On a Return to Normalcy: Dow 8,500 18 comments
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It might not feel like it, but yesterday marked the Dow’s return to normal.
Normal valuations that is.
A little under two years ago (December 2006), I wrote a series of posts on normalized P/E ratios. In my most important post in that series, “In Defense of Extraordinary Claims”, I argued that future returns would not match historical returns, because normalized valuations from 1996 to the present were too high:
Stocks are not inherently attractive; they have often been attractive, because they have often been cheap.
That statement neatly sums up my argument. Buying stocks blindly worked during most of the 20th century because stocks were cheap during most of the 20th century.
That all changed in 1996. In every year from 1996 through 2007, the Dow was more expensive relative to its normalized earnings than it had been in any year from 1935 through 1995. The closest comparison was 1965. But every year: ’96, ’97, ’98, ’99, 2000, 2001, 2002, 2003, 2004, 2005, 2006, and 2007 was more expensive than ’65.
As a result, historical return data from the 20th century was an inappropriate guide for expected returns on an initial investment made at any point from 1996 – 2007.
We were in unchartered territory.
Not any more.
Yesterday, the Dow dropped below 8,750. That number is the point at which the Dow would be trading at the average 15-year normalized P/E ratio for 1935-2005. In those seven decades the Dow posted a compound annual point gain of 6.6%. Back it up ten years to 1995, the last year before the paradigm shift I wrote about and you still get annual point growth of 6.2%.
So at yesterday’s close of 8,579 the Dow is priced to grow at a quite historical six to six and a half percent a year.
That may not sound like much to those weaned on the 1982 – 1999 bull market. However, it’s a lot better than the “new paradigm” market that began in 1996. Since we broke into unchartered territory twelve years ago, we’ve done something like 3.4% in point terms.
And over the last ten years: zilch.
Here’s what I wrote about the possibility that the post 1995 (i.e., permanently higher normalized P/E) environment could be maintained:
Is it possible that the surge in normalized P/E ratios beginning in 1995 was simply the culmination of a crisis within the investment discipline? Maybe normalized P/E ratios have reached "a permanently high plateau" now that a new paradigm has taken hold.
I won't dismiss this argument entirely. There is some logic to it. After all, stocks have been an unbelievable bargain for most of the 20th century. Why should that continue to be the case? Eventually, won't enough investors wise up to this fact and cause the so-called "equity-risk premium" to disappear.
If the normalized P/E ratio remains extremely high, there will be no need for stock prices to fall. Of course, these higher valuations must necessarily cause future returns to fall short of historical returns. But, there's no logical reason why normalized P/E ratios must revert to the mean – future returns can be adjusted down, allowing current prices to remain high.
That's true. In fact, the Dow could theoretically trade around a normalized P/E ratio as high as 40-50 without making stocks so unattractive as to completely eliminate them as a possible long-term investment (all of this assumes the equity-risk premium can disappear).
At around 50 times normalized earnings, the math gets terribly unforgiving. As a result, it's hard to imagine any likely circumstances under which a market trading at close to 50 times normalized earnings could be a viable investment option – though it's theoretically possible if long-term interest rates are very, very close to zero.
But, at lower normalized P/E ratios, such as 30 (and certainly 20) stocks could still compete with other investment opportunities. Stocks might lose most (or all) of their edge over other asset classes; but, stock prices wouldn't necessarily have to fall – they could simply offer much lower returns than they had in the past. This could continue indefinitely – in theory.
I say "in theory", because that seems a rather unlikely scenario. There is absolutely no evidence for it in the data. Before 1995, the Dow's normalized P/E ratio had ranged from 6.88 – 17.40. The average (mean) normalized P/E ratio from 1935-1994 was 12.31. The median normalized P/E ratio was 12.41.
So, a permanent jump to normalized P/E ratios above 20 would be quite a departure from the past. Could the leap be permanent? Could these new, higher normalized P/E ratios become the new norm?
Maybe. If we really are in a new era, the old historical return data isn't relevant – it applies only to an era of low normalized P/E ratios. New, higher valuations must necessarily lead to new, lower returns. On the other hand, if we aren't in a new era, the old historical return data is relevant – and normalized P/E ratios must fall.
And they have fallen. Like a rock.
And saved us a lot of time.
Eight and a half years by my calculation.
Without a severe multiple contraction, the Dow would have had to move sideways for something like eight and a half years to give us the same future return increasing effect of the fall from just under 14,280 to just under 8,580.
Of course this only makes sense if you believe as I do that in the long-run your returns in stocks are derived from the relationship between the price you pay and the earnings power you get for your money.
What about earnings power impairment?
Won’t the current financial panic and the (possible) resulting global recession cause a major contraction in earnings power?
Not really. Actual earnings will be impaired. However, “normalized” earnings won’t move much (certainly nothing like the 40% drop in price) – unless we see conditions considerably worse than anything post 1935.
The Dow has been outperforming its expected earnings for a very long time (since the early 90s). That was never going to last.
The Dow’s actual earnings overshoot and undershoot its “expected” (i.e., 15-year normalized) earnings quite frequently; however, the overshooting and undershooting have tended to cancel each other out over long periods of time as you can see here:
From 1935-2005, the percentage difference between the Dow's actual earnings and its 15-year normalized earnings ranged from (62.12%) to 65.14%. The average (mean) difference between actual and normalized earnings was 0.44%. The median difference was 0.09%.
The swings have been huge, but their net effect has been small. Basically, the Dow’s EPS chugs along at about 6% a year. Although it has managed some remarkable hot and cold streaks (none longer than the one that’s ending now) it’s basically a mirror image of underperformance and overperformance.
