Cut in Half
We were at the World Financial Center on Thursday last
week, on a tour of New York’s commodity exchanges.
On the lapel of an old traders’ jacket hanging in one of
the display cases of the museum, we spotted a pin. It said
"The man who is a bear on the future of the U.S. will go
broke — J.P. Morgan"
J.P.’s message was timely. The next day strong job numbers
were released and the Dow made a new three-and-a-half year
"U.S. employers added 262,000 workers in February, the most
since October, suggesting companies have greater confidence
in the economy," said Bloomberg that day. "Wages were
unchanged, allaying concern about faster inflation."
On Monday the Dow rose again, breaching 11,000 for the
first time since June 13 2001. It is now just 900 points
from an all-time high.
This positive price action made us question our belief in a
secular bear market. But that’s what Mr. Market does. He’ll
aim to sweep you up in his latest trend and then cast you
to the heap.
So periodically, we delve into some of the books on
historical market valuations to sooth our concerns…We
grabbed A Modern Approach to Graham and Dodd Investing by
Thomas P. Au.
It’s not hard to argue that equities are fundamentally
overvalued. On almost any measure – dividend yield, p/e
ratio, discounted cash flow valuations – the major indices
are massively overvalued in relation to historical
Au uses a different measure of value…he calls it
Underlying Investment Value (calculated as book value plus
10-times dividends). Ben Graham developed this measure, and
operated under the theory that a price of one half of
investment value represented a bargain.
"The Dow actually traded at close to investment value
through the early 1970s, until the 1973 oil shock caused a
plunge that pushed the Dow below investment value, a
condition that lasted until 1985," Au shows. "In the late-
1980s, the Dow traded at a modest premium to investment
value as leveraged buyouts and corporate restructuring
promised to raise earnings growth above their historical
trendline. The Dow widened its premium after the Persian
Gulf war and the collapse of the Soviet Union in 1991. The
premium became a chasm in 1995, and remained that way
several years into the 21st century."
With the Dow at 10,787 in 2000, the author calculated IV to
be 3,036, valuing the Dow at a 255% premium to its
underlying investment value.
Some said it was a new era, but not Graham and Dodd
investors. "The world is probably following a pattern that
has been displayed many times before," explains Au. "It is
manifested in the willingness to ignore time-tested
principles in the name of ‘progress.’"
So the question is, how low can the Dow go?
"The historical experience from the 20th century suggests
that stock values grow at nearly 7% real (assuming that
dividends and inflation offset each other)," writes Au. "At
this rate, they would double every 10 years, go up four
times every 20 years, and 8 times every 30 years. Knowing
this fact, and hypothesizing that previous peaks will not
be regained for almost 30 years, one can divide the
previous peak by 8 to arrive at a discounted interim value
for the Dow, in much the same way as one could do with a
"Rounding the year 2000 peak upward to 12,000 and dividing
by 8 gives 1,500 as an indication of how low the Dow could
go past the year 2000. This figure is roughly one half of
the 3,000 "investment value" [calculated in 2000], a
relationship that approximates to the previous market
bottoms in 1932 and 1974. The Dow may trough at a somewhat
higher number, but mainly because of adjustments for
The message is simple. A simple reversion to fair value
would cut the Dow in half, and then some. It may seem
unlikely, but who are we to argue with history…?
Penny Stock Fortunes
Did You Notice…?
By Tom Dyson
Greenspan described the bond market’s recent behavior as a
"conundrum." Rates fell, he noticed, despite his vigorous
efforts to reflate the economy.
The chart below, sent in to us by a reader, shows U.S.
credit market debt as a percentage of GDP. Note that
Chairman Greenspan took control at the Fed in 1987…
"Pure and simple," says the Wall Street Journal, "it seems
to us, the credit spree that the chairman has so vigorously
played so prominent a role in engendering all these years
explains the increasing insouciance with which the bond
market responds to his official posturings."
"They don’t call him ‘Easy Al’ for nothing."
The Day the Buying Stopped
And the Markets…
WTI NYMEX CRUDE