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This quite long (http://www.compareshares.com.au/zeal52.php) but it does pose a method of analysis that I was not familiar with, ie Long Valuation Waves.
US markets
The worst is yet to come
July 21, 2008
Adam Hamilton, Zeal Research
In recent weeks a major secular milestone was achieved in the US stock markets. But because of all the distracting market turbulence, very few investors are even aware it happened. And truth be told, even if the markets weren’t plunging I still suspect only the most diligent students of the markets would have any inkling.
The venerable Dow Jones Industrial Average, or Dow 30, finally returned to fair value as measured by its price-to-earnings ratio. This is major secular milestone because it marks the halfway point in the 17-year secular bear in which the Dow 30, and the broader US stock markets, have been mired since early 2000. Understanding the implications of this milestone is exceedingly important for all stock investors.
Some background is in order. Throughout history, the stock markets oscillate in great cycles running a third of a century each. These cycles are defined by prevailing valuations, the P/E ratios of the broader US stock markets. The stock markets go from undervalued, to overvalued, and back again over a 34-year span. I call these Long Valuation Waves and you can read all about them in another essay.
The first half of any LVW is a 17-year great bull market, like we saw from 1982 to 2000. Valuations go from deeply undervalued levels at its start to extremely overvalued levels at its apex. Once the great bull peaks, though, the 17-year great bear emerges for the second half of the LVW. Valuations are gradually whittled away from extremely overvalued levels to deeply undervalued levels. And then like a phoenix this cycle begins anew.
Now today, since the US stock markets have essentially drifted sideways for 8 years, a decent fraction of contrarian investors are aware of valuation-wave theory. But back in the early 2000s, it was long-forgotten by nearly all. To establish my bona fides in this line of research, I wrote my initial essays on this in December 2001, March 2002, and October 2002 back when thinking this way was heretical and ridiculed.
Within the second half of an LVW that witnesses a 17-year great bear, the defining characteristic is contracting valuations. The first half of this 17-year period is a mean reversion of index P/E ratios. Valuations go from extremely overvalued levels back down to fair value, reverting to their centuries-old average. With the Dow 30 hitting fair value, this mean-reversion stage of the secular bear is now complete.
This chart, updated from my October 2002 original one, shows this process visually. It looks complicated, but it is straightforward. The pair of blue lines is the index P/E ratio for the Dow 30. At Zeal we compute these critical numbers, along with the S&P 500’s and NASDAQ 100’s P/Es, once a month and publish them in our monthly newsletter. Watching index valuations is incredibly important for all long-term investors.
The light blue line is the Dow 30’s simple average P/E ratio. Individual P/E ratios for all 30 component companies are gathered and then averaged. But this measure can be skewed by a relatively small component experiencing a wild valuation anomaly driven by some non-recurring one-time earnings event. Thus I prefer weighting the individual component P/E ratios by each component’s market capitalization.
The dark blue line is the market-capitalization-weighted-average (MCWA) P/E. The bigger any component company, the more weight its P/E ratio is given. This measure is much harder to skew since earnings anomalies are much less common in the largest components compared to the smallest ones. For the rest of this essay, whenever I discuss P/E ratios they will be MCWA trailing (past 12 months, not estimated future) earnings.
The red line is the headline Dow 30 itself that you watch every day. The white line is where the Dow 30 would hypothetically be if it traded at fair value, or 14x (pronounced “fourteen times”) earnings. I’ll discuss this fair-value concept in more depth below. Finally the yellow line is the Dow 30’s dividend yield. Slaved to the right axis, 3000 means 3%. Dividend yields are an important secondary measure of stock-market valuations.
Back in early 2000, the Dow 30 traded deep into bubble territory at a stupendously rich 45x earnings! But since then valuations have been gradually contracting, as they always do in secular bears, while the index itself has largely remained flat. By grinding sideways, the markets effectively grant time for corporate earnings to catch up with prevailing stock prices. This drives the valuation mean reversion.
As valuations contracted over the past 8 years, the fair-value Dow rose. Since the index’s P/E ratio finally hit 14x fair value at the end of June, the fair-value Dow has converged with the actual Dow. Back in 2000, bulls foolishly believed that P/E ratios could stay high forever because we had to be in “A New Era”. But this chart shows how silly it was to believe the bubble hype then and ignore stock-market history. Mania valuations never last.
This fair-value concept is very important to understand. Why 14x earnings? Over centuries, across many stock markets in many great nations, 14x earnings has simply been the long-term average valuation for common stocks. Sometimes valuations are higher, sometimes lower, but they always oscillate around a secular mathematical average of 14x. While long-established historical validity is enough proof, this number is quite logical too.
Stock markets exist solely to facilitate capital transfers between those with surplus capital (savers, investors) and those who need capital (debtors in a loose sense, companies). In order to transfer this capital, both sides of the deal need a fair and mutually-beneficial exchange. If capital is too cheap, investors won’t offer it up for investment. If it is too expensive, companies won’t want to “borrow” it. 14x is just right for both parties.
