By: Brett Arends
Could we see the DOW at 5,000? A true understanding of stock market history shows that Wall Street in the past has moved in long, long swings upwards and downwards, often taking years or even a generation or two. There is a great deal of evidence suggesting that the upward move that began in 1982 is one of them — and that the downward move that first began in 2000 has not ended.
As stock market historian Russell Napier points out in his book “Anatomy of the Bear,” on five occasions in the past 100 years — in 1921, 1932, 1949, 1974 and 1982 — those big downward moves have not ended until share valuations have fallen to just 30% of the replacement cost of company assets. That’s using a powerful, if little-known, economic metric known as Tobin’s q.
And, to cut to the chase, if Wall Street stocks followed the same path today, that would take the Dow down to about 5,000, and the S&P 500 Index all the way down to around 600. (The S&P 500 slumped more than 3% to 1,971 on Friday, extending the drop as much as 5.3% on Monday.)
Yikes.
The “q” is a valuation that they don’t even mention in the training manuals for the official “financial planner” and financial-analyst exams. Your money manager has probably never heard of it. Or, if he has, he probably ranks it with astrology and the mystic rantings of Nostradamus.
But the “q” happens to have by far the most successful long-term track record of any stock market indicator.
It’s been better than the price-to-earnings ratio or quarterly earnings forecasts or economic growth rates or long-term interest rates or Federal Reserve minutes.
Independent analysts — such as professor Stephen Wright at London University and Andrew Smithers at Smithers & Co., a financial consultancy in London — have tracked it back over 100 years.
And in the past there has been no better guide for the long-term investor. It’s been even better than the cyclically adjusted price-to-earnings measure, also known as the “Shiller PE” after Yale finance professor Robert Shiller (which also, incidentally, suggests U.S. stocks could plunge a long way from here).
The “q” looks at the net asset values of public companies and adjusts them for inflation. It makes some intuitive sense. Why would Widget Inc. be valued at $1 billion on the stock market if you could start the company from scratch for a lot less?
Right now, according to data from the U.S. Federal Reserve, the reading on the “q” is about 100%. (It was 106% at the last reading, on March 1, but the S&P 500 has fallen about 10% since then.)
Since World War II, the average “q” reading has been about 70%. So if Wall Street tumbled just to its modern average valuation, that would take the Dow Jones Industrial Average down to about 12,000.
If we just look at the period 1949 to 1994 — in other words, before the gigantic, off-the-charts boom of the late 1990s — the historic average “q” reading for stocks was 57%. If the market falls to those levels, that would take the Dow to about 9,500.
And if the market fell to its historic bear market lows, namely 30% or so, that would mean a Dow of about 5,000.
Why might such a scenario happen? It’s not just about China, or Greece, or slowing earnings, or the “death cross” on Apple’s stock. It would be because, for the past 30 years, Wall Street stock prices have been increasingly boosted by financial factors: collapsing interest rates and Federal Reserve manipulation, culminating most recently in “quantitative easing.” But at some point, that game has to come to an end. When it does, it is possible — not certain, but possible — that valuation metrics could unwind all the way back down again.
Past performance, as they say on Wall Street, is no guarantee of future results. And that means there is absolutely no guarantee that share prices in the future will follow a similar path to the one seen in 1921, 1932, 1949, 1974 or 1982. I would consider that to be very much the outer range of possibilities.
The real reason to be worried right now isn’t that these scenarios are guaranteed or even likely. It’s that 99% of the people managing America’s money, probably including yours, assume that they are completely impossible. And no, they aren’t. Have you factored that into your plans?
