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,
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. 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. 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 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 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. 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.
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 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 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. 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 |
$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 |
CUMULATIVE
10-YEAR GAIN |
S&P 500
TOTAL GAIN |
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, 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. 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.
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:
