U. S., this means that the total stock value of its bellwether companies increased by 3.87:1. Part of that increase was due to inflation. The ratio of the 1991 cost-of-living index to the 1981 cost-of-living index is 1.33:1. This means that the inflation-adjusted ratio of those companies' stock prices increased by 2.91:1. Now stocks were very undervalued in August of '82 so the next question is: how much of that inflation-adjusted 2.91:1 increase is due to stocks becoming more fashionable and expensive, and how much is due to a real increase in the total value of the 30 companies? The answer is an eye-opener. The average P/E ratio of the S&P 500 stocks has risen from about 7:1 in 1982 to about 18:1 in 1991—an increase of about 18/7 or about 2.57:1.In 1982, the average P/B ratio of stocks (the total stock value versus the liquidation value of the company) was about 1:1 and there were a lot of bargains out there. Today, the P/B ratio is 2.6:1. In 1982, the average P/D ratio was 16:1; today, it's 32:1, which implies an inflation-adjusted price inflation of 2:1. The bottom line is that the bulk of the increase in the value of S&P 500 stocks is a result of inflation and the bidding-up of stock prices. These indicators are near the all-time upper ends of their historic ranges (22:1 for P/E ratios, 3:1 for price-to-book ratios, and 38:1 for price-to-dividend ratios). As mentioned above, in August, 1987, just before the October crash, the average S&P 500 P/E ratio reached 22:1, the P/D ratio stood at 38:1, and the P/B ratio attained a value above 3:1.
    These calculations don't include the dividends which were paid from 1982 to the present. I'm going to guess that they averaged about 4% a year, which would represent an increase in real value of about 1.4. If you multiply 1.4 by 3.87, the total return on the Dow stocks from August of '82 to April of '91 is about 5.5:1. The upshot of all this is that the Dow stocks, and to a slightly lesser degree, the S&P 500 stocks now, in April, 1991, are no longer a bargain but are near the upper ends of their historical prices ranges in terms of their traditional value indices, and the acceptable rates of dividend yield which cause institutions to invest in stocks instead of bonds or real estate.
    Given that this is so, why isn't the stock market lower than it is?
    My guess is that current stock prices anticipate the fact that, as we come out of this 1990 recession, price/earnings ratios, and to a lesser extent, price/dividend ratios will improve. Also, the economy may be perceived to be on better ground than it was in the inflationary days of the 70's. Another factor could be that the Dow Jones and S&P 500 stocks have been popular with foreign investors (particularly the Japanese, who don't feel comfortable with small U. S. companies); maybe this maintains their price inflation. Still another contributor could be the fact that commercial real estate has been overbuilt and doesn't look like a good, conservative investment area right now. Add to that the fact that money market yields are getting low (since Alan Greenspan has lowered interest rates to bring us out of this 1990 recession), and the stock market has become the only game in town. The scenario I'm expecting is one in which stock prices will rise during the summer rally, fall this fall, and rise again next summer (1992) in time for Mr. Bush presidential re-election. Price/earnings ratios will improve markedly, price/dividend ratios will improve somewhat, and the stage will be set for a stock market advance into highly dangerous territory. But since the blue chip stocks are overpriced and every professional money manager knows it, next year's blue chip market may be a very nervous one. It may be like "The Masque of the Red Death". The institutional money managers will know that disaster is on its way but no one will know quite when it will arrive, and many people won't want to miss any part of the party until it's too late.

II. FUTURE PROSPECTS
    The Two-Tier Market
    So far, this discussion has been confined to the Dow Jones and the S&P 500 indices. However, the situation with these blue chip indices is quite different from that of small-company growth-stock indices. Small company growth stocks soared from the super-bear-market low in late 1974 to the market peak in June, 1983, rising by a factor of about 6:1, from a NASDAQ composite value of about 55 and an average P/E ratio of about ?:1[8] in 1974 to a NASDAQ level of about 315 and an average P/E ratio of about ?:1 in June of '83. This would represent a price rise of about 21% per year, not including dividends (which tend to be relatively small). Then the NASDAQ average deflated somewhat to a current P/E ratio of about 23:1[9] while the S&P 500 average was inflating by a factor of 2.4:1. While 23:1 is pretty high, earnings may be expected to rise rapidly as the economy recovers from its current recession. If small stocks perform as they have in the past, one forecast calls for small-company stocks to outperform large-company stocks by 2:1 over the next 5 years[10]. It's interesting to contemplate what this might mean. As we have seen, blue chip stocks have an underlying total rate of return of about 11% per year over the last 9 years, and in the current, low-inflation climate, might be expected to yield that kind of total return over the next five years. Subtracting 3% a year for dividends, this would yield a middle-of-the-road Dow Jones value of about 4500 in 1996. If the NASDAQ composite value rose by 100% during that 5-year period, small stocks would deliver about 16% a year over the period, after the inclusion of dividends. A more-likely scenario seems to me to be a 20% per year rate of return over the period, which would boost growth mutual funds by 2.7:1 or better (not all that dramatic compared to prior 5-year periods).

