Progress of the secular bear market: position as of August 31, 2006
The value for R is 1390 as of August 2006. For S&P500 of about 1290 this gives P/R of 0.93
Stock Cycles: Part IV. Secular Trend Theory
The concept of price to resources (P/R) was introduced in part two of this series. Business resources (R) was defined as the cumulative sum of retained earnings of the S&P500 over time, all expressed in terms of constant dollars. P was the value of the index, also in constant dollars. P/R was used to identify the stock cycle. It was also shown that two other measures, Tobin's Q and Shiller's P/E, can be used for the same purpose. In part three, we saw that of these three measures, P/R gave the latest exit signal during the bull market of the 1990's. In addition, it was the only one of the three to suggest that stocks had fallen "enough" by summer/fall 2002 and that buying stocks at these levels was not unwise.
Nevertheless, despite their premature warnings of overvaluation in 1997, both Shiller's P/E and Tobin's Q do a good job of delineating the stock cycles. The reason why they work is that they are asset-based measures, rather than earnings-based. Asset-based valuations do not fluctuate with position in the business cycle, as does a performance-based valuation such as ordinary P/E. This stability eliminates the effect of shorter business cycles, revealing the long-term stock cycle.
Tobin's Q is inflation-adjusted net worth and R is inflation-adjusted retained earnings. Both are measures of assets rather than operations. Shiller's P/E appears to be operationally based, but by using an averaged earnings, what is actually obtained is something that functions like an asset measure. Figure 1 shows a graph of the ten-year trailing average of earnings (in blue) compared to R. Note how the two lines are parallel; average E closely tracks R. Because of this parallelism peaks in Shiller's P/E ratio will necessarily show up at exactly the same time as peaks in P/R.
Figure 1. Smoothed earnings vs. R, and E/R compared to real interest rate
Because R is the cumulative sum of real (inflation-adjusted) retained earnings and shareholder's equity is mostly accumulated retained earnings, R can be thought of as real equity. This makes the ratio E/R analogous to the return on equity (ROE). That is, E/R can be considered as a measure of overall management efficacy for the S&P500 index as a whole, just like ROE is a measure of management efficacy for an individual company. Because the S&P500 is intended to be representative and contains the bulk of total market capitalization, E/R effectively measures management efficacy for the economy as a whole. This is why observations made using R hold for the economy as a whole. An R constructed from the NASDAQ index would not work, even though the index contains far more stocks because the NASDAQ is not representative.
ROE for an individual company will depend on the kind of business the company pursues, the quality of management relative to its peers (i.e. it is above or below average) and the business environment. Because E/R reflects all types of businesses and all qualities of management performance; only the business environment will affect E/R. Thus, E/R will fluctuate with the business cycle. Using a ten year average will smooth out the effects of the business cycle on E/R, much as it does for Shiller's P/E. Figure 1 also shows a trailing ten-year average of E/R. Long-term fluctuations can be seen in the plot of smoothed E/R. These fluctuations define a cycle with troughs in the 1890's and 1940's and peaks in the 1910's and 1970's. This 50-60 year cycle reflects the Kondratiev cycle, about which I have written previously [1-8].
The smoothed E/R plot shows that return from resources declined from about 7% before WW I to a little over 4% after. Since 1930, it has remained around 4% up to the present. Thus, a given amount of R will produce about 40% less earnings today than it did a century ago. This implies that for equal peak market valuations (as measured by P/R), P/E values of today should be about 50% higher than those of the past. Thus, whereas in the 19th and early 20th century a P/E of 20 would be considered very high, today a P/E of 30 should be considered as equivalently high. This is the reason why P/R gave a closer prediction of the timing of the bull market peak than did 10 year P/E. (The fact that P/E did not rise to ~30 in the 1960's bull market reflects generational factors that will be a topic of a later article).
Comparison of E/R with a 50-yr trailing average of real interest rate shows that real interest rates have also declined with time. Overall, the returns businessmen have extracted from R are higher than real interest rates. This spread, which is sort of a "enterprise premium" for business investments relative to moneylending, was about 3% prior to WW I and about 2.5% for the fifty years after WW I. Over the last 35 years it has averaged around 1.5%. Real economic activities have gradually become less profitable relative to financial activities since WW I. This trend has accelerated since the 1960's.