Interestingly the inverse of 14x earnings is a 7.1% yield. If an investor buys stock at a 14x P/E, it will take the company 14 years to fully earn back the price he paid. Without compounding, this translates to 7% or so. 7% is both a fair rate of return for investors’ hard-earned capital and a fair price to pay by companies who need this capital. All over the world for at least hundreds of years, capital has flowed freely at 14x and 7%.
Stock markets oscillate around this 14x fair-value level because this is where the markets clear, all investors with surplus capital have the opportunity to invest it and all companies that want surplus capital have the opportunity to procure it. So this fair-value concept for stocks is not only historically verifiable, but it is eminently logical too. After 8 long years of mean reverting, it is exciting to see the Dow fairly valued again.
This 14x fair-value point is also the anchor from which undervaluation and overvaluation are objectively measured. At half fair value, 7x earnings, stocks are very cheap historically. As soon as you see 7x earnings in the major stock indexes, it is time to throw every dollar you’ve got at the deeply undervalued stock markets. Such levels are only seen at the end of 17-year secular bears, like 1982.
Conversely double fair value, 28x, is classical bubble levels. Once the major stock indexes trade above 28x earnings, it is time to think about exiting investments and preparing for the end of the 17-year secular bull. If you look at a Long Valuation Wave chart over the last century or so, the importance of 7x, 14x, and 28x index P/E ratios is readily apparent. Stock-market history is crystal clear regarding valuation ranges.
The implications of the Dow once again hitting 14x earnings today, for the first time since the late 1980s, are profound. Seeing fair value again validates the thesis that we are in a secular bear, where stocks at best trade sideways for 17 years! Since 17 years is such a huge chunk of any investor’s investing lifespan, it is absolutely devastating for wealth creation to be trapped unaware within one of these secular bears.
And if you add 17 years to the top of the last LVW in early 2000, you get out to 2016 or so for the projected end of this bear. We are only halfway through temporally and even more importantly in valuation terms. Bear markets don’t end at fair value, they continue their relentless valuation-mauling work until the general stock markets hit 7x earnings. Odds are very high that the Dow will still be trading near today’s levels in 2016 but with valuations cut in half again from today!
Going from the bubble top to 14x is the mean reversion, which is now complete for the Dow 30. But just as the crests of LVWs witness extreme overvaluations, their troughs see extreme undervaluations. The second half of the great bear ushers in the dreaded LVW trough, where investors’ morale is crushed and an entire generation completely gives up on stock investing. Sadly the worst is yet to come.
US markets
The worst is yet to come
July 21, 2008
Adam Hamilton, Zeal Research
In recent weeks a major secular milestone was achieved in the US stock markets. But because of all the distracting market turbulence, very few investors are even aware it happened. And truth be told, even if the markets weren’t plunging I still suspect only the most diligent students of the markets would have any inkling.
The venerable Dow Jones Industrial Average, or Dow 30, finally returned to fair value as measured by its price-to-earnings ratio. This is major secular milestone because it marks the halfway point in the 17-year secular bear in which the Dow 30, and the broader US stock markets, have been mired since early 2000. Understanding the implications of this milestone is exceedingly important for all stock investors.
Some background is in order. Throughout history, the stock markets oscillate in great cycles running a third of a century each. These cycles are defined by prevailing valuations, the P/E ratios of the broader US stock markets. The stock markets go from undervalued, to overvalued, and back again over a 34-year span. I call these Long Valuation Waves and you can read all about them in another essay.
The first half of any LVW is a 17-year great bull market, like we saw from 1982 to 2000. Valuations go from deeply undervalued levels at its start to extremely overvalued levels at its apex. Once the great bull peaks, though, the 17-year great bear emerges for the second half of the LVW. Valuations are gradually whittled away from extremely overvalued levels to deeply undervalued levels. And then like a phoenix this cycle begins anew.
Now today, since the US stock markets have essentially drifted sideways for 8 years, a decent fraction of contrarian investors are aware of valuation-wave theory. But back in the early 2000s, it was long-forgotten by nearly all. To establish my bona fides in this line of research, I wrote my initial essays on this in December 2001, March 2002, and October 2002 back when thinking this way was heretical and ridiculed.
Within the second half of an LVW that witnesses a 17-year great bear, the defining characteristic is contracting valuations. The first half of this 17-year period is a mean reversion of index P/E ratios. Valuations go from extremely overvalued levels back down to fair value, reverting to their centuries-old average. With the Dow 30 hitting fair value, this mean-reversion stage of the secular bear is now complete.
This chart, updated from my October 2002 original one, shows this process visually. It looks complicated, but it is straightforward. The pair of blue lines is the index P/E ratio for the Dow 30. At Zeal we compute these critical numbers, along with the S&P 500’s and NASDAQ 100’s P/Es, once a month and publish them in our monthly newsletter. Watching index valuations is incredibly important for all long-term investors.