One reference cites the small-stock-versus-big-stock rates of return shown in Tables I and II.
         
PERIOD

SMALL STOCK

RETURN[11]

$1,000 BECAME

S&P 500

GAIN

INFLATION
CUMULATIVE
1976-1985

27.8%

$11,620

14.3%

7.0%

$1.96

1966-1985

15.3%

$17,240

8.7%

6.4%

$3.43

1956-1985

15.3%

$71,590

9.5%

4.8%

$4.07

1946-1985

14.3%

$209,820

11.2%

4.6%

$6.00

1936-1985

15.2%

$1,182,020

10.7%

4.2%

$7.90

1926-1985

12.6%

$1,236,810

9.8%

3.1%

$6.09


         
PERIOD

SMALL STOCK

10-YEAR GAIN

CUMULATIVE

10-YEAR GAIN

S&P 500

GAIN
INFLATION

CUMULATIVE

INFLATION
1976-1985

27.8%

11.62

14.3%

7.0%

$1.96

1966-1975

4.0%

1.48

3.3%

5.8%

$1.75

1956-1965

15.3%

4.15

11.1%

1.8%

$1.19

1946-1955

11.4%

2.93

16.5%

4.0%

$1.47

1936-1945

15.2%

5.63

8.7%

2.8%

$1.32

1926-1935

0.5%

1.05

5.4%

-2.5%

$0.77


         
PERIOD

SMALL STOCK

10-YEAR TOTAL GAIN[12]

CUMULATIVE

10-YEAR GAIN

S&P 500

TOTAL GAIN[13]
INFLATION

CUMULATIVE

INFLATION,

BY DECADE
1976-1985

20.8%

5.93

7.3%

7.0%

$1.96

1966-1975

-1.8%

0.86

-2.5%

5.8%

$1.75

1956-1965

13.5%

3.49

9.3%

1.8%

$1.19

1946-1955

7.4%

1.99

12.5%

4.0%

$1.47

1936-1945

12.4%

4.28

5.9%

2.8%

$1.32

1926-1935

3.0%

1.36

7.9%

-2.5%

$0.77

During the period from 1975 to 1983, a number of mutual funds outperformed the Dow Jones Index by factors of 10:1 to 14:1, and in the case of the Magellan Fund, by 20:1, corresponding to an average growth rate of 27% (10:1) to 31% (14:1), and 35% per year for the Magellan Fund over the 8.5-year period. However, since that time, they have been lucky to keep pace with the Dow Jones Index and the S&P 500. I have wondered whether this reflects the inflation of small company stock prices from 1974 to 1983[14], followed by their deflation from 1983 to 1991, or whether it means that the increasing sophistication and "computerization" of institutional investors has generated a more-level playing field for mutual fund managers[15]. This question becomes quite important now, with the blue chip stocks overpriced and the possibility of a decade of deflation in blue chip stock prices looming large. Would deflating blue chip prices drag down growth mutual fund performance with it?
    One ray of hope is that small company stocks, despite their recent run-up, are near the bottoms of their historic prices ranges, at or below their levels in 1974. The current 7-year down-cycle of small-stock prices was the second worst since an 11-year streak of bad luck from 1946 to 1957.) Since growth stocks are significantly under-priced, I should think that what happens to the blue chips shouldn't bear very heavily on growth mutual fund performance. Even if growth-fund P/E ratios don't expand, growth stock prices should rise faster than they have over the past eight years because they've now pretty well bottomed out to their "growth trend line", which is faster-rising than that of large companies. (It may be that mutual growth funds have done well to match the performance of the S&P 500 during a time when the universe of growth stocks has been deflating in value even as the blue chip stock indices were becoming inflated—see Footnote 7. If so, the mediocre performance of growth funds may have been setting the stage for a flip-flop in market fashion, and an upcoming surge in growth-stock returns vis-à-vis blue-chip stock performance.) Even though the NASDAQ composite outperformed the Dow by rising 50% from September, 1990 to the present time, it is still significantly undervalued and theoretically ought to have the potential for another many-to-one market rise between now and the year 2000. A reasonable guess for its performance might be a 15% total annual return over the next 8.5 years, leading to a cumulative return of 3.5:1 over this 8.5-year time frame. (This assumes a small expansion of P/E ratios by 10% to 20% over the 8.5-year time frame and 2%/year average dividend yields.) In the same vein, a reasonable forecast for gains by the best aggressive-growth mutual funds over this period might be a total return of 20%/year or about 5.5:1. Of course, identifying the best aggressive-growth mutual funds over an 8.5-year period may not ba trivial task[16].
    Another possibility is the international market, which is depressed right now and may offer good bargains, although currency exchange rates constitute a wild card when contemplating foreign stock transactions.
    A third possibility is to try some individual stock purchases and managing our own portfolios. There have been, and probably are now, investment clubs in Huntsville which help individual investors manage individual portfolios. Of course, it takes time and homework. Someone could even try it without investing actual money. Among the fast-growing companies in town which may or may not be open to private investment are "Steak-Out" and "Adtran".
    One of the questions is that of what to do right now. At the present time, institutional cash is at a twelve-year low. Institutions may be able to raise some additional cash by selling bonds or blue-chip stocks, and individual investors could pump money into the stock market, but otherwise, the money isn't out there right now to fuel a major stock market advance. Chances of a correction this fall are good. On the other hand, everybody is expecting a correction, and that reduces the chance that there will be one. It's probably advisable to get on board the small-company bandwagon soon. Since I can see the advisability of this, institutional investors can surely see the wisdom of it, too, which is probably why the NASDAQ composite keeps working its way up while the Dow remains in a trading range.

