A Brief Update on Equities and Gold
By Tim W Wood CPA, October 23, 2009
The bullish Dow theory trend change that occurred in association with the advance out of the March 2009 low still remains intact. Cyclically, the advance out of the March low also still remains intact. Intermediate-term, equities are overbought and I do see weakness on the horizon. The key to this materializing will be the downturn of my intermediate-term Cycle Turn Indicator.
Longer-term, my research continues to tell me that this is still a bear market rally within the context of a much longer-term secular bear market. Robert Rhea, the great Dow theorist of the 1930’s wrote:
“Bear markets seem to be divided into three phases: the first being the abandonment of hopes upon which the final uprush of the preceding bull market was predicted; the second, the reflection of decreased earnings power and reduction of dividends, and the third representing distressed liquidation of securities which must be sold to meet living expenses. Each of these phases seems to be divided by a secondary reaction which is often erroneously assumed to be the beginning of a bull market.”
From a Dow theory perspective, I continue to view this as the rally separating Phase I from Phase II of what should ultimately prove to be a very long and very ugly secular bear market. I totally realize that this may be a difficult concept to grasp, but this comes as no surprise to me. In 1929 the Phase I decline carried the market down into the November 1929 low. From that low the market rallied into April 1930. As I read the writings of that period it is obvious that they too found it hard to believe and the politicians of the day tried desperately to convince the masses, and probably themselves, that the bear market was over. But, in spite of the efforts to hold things together and in spite of the propaganda spread by the politicians of the day, the bear market resumed and ultimately found its low after an additional 86% decline into the Phase III low in 1932.
During the secular bear market of 1966 to 1974 the Dow theory warned that the rallies into the 1968 and 1973 highs were bear market rallies. Yet, few believed this and again the politicians and media tried to convince the world that the decline was over. Ultimately, the secular bear had his way and the final Phase III low came in December 1974 after a 46.58% decline from a new recovery high in January 1973. It was at the December 1974 low that Richard Russell announced in his December 20, 1974 Special Report that “We are finally in the zone of Great Value.” It was then in Mr. Russell’s January 24, 1975 letter that he gave the hurdles that had to be bettered in order for Dow theory to confirm a primary trend change. The benchmarks were then bettered on January 27, 1975 and in Mr. Russell’s February 5, 1975 issue he made the official call of the Dow theory bullish primary trend change.
The key to Mr. Russell properly calling this low, from my eyes, was that in spite of the propaganda and erroneous media reports throughout that period, Mr. Russell understood the Dow theory, and more importantly the phasing and value aspects of Dow theory. As a result, he was able to navigate that great bear market and to recognize the bear market bottom when it appeared. The same disciplined approach was used by George Schaefer during the 1950’s and 60’s to navigate that great bull market. Before that, Robert Rhea used the Dow theory to call the 1932 bear market bottom and William Peter Hamilton before that to call the 1929 top in his famous editorial in the Wall Street Journal titled “A Turn In The Tide." My point here is that Dow theory can guide us this time around as well if we have the ears to listen to what it’s telling us.
I have discussed the phasing of this bear market with Mr. Russell. I explained to him that based on my read of the Dow theory that the March 2009 low appears to have only marked the Phase I low and that the ongoing rally should ultimately prove to separate the Phase I from Phase II of the ongoing secular bear market. Mr. Russell agreed with my assessment at that time and to date I’m not aware of anything that has changed this assessment.
From a value perspective, history shows that the dividend yield and the P/E will be roughly at par at true bear market bottoms. As an example, I show that the yield on the S&P at the 1932 low was 10.5 with a P/E just under 10. At the 1942 low the yield was 8.71 with a P/E of 7.3. At the 1974 bear market bottom I show the yield on the S&P to have been at 5.9 with a P/E of 7.24. Even at the 1982 low the yield was 6.2 with a P/E of 6.9. At the March 2009 low I show the yield on the S&P to have been at 3.58 with a P/E of 24, which has historically been considered overvalued. At present, I show the yield on the S&P to be 1.99 with a P/E of 144.83. Yes, that is right. The current P/E, based on Generally Accepted Accounting Principle, is one hundred forty four. The historical P/E ratios at the previous lows were also calculated using Generally Accepted Accounting Principles, so these numbers are consistent. If you are seeing any other number showing much lower P/E’s it is because it is a George Orwellian phony bologna calculation. If the S&P were to trade with a GAAP P/E of 20, which has historically been considered overvalued, it would be at 150. If the S&P were to trade with a P/E of 15, which has historically been considered to be fair value, it would trade at 113. My point here is that at the March low the P/E and the yield were no where near par and thus the market did not reach levels in which true secular bear market bottoms are made. Plus, with the spread between the current P/E and the yield at an historic 142, the market is grossly overvalued. This will ultimately be corrected with the Phase II and Phase III declines. If you have not read my article on Bull and Bear market phasing I urge you to read the August 14th Market Observation.
As for gold, I reported here in the October 9th Market Observation that gold was in uncharted waters and that I believed that the 9-year cycle was stretching. In light of the recent advance above the March 2008 high, which marked the 9-year cycle top, current developments suggest that perhaps the 9-year cycle is not stretching and that perhaps it did bottom in October 2008. If so, we truly are in uncharted waters. As of this writing, gold remains positive as the bear market rally separating Phasing I from Phase II of the ongoing secular bear market continues.
Tim W. Wood
© 2009 Tim Wood