Current Market Valuation: Deciphering the Randomness

The Dow lost another 139 points on Friday. Now the stock market is in a downtrend. Is it THE downtrend? Or just another random move, of no particular importance?

Hard to say.

We began questioning our faith last week. Why do we think there’s a bear market in stocks? Why do we think stocks will go below 5,000 on the Dow? For a minute, we couldn’t remember.

We weren’t questioning our reasoning; we were asking much deeper questions. Of course, we don’t want to buy stocks – they’re expensive. And the economy is worse than people think

But what we were wondering about is the idea that stocks move in long trends that take them from epic highs to epic lows. Of course, it is obviously true. Stocks go up and down. They’re bound to hit extreme highs and extreme lows from time to time. Then, when you look at the pattern, it’s going to look like the stock market knew where it was headed. That is, the motion of the stock market could be purely random, just like the finance professors say. Even so, it would still move from a very high point to a very low point.

So what’s the difference between random movements and the patterns that the random movements make? To put it another way, what is it about reality that makes it possible for it to appear completely random and completely organized at the same time?

Or, what if God made it appear that he didn’t exist? What if everything happened in an apparently random way, but according to a plan that was too subtle for us to understand?

Whoa…this is, like, getting heavy…and deep. We’re already in over our heads.

So, let’s back up. Let’s say you knew that the stock market is theoretically random. But let’s say you also knew that this random motion had been headed down for the last 10 years…and that stocks were still not even half as cheap as they were the last two times random motion took it to an epic low? What would you say?

Well, “watch out!” That’s what we’d say.

Our position is that the market is almost random – but not quite. It is so random that almost everything it does can be explained by randomness. It is so random that it is almost impossible to beat with any ‘intelligent’ system. It is so random that it will drive a thinking man mad if he spends too much time thinking about it.

And yet, for all its randomness, it looks to us as though there is a pattern.

29 – 66 – 99

Those numbers were the years in which the Dow hit major highs during the 20th century. Note that they are separated by periods of 33 to 37 years – roughly the period of a human generation.

Bonds do more or less the same thing. From a low in ’49, bond yields rose until ’81 – 32 years. Then, they began an epic decline, which continued until 2008 – 27 years. (This trend may not be over).

The big trends tend to last about as long as a generation. Why? Because one generation learns; the next forgets. After the Crash and Great Depression there was no way investors were going to bid up stocks to ’29 levels. The old timers had to retire…and a new generation of investors had to take over.

Of course, this is just a hypothesis. All we know is that when we look back at the stock and bond markets, we see long trends, punctuated by extreme highs and extreme lows. So, when an extreme high is reached, an investor is well advised to sell. The next extreme will be an extreme low. It can take 10 or 15 years to arrive. But it is a miserable time to be in the stock market.

On the other hand, after an extreme low, an investor has little fear and a lot to gain. All he has to do is buy, sit tight…and hope he lives long enough to take advantage of it.

Where are we now?

It looks to us as though we are 10 years into a bear market. The extreme was reached in ’99 – when tech stocks were trading at extraordinary prices. In the years following, the Dow actually went considerably higher. But adjusted for inflation, the Dow never actually set a new record. The period 2000-2007 was a bit like the period following the ’66 top. High levels of inflation made it hard to see what was happening. The Dow rose to the ’66 level two years later…and never registered deep losses. But year after year, inflation cut the real value of the index…wiping out about 75% of investors’ money over the next 15 years.

Even before inflation is taken into account, stock market investors made nothing during the last 10 years – not in the US. They ended the decade about where they started it.

But this leaves the trend incomplete. Stocks have still not gotten down to super-cheap levels. Look back. The last extreme was on the upside. That means the next one should be on the downside. And it must be extreme – say, Dow below 5,000. Otherwise, the long-cycle prophecy won’t be realized.

For every extreme high there is an extreme low. Otherwise, nature would be out of balance and Heaven would be unfulfilled. So, until we finally reach an epic low…an epic low still lies ahead. And until that time, the souls of dead value investors and grumpy perma-bears are doomed to walk the earth… They can never relax. They can never sit down and have a beer. They will never be satisfied. Only when the Dow finally sells for 5-8 times earnings will they get to say ‘I told you so.’ Then, they can take up their eternal rest.

It is coming, dear reader; it is coming…

Bill Bonner
for The Daily Reckoning

The Daily Reckoning