The Mother of All Bottoms?
by Martin Goldberg CMT. October 2, 2003
Business TV coverage of the stock market is slanted and in general, fundamentally wrong. I've pretty much dismissed TV as a source of anything of real value. I watch it occasionally for a laugh and as a contrary indicator. For example, TV personality and economist Larry Kudlow routinely calls the stock market of October 2002, "The Mother of All Bottoms." How can he seem so sure? In respect to his title, "economist", let's examine October 2002 stock valuations relative to historic stock market valuations.
In this article, I will demonstrate why October of 2002 was not a major bottom, but stocks were actually fundamentally quite expensive by historical standards at that time. Below is data for the S&P 500 index that was assembled by Benjamin Graham and presented in, The Intelligent Investor, Fourth Revised Edition. I have added present day data to the Table 3-3 originally published in Graham's book, including the fundamental data that would correspond to our Tim Wood's estimated S&P 500 bottom of 315 which he based on technical analysis (link: last Friday's market wrap-up). The years selected by Graham and outlined on the Table correspond to years around the release of each successive edition of the Intelligent Investor. The years included on the Table do not include any major stock market bottoms. Therefore, when we compare valuation metrics from Kudlow’s October 2002 “bottom” to previous years outlined in the Table, we are comparing his declared “bottom” to other more typical stock market years.
Table 1. Data Relating to Standard & Poor's Composite Index in Various Years
|Year (b)||1948||1953||1958||1963||1968||1971||Oct '02 “Mother of All Bottoms”||2003|
|Tim Wood’s Tech. Analysis Bottom|
|Closing Price||15.20||24.81||55.21||75.02||103.9||100 (d)||768||996||315|
|Earned in current year||2.24||2.51||2.89||4.02||5.76||5.23||30.04||34.70||34.70|
|Average earnings of last 3 years||1.65||2.44||2.22||3.63||5.37||5.53||27.35||32.70||--|
|Dividend in current year||0.93||1.48||1.75||2.28||2.99||3.10||15.80||16.17||16.17|
|High-grade bond interest (a)||2.77%||3.08%||4.12%||4.36%||6.51%||7.58%||6.10%||5.80%||5.80%|
|Price/last year's earnings||6.3||9.9||18.4||18.6||18.0||19.2||25.6||28.7||9.0|
|3-years "earnings yield" (c)||10.90%||9.80%||5.80%||4.80%||5.15%||5.53%||3.56%||3.20%||--|
|Stock-earnings yield/bond yield||3.96%||3.20%||1.41%||1.10%||0.80%||0.72%||0.58%||0.55%||1.90%|
|Dividend yield/bond yield (e)||2.10%||1.80%||0.80%||0.70%||0.44%||0.41%||0.34%||0.27%||0.89%|
Table 1 Footnotes
If we examine the Kudlow-touted October 2002 “mother of all bottoms,” we can see that in comparison to previous years, the S&P 500 index was actually expensive. The dividend yield at about 2% at Kudlow’s “mother of all bottoms” is extremely meager on a historic basis. In the past, TV experts and many journalists have dismissed recent low dividend rates based on dividends being “out of vogue.” Now that dividends are back in vogue, they are still very low relative to historic stock valuations. Clearly on a dividend payout basis, (either last year’s dividends or today’s), expensive stocks characterized the October 2002 “mother of all bottoms.” Similarly, on a stock-earnings yield to bond yield basis and dividend yield to corporate AAA bond yield basis, stocks were expensive at Kudlow’s “mother of all bottoms” and are much more expensive now.
Last Friday, your knee-jerk reaction may have been to dismiss Tim Wood’s technical-analysis-estimated S&P 500 bottom of 315 as ridiculous. (That was my first reaction.) It’s difficult for most people to visualize the S&P 500 taking a 68 percent drop from today’s levels. Let's take a look at the fundamentals corresponding to Tim Wood’s estimated S&P 500 bottom of 315, on the table above based on todayVs earnings, dividends and corporate bond rates. A “bottom” of 315 results in a dividend yield of 5.13%, which is actually a bit less than the dividend yield of 5.6 and 5.5 percent that occurred in 1948 and 1953, respectively. It is not unreasonable to think that such payout ratios could not ever occur again. That is unless the basic rules of economics and human nature have changed. Do you think they have?
At Wood’s S&P 500 bottom of 315, the earnings to bond yield ratio of 1.9 percent is significantly less than 4, and 3.2 percent in 1948 and 1953, respectively. Therefore, on that basis, stocks would not even be cheap at an S&P 500 level of 315. Similarly, the corresponding dividend to AAA corporate bond yield ratio of 0.89 that would occur at S&P 315 would not be historically inexpensive either. It is also about 12% less than at 1958 year end. It took three years for the S&P 500 to break above its 1958 year-end level of about 55. Again, there is no fundamental reason why such valuations that occurred in the past will not occur again.
Surely, the forward-looking market is not anticipating growth of earnings and dividends to justify or even surpass today’s levels. The S&P 500 trades at a multiple of 18.5 times its 2000 IPO-bubble-boosted peak earnings level of $53.70 – its best year ever. If years like 2000 would return again soon, today's stock market levels would still represent expensive valuation!