What this means is that although the cost of money has declined over time, the fundamental return from business activity has fallen faster. Inflation has obscured this fact. For example return on equity, which is obtained using a book value that is not adjusted for inflation, typically is in the 10-12% range, considerably higher than the 4% value for E/R. One might think that the low E/R values today might reflect a tendency for R to overestimate the resources available to produce profits. That is, R overestimates the true value for business resources, and E is not small. But the stock market price P represents a dynamic market -based assessment of the true value of business resources. The fact that P/R reached an all-time high in 2000 suggests that the market believes that R provides a value for business resources that is too low, if anything.
This observation suggests that the story told by E/R is correct. Profits are lower today. Given this fact, one might expect stocks to have produced a much smaller return after WW I than they did before. This has not been true. As we shall see, the market adopted a clever response to the reduction in E/R that has preserved most of the high long-term returns available from the stock market before WW I.
Additional financial ratios involving R are presented in Figure 2. Here we see a 10-yr trailing average of owner income (dividends) from resources (D/R). Also shown is capital accumulation, or the real rate of growth in R. By definition, since R is simply accumulated retained earnings in constant dollars, the rate at which R rises is equal to the difference between earnings and dividends divided by R, that is, (E-D)/R. As described in Part II of this series, this growth rate in R is equal to the long-term rise in the stock index in real terms. It is also roughly equal to the long-term growth rate in GDP per capita.
Note that while E/R and D/R have fallen over the last century, there has been no corresponding drop in the rate of capital accumulation. It has remained around 2% over the entire period in the figure. What this means is the drop in profitability of American business over the last century has had no adverse effect on the rate of growth of R. That is, it has not affected the rate at which stocks rise in price or the rate at which the economy grows. As long as E/R remains above 2% there will be no adverse effect on either economic growth or long term stock price appreciation resulting from a lack of capital accumulation. Figure 2 shows that the decline in business returns (E/R) has shown up as a decline in the income (dividends) available to owners of the resources of publicly-held businesses (i.e. D/R).
Figure 2. Earnings, Dividends, and Capital Accumulation with Real Interest Rate
Effect of reduced business profitability on stock market returns
So far we have seen that the decline in the rate of return from business (E/R) has had no effect on either real economic growth or real stock price appreciation. The primary impact of the decline in business profitability was a dramatic drop in dividend income (D/R). Consider, D/R has fallen from 1% above real interest rate in the 1871-1911 period to 0.6% below real interest rates in the period since 1960.
Note that D/R is being compared to a real interest rate and not nominal rates. When one reinvests bond dividends in a bond portfolio or simply accumulates interest in a bank account or money market fund, one reinvests into dollar-denominated debt instruments. The real value of these obligations will fall with inflation. When one reinvests stock dividends in a stock portfolio, one reinvests into equity (i.e. R) which is a real thing that retains its value against inflation. Thus, a 5% interest payment used to buy more dollar-denominated debt is a 5% nominal return because what one is buying is money (dollars). In contrast, a 2% equity (R) dividend used to buy 2% more equity (R) is a real return of 2%. For an inflation rate of 3%, a 2% value of D/R is equivalent to a 5% nominal interest rate. Even in the case when dividends and interest payments are not reinvested, stock dividends can still be considered as a real return, whereas interest is nominal. The reason for this is that an interest payment will lose value to inflation, whereas a dividend payment from R will increase with time, keeping up with inflation over the long run.
Since dividends are responsible for the majority of long-term stock returns, one would think that a 55% decline in D/R would have resulted in a sizable decline in total return from stock investments. But this did not happen. The reason is the relevant dividend yield for calculating investor returns is the dividend divided by the stock index market price (P) not equity (R). That is, it is D/P that determines investor return, not D/R. We have already seen that real return from price increases is roughly constant at 2%. Thus, we can write an expression for long-term stock returns as follows:
1. real return = 2% + (D/P)AVG
Here (D/P)AVG is the average value of the ordinary dividend yield D/P over the (long) time period of interest. The expression makes use of the long-term average rate of 2% price rise in the index and adds the average dividend yield to that value to obtain the long-term real return. I must stress that equation 1 refers to a stock return due to the long term trend and does not consider the effect of the stock cycle, which has an enormous impact on actual realized returns. Exploitation of the stock cycle to gain insight into investment planning is of course the whole reason to study the stock cycle. P/R and secular trend theory in the first place.
