The long run: the indicators indicate that the market should fall - which has the experts apologizing

National Review, April 21, 1997 by Mark Bulbert

ONE little-noted side effect of this unprecedented bull market is the elaborate theories that bearish advisors have developed to explain why their forecasting models have been so wrong. The phenomenon itself is quite remarkable. Up until now in my 17 years of tracking the investment-newsletter industry, I rarely have come across an advisor who is willing to admit he's been flat-out wrong, much less devote such energy to explaining why he was wrong. That this practice is now commonplace is testimony to the fact that this bull market has risen further and lasted longer than virtually anyone predicted.

Consider the newsletters whose forecasts I reviewed in these pages one year ago. At the time, the best long-term performers were, on balance, quite bearish. Needless to say, they turned out to be quite wrong. What do they have to say for themselves one year later, with the Dow Jones Industrial Average some 1,500 points higher?

Before reviewing the advisors' explanations in these two categories, let's step back and look at why so many top-performing advisors have been bearish over the last several years. There are three valuation measures that almost all of them focus on, and each is overwhelmingly bearish. These measures compare the market's current value to companies' book value, their stocks' dividend yield, and their earnings.

The market's price-to-book-value ratio is perhaps the most bearish of these three indicators. The S&P 500 currently is priced at about 4.4 times the combined per-share book values of its component companies. This in effect means that investors currently are valuing companies at 4.4 times their net worth. In contrast, the average price-to-book-value ratio over the last seventy years has been 1.7 to 1. Even at the stock market's 1929 peak, the ratio never got above 3 to 1. Never before has the stock market traded at so high a level in relation to companies' net worth.

Another historical perspective on the price-to-book-value ratio is provided by recalling how low the ratio fell during past bear markets. At the last two bear-market lows (mid 1982 and late 1974), for example, this ratio stood at around 1 to 1. Currently the book value of the stocks on which the Dow Jones Industrial Average is based is below 2,000.

The market's price-to-dividend-yield ratio is hardly less bearish than the price-to-book-value ratio. Price-to-dividend-yield measures how much investors are willing to pay for a dollar of dividends, and it has never before reached today's level of 53 to 1. All prior bull markets have ended at ratios no higher than about 35 to 1. One way of appreciating how overvalued the current market is is this: the market would have to drop more than 2,000 points for it to trade at what used to represent extreme overvaluation.

The final valuation measure focuses on how much investors are willing to pay for a dollar of earnings. That ratio currently stands at about 22 to 1 for the companies in the S&P 500. The only other times in U.S. history when this ratio has reached such a level came during times of depressed corporate earnings. Never has the ratio stood this high at a time -- like today -- of record corporate earnings.

The long-run norm for the S&P 500's P/E ratio is about 15. This means that for the stock market to trade this year at its long-run norm, it would have to drop more than 2,000 points. At the trough of the 1973 - 74 bear market, furthermore, the S&P 500's P/E ratio stood at around 7. With current earnings that would translate into a DJIA of around 2,000.

JUST as surely as these three measures are bearish, they have been dismal failures. In fact, these measures turned bearish several thousand DJIA points ago. For the last year they have been screamingly bearish. And yet the market has proceeded unrelentingly upward, having now gone more than five years without even so much as a 10 per cent correction.

The response to this from some of the bearish advisors has been to revise their forecasting models. The advisor whose revision makes the most sense to me is John Hussman, editor of Hussman Econometrics and an adjunct professor of economics at the University of Michigan. Before he turned bearish several years ago, his letter had one of the best market-timing records in my Hulbert Financial Digest investment-letter monitoring service.

Hussman has revised his market-timing model to take into account the trend in interest rates. According to his analysis, whenever interest rates are trending lower, stocks tend to go up -- even during periods of extreme market overvaluation. This explains why the stock market has exhibited such resiliency. Indeed, Hussman believes there is no time limit on how long the market can postpone the bearish implications of overvaluation -- so long as interest rates continue lower.

The key word here is postpone, however, not cancel: Hussman remains extremely bearish about the market's long-term prospects. To illustrate, he fed into his models the assumption that the market retreats to a 3 per cent dividend yield from its current level below 2 per cent -- a modest assumption, since a 3 per cent dividend yield would mean that the market is still overvalued by historical standards. If it takes five years for the market to retreat to a 3 per cent yield, the total return for stocks over the next five years would be zero, even allowing for a 6 per cent annual rate of increase in dividends. If the market takes a decade to return to a 3 per cent yield, Hussman calculates that stocks' return for the next ten years would be just over 4 per cent. In either case you could do better by investing in riskless government securities.