Rechecking our Dow 50,000 Forecast
Once any major forecast has been made, and most especially if it is working, the key is to spend
as much analytical time, if not more, on where the forecast can be wrong. As a matter of further
discipline, we try to read three Bearish forecasts every day; fortunately or unfortunately, they are
easy to find.
After discussing where we think we could be wrong (Deflation), we will restate our Case for
Dow 50,000 by looking at valuation through 1) Stocks versus Bonds, 2) Stocks versus
themselves by the Numbers, and 3) Stocks versus themselves relative to the Generational
Fear/Greed MegaCycle. Easily the most popular Bearish case today is that stocks are some type
of "Asset Bubble." We trust our discussion below will debunk this "Bubble" notion.
In order to reach our Dow 50,000 forecast (40,000 if dividends are not reinvested), the stock
market needs to compound from now to the end of 2025 at less than a 10% annual rate -- 9.8% to
be exact. While 9.8% may be a greater return than the market generates over a complete
MegaCycle, 9.8% is not very impressive if, as we believe, we are in the Secular Bull Market
phase of this MegaCycle. By comparison, from this point forward in the last two Secular Bull
Markets (1950 - 1972, and 1982 - 2000), the market generated compound annual returns of 13%
and 17%.
If we are going to be wrong on our Dow 50,000 forecast, we believe Deflation will be the culprit.
Our working assumption is that politicians and Federal Reserve Boards have mastered the art of
creating inflation. For the last twenty years, inflation has been neither too high nor too low. But
as Japan has discovered for more than a decade, low inflation can turn into Deflation and
Deflation is tough to reverse.
Deflation causes consumers and investors to defer action, which, in turn, raises hell with the
economy and the stock market. When it comes to deflation, we believe that the Fed is your
friend, particularly Chairman Bernanke. The growth of the economy over the next few years
will be the most important determinant of the historical grades for Chairman Bernanke's
leadership. However, Chairman Bernanke also leaves behind a strong imprint of lecturing and
warning against the perils of deflation. Clearly, part of Bernanke's legacy is an army of
economists at the Fed who are watching and ready to take action if there is even a whiff of
deflation.
The most popular bear case is not Deflation but that the current stock market is in some sort of
Asset Bubble. As we will try to show, Stocks are very attractive whether we look at 1) Stocks
versus Bonds, 2) Stocks versus themselves by the Numbers, or 3) Stocks relative to the
Generational Fear/Greed MegaCycle. In our opinion, Stocks are nowhere near an "Asset
Bubble."
Stocks relative to Bonds.
Let me ask you to trust me so that we can keep this section simple. (If you don't trust me or you
want the mathematics, give me a call.) Stocks are more volatile (riskier) than bonds. Therefore,
to entice investors to own stocks, stocks perforce must return more than bonds. Over the long
run, stocks do return more than bonds and the differential is the dividend yield. The dividend
yield is the so-called Equity Premium and averages some 2 - 3% per year.
Over the long term, this means that stocks ex their dividends must have the same return as the
10-year Treasury Bond, which is the traditional bond benchmark. Since neither the Dow nor the
S&P includes dividends in their Index Calculation, the return from these indexes over time have
to equal the return from the 10- year Treasury Bond.
Here is where the trust comes in: If the return from the stock indexes equals the return from the
10-year Treasury Bond, this means that the Treasury Bond Yield over time must equal the
Earnings Yield (the Earnings of the Market divided by the price of the Market or the inverse of
the P/E ratio). As the chart below shows, the Earnings Power Yield divided by the Treasury
Bond Yield is near parity or essentially equal over time. (Earnings Power is a statistically
"smoothed" series of the actual Earnings.)
(Earnings Power Yield)/(Bond Yield)
1962 to date
4.50
4.00
3.50
Median is 1.0, Average is 1.1
3.00
2.50
2.00
1.50
1.00
0.50
0.00
1960
1970
1980
1990
2000
2010
However, there can be big discrepancies along the way. The general rule is that when the Bond
Yield is larger than the Earnings Yield, bonds are more attractive. Conversely, when the
Earnings Yield is greater than the Bond Yield as it is today, stocks are more attractive.
Today the Earnings Yield is 5.8% vs. 2.6% for the Bond Yield. This is a ratio of 2.2, which is a
significant deviation from the historical mean of parity or one. This gap must be closed by either
the Bond Yield rising (bond prices going down), or the Earnings Yield declining (stock prices
going up), or some combination of the two. But clearly the current Earnings Yield to Bond
Yield Ratio of greater than 2 shows that stocks relative to bonds are very attractive. Put
another way, stocks relative to bonds are not in an Asset Bubble.
Stocks relative to themselves by the Numbers.
