Financial history tends to repeat itself, and that is why money managers should be especially wary of the next bear market.
It is perhaps early to talk about a bear market – the U.S. stock market is making new record highs; at the moment, there is renewed bullishness that may continue for some time.
That’s partly because stock markets worldwide probably are going to be blessed with yet another great gift from the central banks – renewed efforts to make the world economy grow by pouring more cash into the financial sector.
That, in turn, is likely to mean more quantitative easing and more negative interest rates. The goal: to raise the rate of inflation, to spur spending and to help governments pay off their growing mountain of debt.
But a bear market some time is inevitable.
Because market history tends to repeat, it is timely to remember that severe market drops have occurred roughly every 40 years. This time span is long enough to replace the generation of market participants who worked through the preceding big drop, so institutional memories of it are dim.
Such a point is at hand. It is 42 years since the last turning-point drop.
In 1974, the market crash ended the postwar bull market, with U.S. stock indices trading at less than 10 times earnings with dividend yields above 5%. The inexorable decline prompted a classic cartoon, with one character asking: “What do you suppose happens when the stock market goes to zero?”
From this extreme low sprang the great bull market of the 1980s through the 1990s.
Looking back 42 years before the 1974 bottom was the 1929-32 crash, which ended the roaring 1920s.
And 36 years before the crash ended in 1932 was another watershed bear market. At the 1896 low, the embryonic Wall Street market ended a 15-year secular bear market. In the U.S., this was known as “the great depression” until the 1930s arrived. A Canadian stock market really did not exist then.
In the current outlook, many analysts and money managers remain bullish despite dropping profits, weakening economic numbers and beaten-down commodity prices. However, Wall Street’s record highs of July failed to enthuse many analysts. The reason: such a price breakout needs a big increase in trading volume to be valid. That didn’t happen – daily trading volumes have been below average.
So, the suspicion remains that this upside breakout will fail. Many fundamental and technical factors support this belief. It fits in with the possibility that stocks have been forming a top since 2013, with momentum subsiding through this period.
Although the 2008-09 global market crash ranks with the 1929-32 and 1973-74 crashes in magnitude, it did not go to the extremes of the earlier downturns in dividend yields or price/earnings (P/E) ratios – nor did the 2008-09 crash interrupt the secular rise of stocks for long. Data from the 1929 and 1973 crashes emphasize the difference.
Barron’s 50-stock average provides the best evidence of plunging P/E ratios in 1929-32. While this average dropped by 85%, its P/E ratio dropped from 20.8 to 7.3. The Standard & Poor’s (S&P) composite index was fairly new in the late 1920s, and P/E numbers for it are sketchy. The index stood at 17.6 times earnings at yearend 1928, but this ratio didn’t drop below 10 until 1937, as corporate earnings continued to skid until the end of the next cyclical bear market. But the composite index’s dividend yield soared to 10.3% at the 1932 low from 2.9% in 1929.
During the 1974 bear market, the S&P composite index’s P/E ratio dropped to 7.2 in 1974 from 20.4 in 1971. Conversely, the index’s dividend yield rose to 5.5% in 1974 from 3.0% at the 1971 high. In the 1971-74 bear market, the Dow Jones industrial average’s P/E ratio dropped on a yearend basis to 9.9 from 16. The dividend yield rose to 6.1% from 3.5% .
In comparison to these extreme swings, valuations and yields in the 2008-09 market crash changed less dramatically. The S&P 500 index’s P/E ratio dropped to 18 from 22. The dividend yield rose to 2.68% from 1.80%.
In Canada, the stock market at the end of July stood 7% below its September 2014 record high. That reflects the plunge in earnings on the S&P/TSX composite index: $303, adjusted to the index, at the end of June – a 53% drop from the peak in March 2015.
The TSX index’s dividend payout ratio has risen to 138% as of the end of June – unsustainable in the long run.
In the U.S., growth in operating earnings for firms on the S&P 500 composite index has slowed for several years. In the 12 months ended March (the latest actual data), earnings dropped by 13% from March 2015.
However, analysts are projecting a 12% rise this year, followed by a 20% rise in 2017.
Similarly, growth rates for sales of S&P 500 index companies has been dropping, falling by 3% year-over-year in the fourth-quarter of 2015.
And dividend cuts in June by U.S. companies outnumbered dividend increases for the first time since 2009.
Above all, investors are paying high prices for stocks. To get $1 of earnings from the S&P 500 composite index, investors now pay $25. The “normal” P/E ratio is around 16. In Canada, the P/E ratio was 46 at the end of June.
Official U.S. statistics are suspect, including inflation and employment/unemployment numbers. If calculated using the method when Bill Clinton became president, the consumer price index would be rising at around 10%.
The official 4.9% unemployment rate excludes people who have given up looking for work and those who work part-time.
A recent survey of Wall Street analysts and money managers revealed most believe the actual unemployment rate is twice that level.
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