We can express investor dividend yield as dividend income from resources (D/R) divided by P/R. The advantage of this formulation is D/R is roughly constant over long periods of time. Also, because D is that portion of E that is not retained, and retained earnings average 2% of R, we write equation 1 as follows:
2. real return = 2% + [(E/R)AVG - 2%] / (P/R)AVG
Here (P/R)AVG and (E/R)AVG are the average values of P/R and E/R over the period of interest. Equation 2 shows that total real return due to the long-term trend in the stock market is a function of fundamental business profitability as expressed by average E/R and valuation as expressed by average P/R. For a given value of E/R, the lower is the average level of P/R, the higher is the total return on stocks. Because investors collectively determine P by their bidding for shares on the stock exchange, they control the total return they receive over the long run, regardless of the value of E/R. That is, investors can compensate for reduced E/R by reducing the average value of P/R.
To see this in action, let us consider the stock returns for the four decades after 1871 with those obtained during the two most recent stock cycles (1929-2000). E/R averaged 7.1% in the 1871-1911 period, much higher than the 4.2% value seen over 1929-2000. But when we look at how investors priced the stock index we see an interesting result. During the first period, P/R varied between 0.63 and 1.34, with an average value of 0.98. Plugging 7.1% for E/R and 0.98 for P/R in equation 2 yields 7.2% as the trend rate of return for the 1871-1911 period. During the second period, P/R varied much more widely, from 0.21 to 1.46, with an average of 0.54. Plugging 4.2% for E/R and 0.54 for P/R into equation 2 yields 6.1% for the trend rate of return for the 1929-2000 period.
By reducing the average level of P/R investors were able to moderate the effect on investment return of a 40% drop in fundamental business profitability (E/R) to a more modest 15% drop in basal return (from 7.2% to 6.1%). The 7.2% real return delivered by the market of a century ago was 3.3% above the average real interest rate. The 6.1% real return for the modern stock market was 4.7% above the average real interest rate. Thus, relative to the alternative, stocks produce a 40% higher return since 1929 than they did before 1911, despite a 40% drop in fundamental profitability.
This increase in investor return, despite poorer fundamentals, was achieved by reducing average P/R without affecting the maximum value of P/R. That is, stocks have produced this increased return at the cost of the large swings in P/R associated with the modern stock cycle. It must be stressed that while average P/R values were reduced, maximum values of P/R have not declined. On the other hand, the minimum level of P/R is much lower than it was before 1911. As a result, index investors today can actually lose money over a 20 year period if they pick the wrong points in the cycle at which to buy (when P/R is high like in 2000) and to sell (when P/R is low like in 1982). Clearly, long-term stock investing in the post-1929 market entails much more risk than it did 100 years ago, but investors are rewarded for this additional risk.
