United States equities have long been skating on thin ice. It appears they have finally collapsed through it, and are now treading water before sinking deeper. From an historical standpoint they have arguably been overpriced for most if not all of the past twenty years. Their dividend yields, price-earnings ratios, price to book values and other meaningful measures have long ago gone beyond all safe valuation parameters. For over hundred years, similar conditions have always signaled caution, if not danger. Why is it now that stocks appear to be finally breaking down, and sounding the alarm of an impending Bear Market?
There are two major guides that have endured the test of time. For at least a few generations they indicated the limits that people were willing to pay for ownership of common stocks. First, whenever the Dow Jones Industrial Average's price-earnings ratio approached or exceeded 20:1, equities normally experienced sharp Bear Market declines. Similarly, periods when its dividend yield plunged to 3% or less usually spelled impending disaster for the fate of stock prices. A bit of history might be useful at this juncture.
After the disastrous Bear Market of 1929-1932 and the ensuing Great Depression, few people ventured into common stocks. The memory of the dark period that lasted from 1930 to the end of World War II and even later, pervaded people's thoughts and actions. This made them shun the stock market. When I was young during the late-1950's and 1960's, the NYSE's daily trading volume gradually expanded. It grew from 1-2 million shares early in this era, and ended with volumes approximating 15-18 million shares. For comparison, during the late 1920's, usual volumes were in the 2-4 million range. These all paled compared with the normal multi-billion share days of today. Only gamblers bought stocks during my youth. At best, common stocks were considered highly speculative!
As time passed and the memory of the debacle of 1929 faded from people's memories, some individuals began to again accumulate equities. But, those who "played the market" had some desire to at minimum get something for their money. Like those before them, they limited their purchases when they had to pay around 20 times the Dow's yearly earnings, or when they received a paltry 3% yield on their investments. This is the reason why Bear Markets typically ensued after P.E. ratios approached 20:1 and dividend yields fell to the 3% range. Traders recognized that the market was overpriced, and wanted out.
The various forms of investments continually vie with one another to attract the available capital. This includes stocks, bonds, real estate, gold etc. The bond market is the stock market's major competitor for money, but it is far larger. This is the primary reason why high interest rates tend to attract money away from equities into bonds and, conversely, money may leave the bond market for stocks when rates are low. The critical factor is the stock market was the decided victor in the competition for the public's investment dollars for the past 20 odd years, and especially for the last six.
It is my belief that we have witnessed one of the few times in history, when this time it was truly different! I believe the extension of the secular Bull Market that began in 1982, was caused by a flight of money from the bond and Treasury markets, into common stocks. The equity advance that began in the mid-1990's and exploded further in the years after the 2007-08 collapse was generated by fear! It would have ended far sooner had it not been for this reason!
Interest rates declined below historical norms in the mid-1990's. Earlier, the livelihoods of countless retirees and numerous others depended upon safe investments such as bonds and annuities. They relied on the interest they earned and counted on a decent return on their money. This allowed them to plan their lives according to their anticipated interest payments.
That all changed in the mid-1990s! As money began to flow out of bonds and into common stocks, equity prices embarked upon an unprecedented boom. Those who previously were the most conservative in their investment choices felt compelled to seek higher returns in order to survive. They could no longer meet their usual household requirements from the money generated by their bond and annuity investments. Their options limited, they felt forced into heretofore believed dangerous investments such as common shares, in their search for higher returns. The term "speculative" which people used when referring to the stock market after the Depression was replaced with "investment", and then even "savings", by the brokerage community. This lured these poor, struggling souls and their money into the market, and fueled the speculative boom that appears to be now unwinding.
All markets go to extremes. This is why most Bull Markets surpass the projections of the most optimistic soothsayers to the upside, and Bear Markets to their lows. Today, I believe the most enthusiastic bulls and the most frightened bond investors have spent their last dollars on common stock purchases. Together, they have driven equities beyond all rational values. Now, the path of least resistance is downward.
Where does this leave us? I have discussed two important indications of the grossly overpriced nature of our stock market. But there are others. One such measure indicative of an overextended market on the verge of topping out, is the level of indebtedness, or margin debt, that stock participants are willing to undertake. It recently struck a never before seen height. This surpassed those preceding the tech bubble top as well as the 2007-08 crash. Also, since the 2009 low, the DJIA was driven higher with continually declining volume. Healthy markets rise with increasing volume when people get excited and rush in to buy. This confirms for me that its 2009-2015 rise was founded on "feet of clay". History teaches us that this is a foreboding of far lower prices to follow. Further, the Baltic Dry Index, a measure of global shipping rates plunged to its lowest level since it and its predecessor were created in 1985. This tells us the depth to which the world-wide economic slowdown has already plunged.
All of the above does not guarantee that common stocks are about to crash! Further, it does not presage a Bear Market as great as those of 2007-08 or 1929-32. It is true that overvalued markets normally fall hard, and further than less-extended ones. But timing is everything when it relates to markets. One timeless stock market saw states, "don't tell me what to buy, just tell me when to buy it". However, given how overextended U.S. equities are in both time and price, I believe the odds greatly favor us witnessing significantly lower prices before 2016 lives out its final days. Prudence dictates avoidance of equities!
