Dow Jones all time new highs – don’t be fooled

March 9, 2007

S&P 500 Historical Chart illustrating secular trends

>> This chart took me quite some time to piece together* but I feel it was time well spent to make an important point: we are trapped in a period dubbed a secular bear market** in American (and Western Equities) – likely to last another 15 to 20 years; refer to the Dow Gold Ratio chart

>>So how exactly can this be true given that the Dow Jones is making all time new highs and the S&P500 is edging ever closer to its 2000 high?

>> Referring to the chart above, we observe that US equities (measured using the S&P 500 barometer) have had the tendency of either trending upwards for extended periods or remaining in a trading range lasting several years. The earlier phenomenon, referred to as a secular uptrend in equities was keenly observable over the periods 1921-1929,1949-1966 and 1982-2000, whereas the latter occurence coined a secular downtrend(or bearmarket) – a period in which US equities have either fallen in price or oscillated in a trading range – was evident over the years 1900 – 1921,1929-1949 and 1966-1982

>> Also observable in this chart is the fact that secular uptrends in US equities have been demarcated by periods of rising P/Es §, otherwise known as valuation expansions and secular downtrend(secular bearmarket) phases have been defined by periods of valuation contractions (falling P/Es).

>> Like prices, P/Es are witnessed to oscillate like a pendulum – rarely settling at fair value and frequently swinging from extremes of overvaluation to undervaluation and back again over a number of years. Over the period 1966-1982, despite a 190% growth in earnings, P/Es contracted from a high of 25 to a low of roughly 28, coinciding with a secular bearmarket in US Equities at the time. In other words, it’s not enough for earning to be growing – the rating on those earnings must be growing as well, to realise a secular bullmarket in equities.

>> Another interesting fact to point out,based on this chart, is that despite the S&P 500 ending up at roughly the same point in 1980, than it started at in 1966, the index lost over 60% of it’s value to inflation over this period (see inflation adjusted chart)! The same trend is observable over the periods 1900- 1921 and 1929 – 1949. Secular bearmarkets simply do not provide sufficient protection to your capital from inflation.

>> A buy and hold strategy for US equities over these periods simply DOES NOT work, for this reason! In order to make money from equities over these period, active management (stock selection and trading the cycles becomes critical to success).

>>Now, coming back to the question we started off with :”How exactly can the Dow Jones(American Equities) be in a secular bearmarket given that it’s making all time new highs?”

>> The bubble in US equities in 2000 bolstered valuations to astronomical levels (observe how far valuations trended over this period above the overvalued level!) – a high of 45 in contrast to the historical mean of 17! Since then, US equity valuations have been in a period of contraction ( a simple 5 year moving average of historical PEs has been trending lower since the bubble peak in 2000) and are not likely to stop until they become very cheap – called a secular bearmarket! Also supporting this belief is the fact that despite the Dow Jones having surpassed the 2000 high (partly due to it’s orthodox construction), it is currently 10% below this value in inflation adjusted terms, whereas the S&P500 – a much more representative bellweather for corporate America, is currently 21% below it’s 2000 high! All these facts have portended to a secular bearmarket in US equities.

Dow & S&P inflation adjusted

Dow & S&P 500 inflation adjusted performance compared to original Dow & S&P 500

>> There are other facts that support this theory – such as the mass retirement of the baby boomers from some time in 2008 onwards, which is likely to put a strain the US economy and especially the health care sector. We won’t try to predict this ,we’ll just keep monitoring the charts.

>>Putting these facts together, what this means is:

  • We are likely to see the dow/S&P 500 continue trading in a range for several years to come, at times possibly testing the range but failing it.
  • Inflation adjusted, both indices are likely to continue falling – you are really losing capital!
  • A buy and hold strategy applied to US and Western Equities is destined to fail – active management is needed in the form of superior stock selection and trading the cycles within the range
  • On a buy and hold basis, US treasuries are likely to outperform US equities over this period.

>> So the next time you hear that the Dow has made a new all time high, just calm down before you jump through a hoola-hoop with your investment money.

* Special thanks to Robert J Shiller for providing the historical data.

** Secular trends are trends that last for secular (very long) time frames – practically the working life of an individual(15-20 years). See chart.

§ Price Earnings Ratios measure the price paid to participate in the earnings of a company. The lower the P/E paid, the cheaper the price paid. As a rule of thumb, the P/E measures the number of years to recouperate an investment.


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