Is The Bubble Thing Returning?

No. The bubble never left. The chart is interesting for it tells a story of the market’s performance since 1920. Keep in mind this is the Dow Jones Industrial Average, which, for this period of time, represented at least 25% of the value of all US stocks, most importantly including a cross section of the “shakers and movers” that reflect the direction of the US economy.

The Dow Jones chart shows three huge bubbles in current stock market history.

Time Period	% INCREASE IN DJIA	CORRESPONDING BEAR MARKET	% DECREASE OF BEAR MARKET
1924-1929	432%	1929-1932	91%
1932-1937	472%	1937-1942	52%
1982-2000	1,480%	2000-?	?

The market’s increase from 1982 to 2000 was obviously out of proportion to prior increases in value. Support levels are created by prices which represent historical average yields and price earnings ratios. Support between 6,000 and 4,000 would represent average to great values. Support at 3,000 and 2,000 would only be reached after panic selling and would be preceded by drastic reductions in corporate earnings. A drastic sell off in values, such as 1929, went way below reasonable support. The more gradual sell off of the market in 1937 reached levels without drastic revaluations.

If we were to reach support immediately, the market would go to a price earnings ratio of 14.4 times earnings and dividend yields of 4.3%, which level would be between 6,600 (the historical average Dow price earnings ratio of 14.4 times) and 4,500 points (the historical average yield of 4.3%).

Levels representing historical values are exactly what Wall Street and the government is trying to avoid, even though the historical average PE existed only seven years ago. The Fed is flooding the market with new money and desperately attempting to avoid a panic sell off of the Dow taking it below average historical yields and PE ratios.

Notice from 1942 until 1962 there was a 20-year bull market in which the market increased in value by a multiple of 8. From 1962 until 1982 the market went nowhere. Because of inflation, investors owning stocks during that period of time lost money. From 1982 to 2000 the market increased in value by a multiple of 14 fueled by deficit spending and ambitious money creation by the Federal Reserve System. Click here to view a graph in pdf format.

The best our government can hope for is that the market remains within the current trading range and that corporate earnings catch up with the market. As corporate earnings and dividend yields grow over the years, they will become commensurate with historical averages. But during that process, the stock market is likely to go nowhere. The government fears a huge sell off taking the market to low levels of support that existed in the 1930’s, or even to1982 levels when gold reached it’s zenith.

DJIA LEVEL	PRICE EARNINGS RATIO	YIELD
6,000	14.0 x	3.5%
4,000	9.3 x	5.2%
3,000	6.8 x	7.0%
2,000	4.7 x	10.5%
Historical Average	14.4 x	4.3%

Technical analysis indicates logical support at around 6,000. A lot of very bright analysts are looking at 4,000. There is a potpourri of analysts looking at 3,000 and 2,000, which does not seem realistic, even from the point of view of statistically analyzing the mathematical potential of this bell shaped curve. Look hard at what we call the “step” created in 1996 at level 6,000. That “step” is the logical corresponding downside stop of the right side of the parabola. TECHNICAL ANALYSIS CONCLUDES A 6,000 DOW IS IN OUR FUTURE!

Wall Street and the Federal Reserve know this, too. What they want to continue to do is flatten out the right side of the curve and maintain a trading range until corporate earnings and yields increase over time. Should they be able to do that, the next 20 years on this chart would look very much like 1962 to 1982 where, as mentioned above, it is unlikely investors will make money in stocks. Particularly if there is inflation. During 1962 to 1982, most money was made in real estate - we had real asset inflation. What are we seeing now in real assets like gold, real estate, and rare objects? Asset inflation!

Let’s take a look at the Standard & Poor 500

The DJIA current PE ratio is 22 times earnings. Look at historical information available on the S & P 500 when the PE ratio is 22. The S & P 500 10 year results following a PE of 22 or more are as follows:

Year PE was 22 or more	Following 10 year return(*)
1929	- .9%
1930	- .4%
1962	+4.0%
1965	- .9%
1966	+1.4%
1969	+ .7%
Historical Average	+ .7%

(*) Includes Dividends

WHAT DOES THIS MEAN FOR STOCK MARKET INVESTORS?

First, studies indicate that when the DJIA is at 22 times earnings or higher, like the present, the 10-year compounded median returns were 5%, including dividends. While this is better than the S & P 500 results, for all the risk that exists at these levels, it’s simply not worth it to hold stocks unless we are holding stocks that have a current dividend yield of 5%, which dividend is well covered. The stock should be “A” rated and selling at 12 times earnings or less.

Second, as the government will have to create inflation to keep the markets at these levels, and since the behavior of the Fed indicates they are committed to creating inflation, assets like real estate, gold and silver, and rare objects are likely to enjoy returns far greater than returns on stocks over the next ten years.

Third, 3-5 year government paper, and “A” rated municipal and corporate bonds, provide security on the downside, security as to income, and provide an investor more safety in these turbulent times. Further, one positions themselves to take advantage of values that will exist if the market has a huge sell off.

CONCLUSION

History indicates the risk in this stock market bubble is so great as to limit returns over the next ten years. It is likely that sometime during this period investors who have positioned themselves conservatively will benefit three ways:

1.		They will not lose principal;

2.		They will receive a reasonable return on their cash;

3.		They may have the opportunity of a lifetime to pick off great values in stocks at the point when stocks become reasonably priced again, or, God forbid, way, way undervalued.

Caveat Emptor!
George Rauch
September 26, 2003

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