The Big Picture
Currently the stock market as a whole is valued at around 1.3 times GDP. This is significantly down from the peak of 1.7 times achieved in March 2000. The question investors must grapple with is: are we in the early stages of a new bull market or the early stages of a long bear market?
All previous bull markets peaked at much lower percentages of GDP - The peak achieved in 1929 was .87 times GDP.
On Jan 11, 1973, before the stock market started to crash, the multiple was .80 times GDP
At the beginning of the bull market that started in 1982 the stock market was valued at .36 times GDP. It is logical to assume that 1.7 times GDP represents extreme over valuation and that .36 times GDP represents extreme under valuation.
One indicator that helps answer the question is the flow of funds from overseas investors. Historically the major portion of these funds rush in at the peak of a bull market. Conversely overseas investors withdraw most of those funds at the bottom of a bear market. Professionals used this indicator to determine that the market was peaking at the end of 1999.
It is our calculation that the market is much closer to a top than a bottom, and it is for that reason that we trade both long and short, at what we consider short term valuation extremes. We are conscious of the possibility that the market can easily become more over valued and that there is tremendous room for an overall contraction in valuations.
The trend for the last 10 years has been towards disinflation as a result of productivity gains. Productivity gains must continue for current levels of debt to be maintained. The other necessary ingredient is that consumption must continue to support those productivity gains.
Debt as a percentage of GDP is substantially higher than it has ever been so the FED, while being congratulated by just about every economist for creating economic growth without inflation, must be concerned about maintaining stability even as debt liquidation takes place.
Retail Investor Psychology
It seems that most analysts and retail investors are marrying even a mild economic recovery to increased stock prices. Once people begin focusing more on valuations, as I think they are doing right now, there is plenty of room for downward adjustments even in a healthier economy.
Is the retail investor doing better than the leading fund managers? This is a reasonable question to ask because the leading fund managers are negative 2% for the year so far. Does this mean that dissatisfied money is leaving the funds? Further, If money is leaving the funds are individuals taking on the task of portfolio management themselves, and if so what are their expectations?
There are so many people promising to show investors how to double their money in no time flat that I am confident individual expectations are way too high. First of all common sense tells us that achieving those returns means taking extremely high levels of risk. My advice here is to keep an eye on values and dividend yields. Companies can issue pro forma earnings reports but dividends are real, and suggest that the company is financially sound.
Very Important - The bull market lasted from late 1982 to early 2000 - a period of 18 years. From a peak in March 2000 the markets took 72 weeks to arrive at the benchmark low set on September 21. A correction of 18 years of bull market is likely to span at a minimum 25% of the time the bull lasted, but more likely 38% of the time. That's a minimum of 4.5 years and we have only gone 2 years. That is the big picture.
Common Sense as a Guide
Our common sense tells us that there are serious questions about stock market valuations that have to be addressed, even if it is a fact that the economy is coming out of recession. It will take an explosive recovery to justify current stock prices. That does not mean that there are no opportunities in owning stocks. There are, but timing, values, and a lot more need to be considered.
Recessions, and Consumption Levels
Most recessions have been led by a drop in consumption. The recent recession was the exception as it was led by a fall in corporate capital spending. In fact it is the consumer who is being credited with saving the day.
Since consumption represents about 77% of GDP this area of current strength holds the potential for problems in the near future. The reason for this is that current levels of household debt are unsustainable.
Conclusion
There are signs of economic recovery that are encouraging and there are signs of vulnerability that are cause for concern.
While the Dow Jones Industrials show strength, they are not so far being supported by the Transports. Dow Theory suggests that once the industrials are doing better the effect must show up in the transportation averages. Goods that are being produced in greater quantity must be transported by sea, rail, air or road. Therefore an advance by the industrials must be confirmed by the transports. So far the transports have failed to confirm what the industrials are telling us.
Valuations, as well as corporate and consumer debt are at dangerously high levels. While debt liquidation must take place, it must take place without any pullback in consumption.
Colin completed his first real estate development at age twenty-eight, another five by age 34. His first won the Govenor General's Award of Merit for Architecture.
As a Manufacturer he formulated, the popular O'Rileys Rum Cream.
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