With the Dow Jones Industrial Average well within striking distance of a new high, it seemed an appropriate time to revisit a theme we consider important enough to get right and sit tight. That theme is the concept that the long-term bull market of the 1980’s was due as much to expanding valuations as it was to improving fundamentals. Under this thesis, valuation tends to move in waves over very long time horizons. The chart below, which was taken from Barron’s (via The Big Picture) provides graphic support to the theory. During the flat periods, earnings growth is largely offset by shrinking multiples the market is willing to pay for those earnings.
It is easy enough to argue over where a given valuation expansion or contraction starts and ends. The point is that we aren’t talking about a matter of days or months, but of years. And more than six of them (eight if one looks at broader market indices), which is our current tally in what we believe to be a contraction cycle. The fact that the market is now back to long-term average P/E multiples suggests that the contraction may be halfway through – which would give us the equal number of periods below and above the average necessary to label it “average.”
So, will breaking above the previous record change our opinion that we are in a long-term contraction phase? Not at all. In the last contraction cycle (roughly 1968-1982) the market reached new highs several times. However, it tended not to stay there and the new highs were at lower earnings multiples (P/E ratios) than the previous ones.
The second chart compares the Dow Jones Industrial Average from 1968-1982 with the same index from 2000-Present (Source: Yahoo! Finance). The point is not to say that the monthly returns should exactly overlay each other, but to demonstrate that they are similar. And just as the Dow made new highs five years into the last P/E compression cycle, doing so six years into the current one would hardly invalidate the thesis.
So, do we stubbornly stick to our guns despite whatever evidence may come along to the contrary? Of course not. We merely set a fairly high bar for what will qualify to knock us off a key belief. For example, a close that exceeded the previous high by maybe 10% would be enough to revisit the thesis. In this case, that would mean a close above 12,895 – heck, let’s call it 13,000 because we like round numbers.
Yet even a 13,001 close wouldn’t necessarily invalidate the thesis. Remember, we aren’t predicting a flat stock market so much as that valuations will compress. They may compress at a slower rate than earnings grow, in which case higher stock markets would still fit into the thesis. Or, they could compress at a faster rate than earnings grow and signal an S&P level of 800.
We know that to some extent this thesis is a gloomy one (although it is possible to make money in any kind of market given the right strategy.) We also know that, after six generally difficult years it is tempting to celebrate new technical highs. So by all means, break out the bubbly when the Dow breaks its previous record. Just don’t drink so much that it goes to your head.Like this article? Why not try out: