Stock Market Long View – Is This a New Era?

by Martin Goldberg CMT. June 24, 2004

Also, "Casinos Under Distribution" and "Some Aggressive Tech. Funds Back In Bear Market"

This short article presents a long view of the stock market performance from early 80's until the present. My trendline analysis suggests that, even though the stock market is well off of its highs of a few years ago, we are still in somewhat un-chartered high ground with respect of stock market valuations. If you believe that we are now in a new bull market, you have to believe that the 8.2% appreciation trendline that began off of historically high valuations in 1987 (at least 5 years into a secular bull market), is not a legitimate trendline because 8.2% per year is not steep enough. In short, you would have to believe that we are in a "new era" of stock market valuations and business earnings growth.

The Roaring 80's

The stock market entered into a roaring bull market that started in the mid 70s. It accelerated during the Reagan presidency into a parabolic move that led into the 1987 crash. The magnitude of the rate of appreciation between 1982 and 1987 is often forgotten in the wake of the stock market behavior of the 1990's and 2000's. The nature of the rapid rise in stock prices, which was fueled by excessive optimism, greed and corruption, was characterized by the popular move of that time, "Wall Street." I'm not suggesting that the movie had any significance, but similar to the two low quality TV series about the stock market that premiered near the height of the internet bubble, popular culture sometimes provides a looking glass into the mood of the day. While not of the magnitude of the March of 2000 Nasdaq bubble or today's, there was clearly an excessive amount of optimism in the stock market at that time. Following the October 1987 stock market crash, the long term bull market resumed. From 1988 to 1995, the stock market, as measured by the S&P 500, appreciated at a rate that averaged approximately 8.2% per year. Even considering inflation, this 8.2% per year rise probably more than represents the amount of growth that can be expected to occur from the underlying economic growth in corporate America's earnings. This 8.2% yearly growth trendline is depicted in the long-term quarterly chart below.

Fourteen years into the new bull market, the trendline probably originated at a level that is equal to or greater than a historically rich stock valuation level.

The Roaring 90's

In 1995, concurrent with the newfound popularity of the internet, the S&P 500 entered into a steep parabolic run (shown in red in the long-term chart above), where it appreciated almost 400 percent in just 5-years. Following the partial bursting of the Internet bubble early in 2000, the stock market crashed back down to (but not through) the 1987 to 1995 trendline. The bounce from the trendline in itself lends technical legitimacy to the trendline. After the bounce off of the trendline, the S&P 500 entered into what I believe, is the mother of all secondary corrections, and now sits very close to its correction high at about 1,144. This trendline is now in the mid-800's.

The 2000's Crash with 50% Retracement Rally

The monthly chart below provides a closer view from the early 90's to the present with the trendline. As you can see after the S&P crash back to the blue 8.2% growth trendline, the S&P recently rallied back to the 50% retracement level at about 1,163 as indicated by the purple Fibonacci retracement lines. Assuming that this is still a secular bear market, principles of technical analysis suggests that the S&P 500 should not surpass the 61.8% retracement level of 1,255. Of course if we are in a new secular bull market, the S&P will trend higher than 1,245 within this bull run.

Where Do We Go From Here?

Are we in a new bull market or are we near the end of a secondary correction within a secular bear market? If you assume that the historically high valuations reached at the origin of the trendline in 1987 were "fair," then there are five logical views of the long-term stock market. I'll summarize them in order of the most to the least optimistic.

We are in a new bull market. The trendline above has no legitimacy and we can expect stock prices to increase from today's levels at double-digit rates, perhaps greater than 8.2%. Old era valuations do not apply to today's corporate America because of productivity gains that didn't affect the business of yesteryear. (Or insert your own rationale.) Expect the rise rate of the market to be more than 8.2%, may be even the 4-fold in 5-year rate achieved before crashing just a few years ago. Corporate America is holding something back that is not yet reflected in today's stock market valuations.
The trendline has legitimacy. We can expect stock prices to rise at a rate (slope) equal to the 8.2% growth trendline. Growth of 8.2% is a normal and expected amount of yearly stock market appreciation because after all of these years, corporate America "figured it all out." Stocks will not drop back to the trendline because of some "special item" or "one time event" rise-dynamic that occurred in recent years. (Insert your own rationale for the "one time event.")
The trendline has legitimacy. We can expect stock prices to drop down to the trendline at about 850 to 950, probably sometime after the election, and then rise in accordance with the average 8.2% rise-rate of the trendline. Corporate America "figured it out", and 8.2% earnings growth is an expected and realistic goal.
The trendline has no legitimacy. Any large publicly traded business would love to achieve 8.2% annual growth as reflected in the trendline, but the nature of competition, as well as supply and demand, will not allow this to occur. Stocks are priced to perfection, and a 4 to 6% earnings and stock appreciation would probably be a more realistic goal for practically all-large corporations to achieve, including technology companies. (Of course no large company management would publicly admit the excessive long-term growth projections implied by current stock market valuations.) In addition, the trendline's origin in 1987 began at already excessively rich stock valuations. Accordingly stocks should drop significantly in the future to reach their fair value, and average a future rise in accordance with a 4 to 6% yearly rate.
The trendline has legitimacy, but only in technical terms. The steepness of the previous parabolic rise in the stock market that occurred in the late 90's reflected excess optimism in the stock market and probably inspired many important misguided corporate decisions that rendered the trendline no longer applicable. These misguided decisions in aggregate, resulted in the current production over capacity and other economic displacements that have not yet been corrected or reflected in stock prices. Post bubble stock market dynamics suggest that bear markets end with public revulsion that lasts at least one generation afterward. This is what occurred after the 1929 crash, and there has been nothing in recent stock market behavior suggesting that post bubble market dynamics will not result in a resumption of the secular bear market. However our recent bubble, which is still not deflated as indicated by the distance between stock prices and the trendline, is much more significant in magnitude compared to 1929. This is apparent by the relatively higher and absurd stock market valuations now compared to 1929. The simplest measure of the overvaluation is the meager dividend rate of the S&P 500, which remains lower than 2% even over a year after tax law changes made it advantageous for corporations to reward their shareholders with dividends. Therefore, when this bubble ends, stocks will be even cheaper by comparative historical terms.