How lower P/R is generated
It is instructive to see exactly how the market manages to generate this low average value of P/R. Looking at equation 2, one can calculate that for the modern era of 4% E/R, investing at a P/R of 0.5 should yield a 6% long-term real return, which is a perfectly acceptable return. Hence people should simply buy stocks when the market is priced that way and all should be well. All would be well except for the stock cycle. The stock cycle holds that stocks oscillate around the value (P/R)AVGsometimes getting as high as a P/R of 1.2-1.5 and sometimes getting as low as a P/R of 0.2-0.4. The stock cycle suggests that the market will wander from the high level to the low level in about 18 years, and then return back up over the next 18 years. The first period is a secular bear market and the second a secular bull market. Figure 3 in Part III showed plots of P/R over secular bear markets that showed the declining trend typical of such period. Based on these past trends, P/R can be expected to decline about 6-7% each year (on average) over a secular bear market. This declining trend in P/R is countered by the natural rising trend in R of 2% to give a trend in real price of -4% or -5%. If we put this into equation 2 for the capital gains component we obtain:
3. real return = -4.5% + [(E/R)AVG - 2%] / (P/R)AVG
If we then input a 4% value for E/R into equation 3 we obtain:
4. real return = -4.5% + 2% / (P/R)AVG
Equation 4 says that to obtain a 1% real return (about what money markets do over the long run) P/R would have to fall onto the 0.3-0.4 range. Recall that the returns calculated in this fashion are the trend rates, the basal background rates that investors swim against during secular bear markets and float with during secular bull markets. Over shorter periods returns can be positive or negative independent of P/R due to the effect of shorter term cycles and market randomness. These equations show why P/R can get so low during secular bear markets. It is not until a very low value of P/R is reached that the underlying long-term trend becomes favorable. At this point the secular bear market can end. Now comes the secular bull market, when instead of a 6-7% declining trend in P/R, the investor faces a 6-7% rising trend in P/R. In this case equation 2 becomes:
5. real return = 8.5% + 2% / (P/R)AVG
Projected trend returns remain very favorable right up to the end of the secular bull market. This is why secular bull markets often end in an energetic speculative blowoff, while secular bear markets end in very desultory trading. The trend is always with you (until it isn't) in a secular bull market. Secular bull markets turn into secular bear markets when a change in sentiment causes a change in belief about the trend return. Hence, euphoria shifts to fear in a relatively short span of time. In contrast, in a secular bear market, once P/R gets low enough, the trend can become favorable without any change in sentiment. This is why trading is so desultory late in secular bear markets despite what, in retrospect, were wonderful investment prospects.
It is the downwards trend in P/R during a secular bear market that counteracts the potential return available from dividends during a secular bear market. Because of this negative trend, high dividends don’t stop the decline in stocks, allowing dividends to rise still further. The process usually ends when P/R reaches extremely low values in the neighborhood of 0.25 (reflecting not only the bottom of the stock cycle, but also the bottom of other shorter-term cycles). In the next and final installment of this series, the effect of these short cycles will be discussed.
At this point the secular bear market ends and a new secular bull market can begin. It is this secular bear market process that allows the average value of P/R to fall to sufficiently low levels to preserve a high-return trend in the face of low E/R. For it to work, it is necessary that the secular bear market begin at a high level of P/R. The favorable conditions during the secular bull market ensure that this occurs. Thus, the stock cycle functions somewhat as a bellows, pumping up P/R using euphoria during the secular bull markets in order to generate high dividend yields by deflating sentiment during the secular bear markets. It is the secular bear market that creates the long-term returns enjoyed by American stock market investors. The secular bull market merely harvests them.
When business fundamentals (E/R) are so good that D/R is superior to the real return available from bonds, no mechanism exists to depress P/R during secular bear markets. P/R remains high all the time. This was the case over the 1871-1911 period. When E/R began to fall, it became necessary for the market to begin wide fluctuations in P/R in order to force yields up during secular bear markets and preserve the long-term excellent returns demanded by American investors. The great bull market of the 1920's and 1960's and the subsequent serious secular bear markets in the 1930's and 1970's have done the trick. The size of the 1990's bull market and the initial stock market decline in this secular bear market suggests that this phenomenon of big oscillations in P/R with the stock cycle is still very much alive. Thus, we can expect that by the end of this secular bear market in around 2020, P/R will reach the 0.2-0.3 level.
An application of secular trend theory: Dow 36,000
So far we have used the definition of P/R to show that the appearance of large-scale stock cycles after WW I naturally follows from a decline in fundamental business profitability (E/R) at that time. This decline in E/R also explains the phenomenon of 30+ market P/E seen today that have so puzzled stockmarket analysts. Only P/R permits these types of analyses to be done. There is no natural relation between Tobin's Q, earnings and dividends that can be used to obtain a similar result. This application of the concept of business resources (R) to explain some aspect of market behavior is an example of what I call secular trend theory. At present, these applications have little direct relevance for investment strategy. They mainly explain why the stock cycle needs to occur and why a "steady-state stock market" is not likely to occur.
The idea of a steady-state stock market was advanced by Glassman and Hassett in their book Dow 36,000. These authors argued that because stocks outperform bonds over the long run, there is no reason for stocks to be considered as more risky than bonds. Thus, intelligent investors should realize that stocks do not warrant a risk premium. The risk premium is the additional return provided by stocks relative to bonds that compensates for the increased risk of holding stocks. The risk premium has been declining over recent decades, suggesting that investors are coming to believe that the risk premium is unnecessary. In the next few years, Glassman and Hassett predicted, investors will likely bid up stocks to completely eliminate the risk premium. They calculated that after this has happened, the Dow should be in the 36,000 range, hence the title of their book.