As the chart below shows, stocks have historically had an average Price Earnings Multiple of
16.4. (10-year Treasury Bonds have had an average yield of 6%. Per the above, the Earnings
Yield has to also be 6%, which translates to a theoretical 16.6 Earnings Multiple.)
S&P Multiples
based on Earnings Power
40.0
35.0
30.0
25.0
16.4 Average
20.0
15.0
10.0
5.0
0.0
1960
1970
1980
1990
2000
2010
2020
However, a much better statistical fit for the P/E ratio is to adjust the theoretical P/E ratio for the
current bond yield which, in turn, is importantly a function of inflation. Since higher inflation
makes future earnings and dividends less valuable, higher inflation translates to not only higher
bond yields but also to lower P/E multiples. The opposite is also true as lower inflation
translates to higher P/E multiples. With the current inflation rate running less than 2%, the
theoretical P/E ratio should be 21-22-23. At the current multiple of 16.5, stocks compared to
their historical valuation numbers are nowhere near an Asset Bubble.
Stocks relative to the Generational Fear/Greed MegaCycle.
Sociologists/psychologists define a generation as 30 years. Judging by stock market history, we
investors are taught and re-taught the lessons of too much greed and too much fear once a
generation. Think of the MegaCycle from 1950 to 1982 with the top in 1972 and think of the
MegaCycle from 1982 to 2009 with the top in 2000. Stock market history shows that
emotionally we humans move from Extreme Fear to Extreme Greed and back again. At times of
Extreme Fear, the market multiple is very low; whereas, at times of Extreme Greed, the market
multiple is very high.
Fear and Greed manifest themselves in Confidence, which has a profound influence of the
cyclicality of the economy. In essence, the economy is a huge flywheel that has three
interdependent variables -- the stock market, economic growth and the credit cycle. When
Confidence is trending positive, the huge economic flywheel moves in the positive direction
which generates ever-higher earnings and stock prices. The economic flywheel continues to
move in the positive direction as Fear abates and Confidence gains ascendancy. This continues
until the Confidence turns to Over-confidence that, in turn, moves to Excessive Greed.
The Excessive Greed stretches the economic growth beyond its natural limits and the problems
begin to raise their ugly heads. These problems lead to decreasing Confidence and increasing
Fear that, in turn, pushes the Economic Flywheel in a negative direction. This means that the
Credit Cycle Contracts, the Economic Growth slows and the Stock Market moves into the
Secular Bearish phase of the Generational Fear/Greed MegaCycle.
The good news is that Productivity, which trumps all economic variables, continues to push ever
higher even as the Economic Flywheel is moving in the negative direction. Thus, each
Generational Fear/Greed Cycle is higher than the last Cycle. The further good news is that we
believe the stock market began a new MegaCycle on March 9, 2009; thus, this market is in the
early stages of a new Secular Bull Market.
We think there are very identifiable psychological stages in the stock market.
The Human Emotions of a MegaCycle*
that Control the Level of Confidence
Euphoric Top
Greed
Super Confident
Confident
Somewhat Confident
Fear
Mixed Fear and Confidence
Mixed Greed and Doubt
Doubt
Serious Doubt
Fear
Panic Bottom
Panic Bottom
*The Stock Market is a linked series of MegaCycles where a MegaCycles lasts 30 years or so.
Think 1950 – 1982 and 1982 – 2009. Two-thirds ( 20 years or so) of a MegaCycle is a Secular Bull
Market, and one-third (10 years or so) is a Secular Bear Market. Productivity Increases drive
Earnings and Dividends ever higher which makes each MegaCycle higher than the last. This
overall process makes the Stock Market a Winners’ Game.
Today we think the market is between the stages of Somewhat Confident and Confident. To be
sure, year-to-date the stock market has produced some outsized returns. But do you hear your
friends bragging about their returns or that they have discovered the "secret" to the market? The
answer is clearly "No." The real key is that as long as your friends can quickly name a myriad of
economic problems, you and the stock market are Okay. The time to worry is when no one is
worrying. On a psychological basis, the stock market is nowhere near an Asset Bubble.
In summary, the best case for a Bear Market rests on inflation turning to deflation. We simply
do not see that happening. However, if the economy does move into deflation, all of our bets
and forecasts will be removed from the table.
But short of deflation, we simply believe the other cases for an Asset Bubble rest more on sour
grapes rather than hard analytical/psychological facts. Despite the many bumps and bruises that
lie ahead, we strongly believe that the earnings and multiple are on track to deliver by the end of
2025 a Dow 50,000.
Peace be with you and your portfolio,
Harry E. Wells, III
SkipWells@Verizon.net
WellsAssetManagement.com
August 9, 2013: S&P 1690