The Dow gives you 6% earnings growth. What you get depends on what you pay.
Starting today, you’re paying par. You haven’t had that chance in over ten years.
What do I mean by par? Since the Dow is now at (actually a bit below) its average 15-year normalized P/E ratio for 1935 – 2005, your long-term returns should match the Dow’s long-term EPS growth.
Both should be around 6% (ex-dividends).
Long-term future returns should once again be similar to long-term historical returns.
Could the future be different from the past?
Maybe.
But I wouldn’t bet on it.
The last ten years turned out to be nothing new.
Just a detour on the road to normalcy.
P.S.
All this brings up an interesting question – and I know a lot of people may not agree with my strict either/or dichotomy between a price drop or a stock market that does nothing for many years – but assuming the Dow’s normalized P/E had to revert to the mean for it to offer its historical returns once again…
Which would you rather lose: Forty percent or eight and a half years?
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This article has 18 comments:
Opinions like yours (which I share) have been ridiculed for years by the majority of the 30- and 40-something investor class who believed they were stock market geniuses but really were riding the wind, and are now reaping the whirlwind.
is it:
1) online trading, and the expansion of trading platforms in general, enabling Joe Sixpack to enter the market
2) the regulatory and marketing changes steering people to invest in the marekt via 401ks, IRAs, etc.
3) the expansion of the money supply to pay off our deficits (budgetary and import/export) teamed with an ever cheapening cost of living, a la chinese manuacturers and technology creating a bundle of excess cash that needed somewhere to go?
Given that earnings from financial firms grew from 15% to 30% of total Dow earnings over recent history and that most financials are now in meltdown mode, it isn't a big leap of faith to conclude that Dow earnings will decline from current levels. This would imply that today's Dow level might still be a bit on the high side historically.
It's also likely to overshoot to the low side before the economy gets a firm footing for further growth.
Though, I think it's arguable that P/E ratios are still higher than they were before. After all, P/Es tend to be higher in bull markets and lower in bear markets. One argument as to why P/E ratios might be higher is that taxes have declined significantly (corporate, capital gains, dividend, and even individual) since the early '80s thereby producing greater returns. I don't know if that fully explains it, but it's a thought at least.
I'd also be interested to see average P/Es at the height of a bull market and the bottom of a bear market. My guess is that we still haven't hit the average P/E pre-1982 for the bottom of a bear.
Whether we will now trade at a discount to the long term normalized PE is an open question. My view is that once the panic subsides, the market will pay a premium on normalized PE's for several decades.
There have rarely, if ever been the kind of triggers for growth that are in place today. The urbanization and industrialization of India and China has a long way to go; as an aggressive investor with access to capital, intellectual property and management skills, the United States will be a significant beneficiary.
Global GDP has grown and is continuing to grow at a rate in excess of historic norms. Global capacity is short and investment is required. Now that the bank crisis has been addressed by the world community, the healing process has begun. From it will emerge a more responsible financial services industry, which will hopefully focus more on credit quality and will not over-leverage as in the past. Once the de-leveraging is done, growth will recommence, perhaps at a more sedate pace, but nonetheless at a rate of growth higher than the long term average.
If demographics are studied, China will start having an increase in the aged population as a % of the working population only after 2030. In India, it is not expected to happen until closer to 2050. The standing army as it is today is under-served, so there is a big catch up to be done. Once that is done, growth needs to be sustained to serve the accelerating population.
Demographically, United States is an aging nation and as the baby boomers retire, it is perceived that (a) consumption will decrease (lesser demand from older people) and (b) there will be dis-savings as older people withdraw savings from pension funds and social security.
However, thus far United States has maintained an excellent demographic balance through immigration (more recently supported by high birth rates amongst the Hispanic and Asian communities). I expect this to continue because United States continues to attract the best of the globe to its educational institutions and thus they are able to preserve that competitive edge arising through home grown and imported intellect.
With the balance between the working and retired being maintained, there should be no unimaginable dis-savings. I would argue that a lesson will have been learnt from past excesses and consumption funded by debt will reduce considerably. This reduced consumption will lower the burden on future generations. The savings that arise as a consequence of lower consumption will be invested. I expect considerable investment within the United States as she strives to re-assert her supremacy as a producer nation. I also expect considerable capital outflows from a capital resource surplus country to capital constrained societies.
As far as I am concerned this is not the end of the world; the problem is making the world believe it.
Most importantly - every economic boom has peaked almost EXACTLY 6.4% above the previous one, and every economic bust has bottomed almost EXACTLY 6.4% higher than the previous.
If you graph year end S+P PRICES on top of the trend line channel for EARNINGS, it's the same exact chart...... lol, except for the timing.
Until the late 1990s, it held, but we went so much higher in prices, that now we have simply returned to normal.
My chart is showing normal as 14X that central tendency of earnings, what earnings would be if they never boomed, never busted. 14X AVERAGE, normalized earnings, as reported, trailing.
The market bottoms at 8X those normalized EPS, and peaks at 20X (until just recently, as the author wrote.)
FWIW, S+P has just lowered estimates for 2009, and the number is (again) almost exactly at the trough.
For 2008, this (theoretical) normalized EPS number is $67.84, meaning we are currently at 13.25 normalized earnings.
(I've published the simple chart at the above link. In case it doesn't work, try here: www.investorvillage.co...
Who knows if this is a short-term bottom. For me, I've got 20 years left until I'm eligible for SSI, and I figure this could now be the best time to buy equities in my lifetime. I made the mistake on the way up once, but don't want to make that same mistake again. 20 years of 6.6% returns plus dividends should give me a nice retirement; and I do think overseas equities will return more than 6.6% in dollar terms.
'Nuff said.