Applying secular trend theory, we can use equation 2 to express this concept. The argument is that investors of the future will be content with a bond-like return from their stock market investments and will adjust average P/R to do this. The decline in risk premium began around 1960, suggesting that the 2.8% real rate of return for bonds since 1960[9] may be a good target for this eventual return for stocks. If we plug this 2.8% return into equation 2 (using E/R = 4%) we obtain:
6. 2.8% = 2% + 2% / (P/R)AVG Þ (P/R)AVG = 2.5
Glassman and Hassett suggested that elimination of risk premium might occur in as little as five years after the time of writing. R is 1380 today. Equation 6 suggests that if investors had removed the risk premium, the S&P500 would likely be at about 3500 today, which would correspond to Dow 31,000, about what Glassman and Hassett projected.
The Dow 36,000 argument can also be applied to the stock market of the 1920's. A hypothetical bond return of 2.6% can be obtained by adding the long-term bond premium of 0.8% to the 1.8% real return from short term interest rates over the preceding three decades. Actual bond returns were artificially depressed by WW I and are probably not valid for this analysis. Plugging these values into equation 2 yields a projected value of 3.3 for P/R. A 1929 Glassman and Hassett would have called for Dow 1000. In reality, the market got to a little over a third of what this analysis predicts in 1929, much like it did in 2000.
American stock investors were no more willing to put up with bond-like returns in 1929 as they were in 2000. Instead, the stock cycle continues and secular bear markets began in these years. The take-home message is that the excellent long-term returns that have been achieved from the American stock market doesn't reflect the performance of the American economy, but rather, the culture of the American investor that frowns on poor investment performance. Thus, American investors do not consider it bad form or unpatriotic to adopt a bearish posture with respect to the equity markets (e.g. selling America short). As a result financial mishaps are largely self-correcting in America. Individual investors are wiped out, but those not involved directly benefit from the improved future environment made possible by those individual losses. Having been the victim of stock meltdowns, it is sometimes hard for me to appreciate the austere beauty of the American stock cycle, and the ingenious way in which it extracts good returns from lackluster raw economic potential.
In contrast, Japanese investors have historically not demanded high returns as evidenced by the large amount of funds invested in low-yield postal savings accounts. Japanese were prodigious savers and so did not require the higher returns potentially available through risky investments to fund retirement. Their stock market has produced a long-term real return of 4.5%[9]. In contrast, Americans save less and thus require high investment returns. Thus they have forged a financial system that delivers them. The American stock market shows a long term real return of 6.8%.
Secular trend theory can be used to examine a range of problems relating to long-term investment returns. In future articles, I will make use of these concepts. But for now, the central question is what will the (stock) investment terrain over the next 10 or 15 years look like? In the next and final installment, I will outline what secular trend theory has to say about the future course of the market.
References:
1. MA Alexander, "The Kondratiev Cycle and Secular Market Trends" Safehaven, May 12, 2001
2. MA Alexander, "The Kondratiev Cycle in Prices", Safehaven, March 24, 2002.
3. MA Alexander, "The Kondratiev Cycle Revisited: Part One, Current Position in Cycle", Safehaven, May 5, 2002.
4. MA Alexander, "The Kondratiev Cycle Revisited: Part Two, Economic Implications", Safehaven, May 6, 2002.
5. MA Alexander, "The Kondratiev Cycle Revisited: Part Three, Implications for Gold", Safehaven, May 11, 2002.
6. MA Alexander, "Generations and Business Cycles - Part I", Safehaven, November 6, 2002
7. MA Alexander, "Generations and Business Cycles - Part II", Safehaven, November, 2002
8. MA Alexander, "Oil Prices, the Kondratiev Cycle and Peak Oil", Safehaven, April 22, 2006
9. Dimson, Elroy, Paul Marsh and Mike Staunton, Triumph of the Optimists: 101 Years of Global Investment Returns, Princeton, NJ: Princeton University Press, 2002.
