Great Depression vs. Great Bubble

Includes: DIA, QQQ, SPY
by: Dean Morel

Motley Fool's Matt Koppenheffer hit the investing mainstream last week with his article on looking at value not price appreciation. It's an easy yet worthwhile read, I've reprinted some highlights from the article below. Matt's main thrust was "our concern shouldn't be over how much the market has gone up or down, but rather whether its valuation is attractive or unattractive".

Wise words, but I still can't get the wiggles out of my head.

Perhaps this chart from dshort is a Rorschach test and not manipulated data to present a negative view. Perhaps focusing through two beer bottles confused my addled brain when I looked at the chart earlier this week.

To check, I decided to take a fresh look at Professor Shiller's data to see what pretty graphs and inferred meaning I'd see with a clearer head. Guess what? I still find a more positive picture than dshort painted and struggle to draw a really negative picture, though the mid-term could be rough.

I look forward to finding out why dshort chose his mini-trough to misalign his chart with and why he decided to disregard time from peak and most other reference points. Upon a good explanation, I'll be happy to conceed that it is I who is misaligned.

The following charts of the S&P 500 use Shiller's monthly data (click the images to enlarge).

This first chart aligns the Great Depression and Great Bubble's initial peaks. If we continue to follow the same pattern then we're likely to experience slim picking on stock markets for the coming years. These tea leaves are supported by plethora of fundamental reasons from over-leverage to printing presses and on to valuation levels. However, before you slash your wrists, or to keep with the theme, jump out of an office building, let me say this: I have looked at hundreds of aligned graphs over the years and the one thing they all have in common is the alignment eventually breaks down.

Great Depression vs Great Bubble initial peak aligned So what do the tea leaves say lies ahead of us? When I zoom in on the data and align the initial major stock market troughs from the Great Depression and the Great Bubble I can't help but see a positive picture.

Great Depression vs Great Bubble trough aligned

Could the S&P 500 pull ahead 500% over the next 15 years, just as the post depression market did? Could it happen even quicker? After all six of those post depression years were taken up by WWII and the bulk of those gains happened in around 12 years.

As Professor Albert Bartlett said "the greatest shortcoming of the human race is our inability to understand the eponential function" or simply, human brains aren't wired for big numbers.

So let's break down 500% into a yearly figure. If you were excited by the thought of 500% in 12 to 15 years then look away now, as you may be disappointed by the yearly growth. 11% and 14% will return 500% over 12 and 15 years respectively. I'm not sure why I said you might be disappointed, as I'd settle for 11% and be estatic with 14% over those periods.

If we pull back five years before the peaks and align the peaks, the déjà vu continues.

Depression and Bubble peak aligned

But if we pull back even further then a remarkable new picture appears. This time let's start from near the pre-bubble low in mid 1980 and peak align the data.

Depression vs bubble from 1980 lows

I knew the eighties and nineties were amazing, but wow! Com-pu-pu-pu-pu-pu-puter-puter-puter-puter, computer games. Did the computer deliver that growth? Or was it the Ponzi printing presses? Whichever, I enjoyed watching that Mi-sex video again and computer vs. press is a topic for another day.

Here are the snips from Matt Koppenheffer's article; like me he has used Professor Shiller's data. We're all looking at the same data, the only thing that's different is us.

Don't Mind the 47% Stock market commentators tend to be a rather fearful bunch. When times get bad and the market is sinking, many of them seem to suffer from taphephobia -- a fear of getting buried alive -- and they want to run for the hills as quickly as possible. On the flip side, when the market is shooting up, acrophobia -- the fear of heights -- seems to come into play and, well, they're off running for the hills again. But if you ask me -- or really any fundamentals-oriented investor -- our concern shouldn't be over how much the market has gone up or down, but rather whether its valuation is attractive or unattractive. If a hot market with sky-high valuations rises 47% in a few months, that acrophobia is probably warranted. On the other hand, if a sorely undervalued market tacks on that same 47%, there could still be good reason to buy.

Do Mind the Valuation ...The long-term average for the P/E number that Shiller tracks is around 16.3. The current readout is 17.5, which is up from 13.3 in March and down from 27 prior to the market's crash. So today's valuation isn't nearly as attractive as March's, but it's much more attractive than what was available to us pre-recession. What's concerning though, is that earnings estimates for the S&P index from Standard & Poor's suggest that earnings will remain well below their pre-recession levels. This means that even if the market doesn't move up much more, its valuation will rise as average earnings fall. ...

So What Do You Do? ... If you're a long-term retirement investor and you want to keep it simple, you're still probably fine grabbing those index funds today. For investors who like to put on a hard hat and go prospecting for the best stock opportunities, though, now is a good time to start eschewing the index funds in favor of some individual stocks that are still undervalued. ...

So What Are You Going To Do?

I'll go first, though I'm really writing this to hear from you. I'm going to continue to stick to my regularly updated investment plan. Specifically I'm going to continue to invest as much as possible like an emotionless Vulcan by acting to limit my greed and fear. The best way I know to do that is buy when I am fearful and sell when I'm feeling greedy.

As I said last week I've started to feel greed misting my thoughts. I also agree with Matt Koppenheffe, Shiller's data, Grantham, Hussman and many other commentators that the market is currently slightly overvalued, nothing to get you knickers in a twist over, but also nothing to get excited by.

I'm more concerned about downside, as I have already achieved a relatively comfortable life there is little utility in the current potential upside. That's reinforced by rediscovering my mojo and totally kicking the market's arse again this year, after a narrow combined win last year and a loss in 2007. So I'm trimming my portfolios.

The other reason for my trimming is my continual seeking of alpha. In baseball you have to step up to the plate to get a swing at the ball. Similarly in markets you need to put yourself in a position to be able to outperform. I find it easiest to do that by cashing up when I sense greed is growing and valuations are unfavourable and investing when it makes me feel nauseous to do so.

By trimming now I'm exchanging a low probability of performing in line with the market for a higher probability of outperforming the market. I know I'm really pushing this concept, but I think of it this way. What will annoy me most, missing out on some gains or not having cash if the indices fall 20%?

In short I see a higher probability of being able to buy at lower valuations sometime over the next five years than I do in this being the beginning of a new bull market and 1,000 never being seen on the S&P 500 again. So, as I said, I'll continue to trim and even watch for the opportunity to go short, though perhaps I'm simply suffering from acrophobia.

Disclosure: The author is net long North American, Australian and a couple other stock markets via equity and fund investments. He is currently raising his cash levels, though remains ambivalent to the market direction.