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5 "Tells" that the Stock Markets Are About to Reverse

Dow Jones Stocks Index Hits Price to Earnings Fair Value

Stock-Markets / Stock Market Valuations Jul 18, 2008 - 11:57 AM GMT

By: Zeal_LLC


Best Financial Markets Analysis ArticleIn 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.

For a rough road map of how the Dow 30 is likely to trade sideways and how its valuations are likely to evolve between now and 2016, we can consider the last LVW trough approach in the 1970s. The second half of that decade saw the same LVW section roll though that we face today. This next chart shows, very clearly, that secular bears do not conveniently end at fair value. They linger on until 7x is seen.

Although this is a chart of the S&P 500, conceptually it is the same for the Dow 30. In fact, over 6 years ago when I first did this long-trading-range analysis I used the Dow 30. All 30 of the elite blue-chip Dow components are also in the S&P 500 (SPX). And these Dow components dominate it too, representing 32% of the entire SPX's market capitalization but just 6% of its components!

While these are SPX P/E ratios in this chart, they approximate the Dow 30's pretty well. Since the Dow has much higher quality components on average than the SPX, the Dow's P/E is usually a bit lower. For example, at the end of June when the Dow's P/E hit 14.0x, the SPX's was running at 18.1x. Nevertheless, the general P/E progression lower during secular bears certainly still applies to both indexes.

As you can see here in the SPX, the US stock markets continued drifting sideways on balance throughout the rest of the last secular bear for over 8 years after fair value was reached! 14x in 1974 wasn't the end, under 7x in 1982 was. While there were big cyclical bulls and bears within this period of time, when all was said and done the markets were dead flat. This gave earnings time to catch up with stock prices and the entire 34-year LVW cycle time to fully run its course.

Since the LVWs slowly oscillate from undervalued levels to overvalued levels and back again, merely hitting fair value isn't the end. It is only the halfway point in secular bears. This is crucial for investors to know because Wall Street is increasingly claiming that stocks are the cheapest today that they've been in decades. While true, this is very misleading and is going to hurt a lot of naïve investors.

14x earnings is definitely cheap compared to the Dow's 45x in early 2000. But it is still very expensive compared to the 7x seen at the ends of secular bears manifesting in the second half of LVWs. Investors who watch their elite blue-chip stocks drift sideways on balance for 8 more years, taking real losses after inflation, will be devastated. Their portfolios will only be worth a modest fraction of what they could have been if they had understood the LVWs .

So what's a besieged stock investor to do? Sitting in cash or bonds certainly isn't the answer. With the Fed doing everything in its power to destroy the US dollar , inflation is only going to accelerate. And with interest rates still not too far above half-century lows, longer-term bonds are going to take a beating as long rates inevitably rise. Odds are the coming 8 years won't be kind to cash or longer bonds either.

8 years ago I faced this same quandary regarding my own investment capital. I wanted to invest and speculate through the coming secular stock bear. So I studied market history and looked for sectors that performed well in such an environment. The most promising one by far was commodities and the companies that bring them to market. Commodities tend to thrive during secular stock bears, as I wrote way back in April 2001 .

Just as these secular stock bears tend to run for 17 years, so do the concurrent secular commodities bulls. While Wall Street loves to call today's great commodities bull over the moment commodities start pulling back, the probabilities are very high that commodities will continue rallying on balance for another 8 years or so. And elite commodities stocks, with their high profits leverage to commodities prices, should see phenomenal gains.

Although there are times within secular bears when most large commodities stocks get sucked down with general stocks, particularly during the vicious cyclical bears like we're in today, most of the time they thrive. Investors can not only weather the general stock bear, but earn fortunes to boot, by prudently deploying capital in elite commodities stocks.

And interestingly, it is actually the stock-market LVWs that really help drive these concurrent but inverse cycles in the commodities markets. During great bull markets in stocks, stocks become so sexy that virtually all investment capital gravitates toward stock markets. This starves other realms of much-needed investment. For example back in the late 1990s, everyone wanted to buy junk tech stocks but no one would touch oil producers.

So by the end of the great bull in stocks, the first half of the LVW, commodities infrastructure has been starved of capital investment for at least a decade. Global capacity for producing raw materials is rusting away and not keeping pace with growing global demand. Raw materials just can't compete for investors' attention when the general stock markets are hot, leaving inadequate capital investment to handle world demand growth.

By the time the great bear in stocks arrives, the second half of the LVW, commodities prices are gradually starting to rise simply because long-neglected supplies are inadequate. Then contrarian investors, looking for alternatives to thrive through a general-stock bear, start investing in this beaten-down sector. Commodities stocks are driven higher and even commodities themselves eventually become investment destinations.

So the great valuation cycles in the stock markets, by virtue of so powerfully shaping global investment capital flows, heavily influence commodities too. Commodities infrastructure is neglected and left to rust when stocks are sexy. But when stocks start drifting sideways for 17 years, commodities regain favor as an alternative investment and capacity is rebuilt. Everything in the capital markets is interrelated.

At Zeal, we started investing and speculating in commodities and commodities stocks back in 2000 when they were universally loathed. We've been blessed with tremendous returns over the years since. We relentlessly study the stock markets, the commodities markets, and individual stocks in order to know when probabilities favor deploying capital. And when they do, we pull the trigger and add investments and/or speculations.

We are going to continue this approach we've used so successfully over the last 8 years of this secular bear to thrive in the next 8 years. If you want to get world-famous cutting-edge analysis on the stock markets and commodities, along with real-world trading recommendations based off of it, subscribe today to our acclaimed monthly newsletter . In our current July letter I discussed neat new bear-market trading strategies in short-oriented stock ETFs.

The bottom line is even though the Dow 30 just hit fair value, the secular bear is not over. Wall Street will tell you stocks are the cheapest they've been in decades, which is true. Nevertheless, valuations still remain twice as high as they ultimately travel at the ends of secular bears. Odds are the stock markets will continue drifting sideways on balance for the next 8 years or so until the Dow 30 actually retreats to 7x earnings .

This is certainly depressing if you are a long-term investor. Watching the markets trade sideways, and taking real losses due to inflation, is no fun at all. Thankfully a secular commodities bull is running concurrently with the secular stock bear. So opportunities to profit abound, both on the long-term investment side and short-term speculation side. There's no need to totally sit out a secular stock bear.

By Adam Hamilton, CPA

So how can you profit from this information? We publish an acclaimed monthly newsletter, Zeal Intelligence , that details exactly what we are doing in terms of actual stock and options trading based on all the lessons we have learned in our market research. Please consider joining us each month for tactical trading details and more in our premium Zeal Intelligence service at …

Questions for Adam? I would be more than happy to address them through my private consulting business. Please visit for more information.

Thoughts, comments, or flames? Fire away at . Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

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