Footnotes:


[1] - It's important to mention that the stock market isn't an infallible predictor of recession. Some wiseacre has observed that "the stock market predicted 9 of the first 4 postwar recessions".
[2] - Alan Greenspan made claims about a "soft landing" for the economy last summer. However, he may have spoken in good faith. The recession hasn't been very deep, and the Gulf War certainly had an adverse effect upon last fall's economy. However, the best guess is that we were already in a recession before Iraq invaded Kuwait, so a soft landing probably wasn't in the cards even if there hadn't been any Gulf War.
[3] - The reason that printing up more money is inflationary is because you then have more money chasing a given amount of goods and services. This causes an increase in demand, allowing prices to be bid up. (Bear in mind that commodity prices, land, and many other basic prices are determined by auction, not to mention the various "sales" on retail merchandise.) Another way to say it is that the ratio of available money to available goods and services rises, which is equivalent to saying that prices go up when the money supply goes up. Conversely, lowering the money supply is deflationary, but it can bring the economy to its knees.
[4] - As it stands, we are the beneficiaries of such a situation with respect to the Japanese. Interest rates are very low in Japan, so Japanese investors are buying U. S. Treasury Bonds to lock in their 9% yields, thus helping to finance the interest on our national debt.
[5] - This was another one of those times when P/E ratios reached 22:1 and P/D ratios hit 38:1
[6] - On an inflation-adjusted basis, the stock market dropped in value by a factor of, perhaps, 2:1 over that 16-year period.
[7] - Lavery, Jack W., "Re-equitizqtion—Rebuilding the Real Economy: a Theme for the 1990s", Merrill Lynch, Pierce, Fenner, and Smith, Inc., Special Report, Spring, 1990.
[8] - So far, I have been unable to find data concerning P/E ratio "turning points" for small stocks.
[9] - The NASDAQ Composite Index rose by a factor of 1.6:1 from June, 1983, to June, 1991 (5%/year), or by a factor of about 10:1 over the entire interval. However, by September of 1990, when it again hit a value of 315, it was lower in terms of its average price/earnings ratio than it had been in 1974.
[10] - USA Today, 8/28/91, pg. 1B.
[11] - Average 60-year gain: 14.4%/year
[12] - 9.2% average inflation-adjusted total return.
[13] - 6.73% average annual inflation-adjusted total return
[14] - Small company stock prices were beaten down in 1974 to an average P/E ratio of about 20:1. By 1983, P/E ratios of 40:1 were common for such stocks. A doubling of P/E ratios in 8.5 years represents an 8.1% growth rate. Coupling this with the fact that small companies have higher growth rates than blue chip companies, the average growth stock price would have to have advanced by 19% to 23% to accommodate the aforementioned 27% to 31% growth of mutual fund values. Conversely, if they continued to rise in value at this 19%-to-23% rate while their average P/E ratio shrank from 40:1 in June of 1983 to about 18:1 in June of 1991(about 10%/year), the NASDAQ average would only have risen by about 9% to 13% a year over this period—a factor of 2:1 to 2.8:1—while the Dow rose by a factor of about 2.4:1. In practice, the NASDAQ composite rose only 17% from June of 1983 to September, 1990, and then rose 50% further from 9/90 to April 30, 1991.. a factor of about 1.7:1. Consequently, the small-company mutual funds seem to have outperformed the NASDAQ composite by a considerable margin.
[15] - I bought Peter Lynch' book "One Up on Wall Street" when we were in Birmingham. He says that good fund management can make as much difference as it ever did. Also, Growth Fund Guide refers to this decline in mutual fund performance and indicates that, if small growth stocks become fashionable again, the growth-fund mutual funds will again grossly outperform the major blue chip market indices.
[16] - Why 8.5 years? Because that carries us through the Presidential elections in 1992, 1996 and 2000. Of course, the party could be over in 1992 or in 1996 if growth stocks become overheated at either of those points.