The light blue line is the Dow 30’s simple average P/E ratio. Individual P/E ratios for all 30 component companies are gathered and then averaged. But this measure can be skewed by a relatively small component experiencing a wild valuation anomaly driven by some non-recurring one-time earnings event. Thus I prefer weighting the individual component P/E ratios by each component’s market capitalization.
The dark blue line is the market-capitalization-weighted-average (MCWA) P/E. The bigger any component company, the more weight its P/E ratio is given. This measure is much harder to skew since earnings anomalies are much less common in the largest components compared to the smallest ones. For the rest of this essay, whenever I discuss P/E ratios they will be MCWA trailing (past 12 months, not estimated future) earnings.
The red line is the headline Dow 30 itself that you watch every day. The white line is where the Dow 30 would hypothetically be if it traded at fair value, or 14x (pronounced “fourteen times”) earnings. I’ll discuss this fair-value concept in more depth below. Finally the yellow line is the Dow 30’s dividend yield. Slaved to the right axis, 3000 means 3%. Dividend yields are an important secondary measure of stock-market valuations.
Back in early 2000, the Dow 30 traded deep into bubble territory at a stupendously rich 45x earnings! But since then valuations have been gradually contracting, as they always do in secular bears, while the index itself has largely remained flat. By grinding sideways, the markets effectively grant time for corporate earnings to catch up with prevailing stock prices. This drives the valuation mean reversion.
As valuations contracted over the past 8 years, the fair-value Dow rose. Since the index’s P/E ratio finally hit 14x fair value at the end of June, the fair-value Dow has converged with the actual Dow. Back in 2000, bulls foolishly believed that P/E ratios could stay high forever because we had to be in “A New Era”. But this chart shows how silly it was to believe the bubble hype then and ignore stock-market history. Mania valuations never last.
This fair-value concept is very important to understand. Why 14x earnings? Over centuries, across many stock markets in many great nations, 14x earnings has simply been the long-term average valuation for common stocks. Sometimes valuations are higher, sometimes lower, but they always oscillate around a secular mathematical average of 14x. While long-established historical validity is enough proof, this number is quite logical too.
Stock markets exist solely to facilitate capital transfers between those with surplus capital (savers, investors) and those who need capital (debtors in a loose sense, companies). In order to transfer this capital, both sides of the deal need a fair and mutually-beneficial exchange. If capital is too cheap, investors won’t offer it up for investment. If it is too expensive, companies won’t want to “borrow” it. 14x is just right for both parties.
Interestingly the inverse of 14x earnings is a 7.1% yield. If an investor buys stock at a 14x P/E, it will take the company 14 years to fully earn back the price he paid. Without compounding, this translates to 7% or so. 7% is both a fair rate of return for investors’ hard-earned capital and a fair price to pay by companies who need this capital. All over the world for at least hundreds of years, capital has flowed freely at 14x and 7%.
Stock markets oscillate around this 14x fair-value level because this is where the markets clear, all investors with surplus capital have the opportunity to invest it and all companies that want surplus capital have the opportunity to procure it. So this fair-value concept for stocks is not only historically verifiable, but it is eminently logical too. After 8 long years of mean reverting, it is exciting to see the Dow fairly valued again.
This 14x fair-value point is also the anchor from which undervaluation and overvaluation are objectively measured. At half fair value, 7x earnings, stocks are very cheap historically. As soon as you see 7x earnings in the major stock indexes, it is time to throw every dollar you’ve got at the deeply undervalued stock markets. Such levels are only seen at the end of 17-year secular bears, like 1982.
Conversely double fair value, 28x, is classical bubble levels. Once the major stock indexes trade above 28x earnings, it is time to think about exiting investments and preparing for the end of the 17-year secular bull. If you look at a Long Valuation Wave chart over the last century or so, the importance of 7x, 14x, and 28x index P/E ratios is readily apparent. Stock-market history is crystal clear regarding valuation ranges.
The implications of the Dow once again hitting 14x earnings today, for the first time since the late 1980s, are profound. Seeing fair value again validates the thesis that we are in a secular bear, where stocks at best trade sideways for 17 years! Since 17 years is such a huge chunk of any investor’s investing lifespan, it is absolutely devastating for wealth creation to be trapped unaware within one of these secular bears.
And if you add 17 years to the top of the last LVW in early 2000, you get out to 2016 or so for the projected end of this bear. We are only halfway through temporally and even more importantly in valuation terms. Bear markets don’t end at fair value, they continue their relentless valuation-mauling work until the general stock markets hit 7x earnings. Odds are very high that the Dow will still be trading near today’s levels in 2016 but with valuations cut in half again from today!
Going from the bubble top to 14x is the mean reversion, which is now complete for the Dow 30. But just as the crests of LVWs witness extreme overvaluations, their troughs see extreme undervaluations. The second half of the great bear ushers in the dreaded LVW trough, where investors’ morale is crushed and an entire generation completely gives up on stock investing. Sadly the worst is yet to come.