Where do you stand? While the discussion above may not be relevant to the stock market action between now and say, election time, I hope it may give you pause to think about realistic expectations for the long-term money you may have parked in the stock market.

Casinos Under Distribution

In the shadow of the MGM/Mandalay deal, Wall Street is gushing for one of its currently hot sectors - Casinos. Yet traders and investors may want to consider that the stocks appear to be under some newfound distribution as shown in the long-term monthly price/volume sector chart below.

It is also notable that a couple of hot gaming stocks, Alliance Gaming (AGI) and International Gaming Technology (IGT), have produced a couple of spectacular plunges. Finally, an "industry" stalwart, Harrah's Entertainment (HET), is showing technical weakness as shown in the chart below.

I'm not suggesting that you indiscriminately short stocks in this market-leading sector, but it is probably time to take some of your chips off the table.

Most Aggressive Nasdaq-Invested Funds Back Into Bear Market

Some of the most aggressive technology and Internet funds are showing technical weakness. Can the entire Nasdaq index be far behind? Following is an arithmetically plotted chart of an aggressive technology/internet mutual fund dating back to its inception in July of 1999. As you can see, the fund performance has resembled the Nasdaq with a magnifying glass on it. This is due to its very aggressive growth holdings.

Here is the fund's performance over the last year.

The fund sits about 20% off of its recent high in January, and more than 80% off of its March of 2000 high. So while the major indices are close to their recent highs, some of the more aggressive portfolios are already back into the secular bear market. It is notable that while technically weak in the intermediate term, this fund has advanced over 5% in the last 2 days, as it has simultaneously broken to the upside of its neckline of a head-and-shoulders reversal, and its 50-day moving average.

Today's Market

Below are 6-month charts of the major indices and their respective trendlines:

It appears that the indices have broken above their down trendlines, perhaps not yet decisively. As stated by Dr. Alexander Elder in Trading for a Living, Page 88, "How to Draw a Trendline":

"Most chartists draw a trendline through extreme high and low points, but it is better to draw it through the edges of congestion areas 'Those edges show where the majority of traders have reversed direction. Technical Analysis is poll-taking - and poll takers want to track opinions of masses, not of a few extremists. Drawing trendlines through the edges of congestion areas is somewhat subjective'"

So while it appears that the trends have been broken, perhaps we are viewing the opinions of a few extremists. If the indices maintain their residency above the trendlines or break about 3% above the trendlines, then of course, we can consider the downtrends broken. The next few days are critical in determining the intermediate trend of the market. A decisive break back below the trendline would suggest technical weakness that could carry the Nasdaq back to about 1,900.

After yesterday's rally, today the indices performed in a way that any hot guru would suggest is "just what you would like to see". Each index pulled back on lower volume than the day before. The Dow and S&P 500 were each down about 1/3 of a percent, and the Nasdaq was down 1/4 of a percent. It seems as though those stocks that were down the most from the January top carried the rally of the last few days. Example: the fund whose chart is featured above was up marginally today in an overall down market.

The economic data was just lousy enough to support the bond market without hurting stocks too much. The big question that seems to be debated regularly in the media is whether the Fed will increase short term lending rates by 1/4% (which will be inadequate to fight inflation), or by 1/2% (which will be inadequate to fight inflation). The 10-year note price closed up 0.42 to close at 108.97. Here is the weekly chart showing that the intermediate trading range remains intact.

Gold produced a big decisive upside candlestick today and closed over $400/ounce. Whereas in the last few months there was little premium on "truth" as indicated by the performance of precious metals; maybe the tide is changing.

Silver was up big today as it gapped up $0.28 per ounce. I'm not sure, but I think this is technically bullish. Hold on to your hats!

The dollar finished down against practically all-major currencies. It appears that the dollar having just broken its downward trendline was measuring the opinions of "a few extremists." Again, I'm with Warren Buffett on the dollar.

Have a great evening!

Martin Goldberg

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Martin F. Goldberg CMT | Market Commentator
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