(I should mention here that the earnings referenced on the Table are those according to generally accepted accounting principles (GAAP). If you evaluate "operating earnings" or any "pro forma" metric, then the current valuations look more reasonable (but still expensive). In today's stock market, the relationship between any company-published non-GAAP earnings number and GAAP earnings is similar to the relationship between reality TV and actual reality. I believe that in the historic data cited by Graham before the 80's, there was basically only one earnings number typically published. Using GAAP for today's data enables us to compare today's data with yesterday's on an apples-to-apples basis.
Why the Disconnect In Valuations? Speculation
Why is there such a difference between the historic valuations cited and those that we have in our current stock market? The reason is that for a period of several decades, the stock market has traded mainly as an object of speculation. That means stock market transactions occurred with buyers and sellers that were not seeking an actual return on their investment. As with any other business, returns on investment typically consist of dividends and increases in shareholder equity through retained earnings. However, as objects of speculation, buyers' and sellers' transactions are purely to buy something for a price, and sell it in the near future at a higher price. Speculation is still the prevailing influence in the stock market. This is evidenced by the underperformance of dividend paying stocks versus more speculative options-bleeding stocks immediately after the new tax laws were passed.
As Charles P. Kindleberger states in Manias, Panics, and Crashes – A History of Financial Crises (parenthesis notes are mine),
"Pure speculation, of course, involves buying for resale rather than income in the case of financial assets". Excessive gearing (overtrading) arises from cash requirements that are low both to the prevailing price of a good or asset and to possible changes in its price (margin) "As firms or households see others making profits from speculative purchases and re-sales, they tend to follow: 'Monkey see, monkey do.'"
Overtrading – Evidence of a Bottom Not Seen
What we are seeing in the US economy over the last few years is described by the bubble economic cycle and is as old as the hills. The corresponding stock market reaction is also very predictable in its long-term trend. (And more difficult to predict in its intermediate trend.) I recommend reading Kindleberger's Manias, Panics, and Crashes. There also is a more concise description of the economic boom-bust cycle of emerging markets in the excellent book, Tomorrow's Gold – Asia's Age of Discovery, by Marc Faber.
A detailed description of what we are seeing in the economic cycle is beyond my scope for this Market Observation issue. However, I would like to focus on the continuing presence of overtrading as one more piece of evidence that we have yet to experience the "mother of all bottoms" in the current bear market. According to Faber, there are six phases to a market cycle, consisting of the spark, recovery, boom, down-cycle doubts, realization, and capitulation (and the bottom). One important characteristic of the capitulation and the bottom is that investors give up on stocks. At the bottom according to Faber,
"Volume is down significantly from the peak levels reached in phase three – usually (down) 90%."
We are clearly seeing a continuation of overtrading in today's stock market that indicates we have not seen the bottom. Two weeks ago I wrote about how many large cap tech and internet stocks still routinely turnover in a period of a few months (See). Such rapid turnover of shares is clearly an obvious indication of overtrading. At the NASDAQ's hyper-bubble peak in March of 2000, the monthly share volume traded was 43 billion. This September, the NASDAQ has traded about 39 billion shares. This is very close to volume at the ultimate bubble March 2000 peak. Therefore overtrading is very similar today to the March 2000 NASDAQ peak.
Similarly, prior to Kudlow's "mother of all bottoms" in September of 2002, the NASDAQ traded about 29 billion shares. This is about 60% of today's almost record high volume levels, but far from capitulation or give up levels. Also, these relatively low volumes lasted only a couple of months before picking up to near the current trading levels.
What is truly alarming is to see the recent big increase in margin loans as indicated in Barron's last week. Speculators are assuming this margin. Clearly this is another indication that the recent market has not ever capitulated or "given up." The rising margin debt is an accident waiting to happen. To believe today's market doesn't have to capitulate or give up before a new long-term bull market can occur; you would have to believe that an unprecedented market recovery would follow the biggest stock market bubble of all time. Could it be that since we now have CNBC, something has fundamentally changed? Not likely! 1929 had its popular market gurus and celebrity CEOs as well!
Although there are many other examples, I will cite one example of an entire stock market capitulating or giving up, thereby signaling a long-term market bottom. In 1929 at the stock market peak in October, the Dow Jones Industrial Average (DJIA) stocks traded 142 million shares. At the eventual bottom in June of 1932 the DJIA stocks traded just 23 million shares, only 16 percent of the volume at the peak. This was not overtrading. It was capitulation. It was the bottom.
Have we seen our Mother of All Bottoms? I don't think so!
Not much of importance happened in the market today. Federal Reserve Officials' talk of accelerated economic growth made the bond market drop. Gold was about even, and gold stocks were generally up. The Dow, S&P 500, and NASDAQ each finished up about 0.2 percent on low trading volume.
There seems to have been a recent trend of higher volume sell-offs, and lower volume rallies. This is something to keep an eye on for the near term future.
Have a great evening!
(Observation graphic from Elyse Goldberg, Martin's daughter.)
- Yield on S&P AAA bonds.
- Calendar years in 1948-1968, plus year ended June 1971.
- "Earnings Yield" means the earnings divided by the price in %.
- Price in Oct. 1971, equivalent to 900 for the DJIA.
- Three-year average figures.
© 2003 Martin Goldberg