Value and the Dow Theory
The following is an excerpt from Richard Russell's Dow Theory Letters
"Good judgment comes from experience. And where does experience come from? Experience comes from bad judgment." Mark Twain.
Back in 1974 I taught a course at San Diego State University on the stock market with special emphasis on Dow Theory and technical analysis. I had a large class of over 100 students. I also had one outstanding student named Jon Strebler. Jon possessed a great talent for charting and understanding markets. His particular interest was gold and precious metals.
Jon graduated from San Diego State University magna cum laude in '74, and had a successful career as a trader, broker and vice-president at several brokerage firms, as well as teaching finance, economics and history at both the high school and university levels. Jon has drawn my annual charts of the D-J Averages and the A-D ratio ever since the 1970s.
For years I have been trying to entice Jon to join with me and aid me in my work. The conclusion is that Jon has agreed to write a column every Tuesday. His first column starts below. I will add some sundry tidbits at the end of this site.
Value and the Dow Theory
Long-time DTL readers know that the Dow Theory isn’t just about mechanical buy and sell signals based on important highs/lows of the Industrial and Transportation averages. The other part of the story is the role that value plays in deciding whether a Bull market or a Bear market is in force, and thus, to own or avoid stocks.
As the father of the Dow Theory, S.A. Nelson, wrote over 100 years ago “…value is the determining factor in the long run”. William Hamilton and Robert Rhea, the reigning Dow Theorists of the 1920s and ‘30s respectively, also emphasized the importance of knowing whether stocks as a whole were over- or under-valued before deciding to invest. Of course, value has also played a major role in the 55 years of Richard Russell’s market analysis and advice.
Historically, the value of the market as a whole has been measured by comparing prices to earnings and to book value, while also considering dividend yield. Until the late-1980s, history showed that stocks were “cheap” when the market was selling near book value, with an average P/E ratio of about 10 or less, and yielding about 5% or more in dividends. Buying stocks when the market met two or more of those criteria – especially in line with key new highs in the Industrials and Transports – put the odds clearly in investors’ favor. On the other hand, investing when the market was selling at twice or more of its book value, with a P/E over 15, and yielding less than 3% was likely to bring losses. But all that started changing by the late-1980s.
Market P/E levels: For over 100 years until the 1990s, P/Es ranged between 5 and 25. Under the “new normal”, a P/E of 15 is cheap and God only knows what defines expensive! Source: Robert Shiller and his book Irrational Exuberance
Dividend yield: Meanwhile, dividend yields bounced around mostly between 3% and 8% for decades, but have remained under 3% for the last 25 years. Source: Robert Shiller and his book Irrational Exuberance
As for the price/book value ratio, the last time stocks were under-valued was at the beginning of the great bull market that started in the early-1980s. Ned Davis Research’s chart below suggests that nowadays stocks aren’t over-valued until 4.9 times book value (!), vs. the old 2 times book value rule of thumb.
This change during the last 25 years has created a big conundrum for the true Dow Theorist. Given strong market internals and buy signals from the mechanical side of the Dow Theory, it’s nevertheless been hard to recommend buying stocks at what have historically been expensive or at least, not cheap, prices. Yet both the Dow Industrials and the S&P 500 now sit at five times what their prices were in early 1988. Calling a spade a spade, anyone who stayed out of the stock market the last 25 years because it was “over-valued” can’t feel good about that decision today.
But that was then and this is now. What to do, going forward? With fresh evidence of a renewed bull market, how much should we care that stocks are “over-valued”? (Not to mention the lowest VIX levels in 5 years, and the continuing horrible fiscal news bound to come out of Washington.) Since value should always be a part of one’s decision to buy, how can we change the parameters of “over-priced” vs. “under-priced” markets to again make value a relevant concept? Most importantly, what is the proper investing procedure for DTL readers to follow now, given these mixed messages?
Those are topics of future discussion here. But for now, buying at least some US and even foreign stocks apart from gold and silver mining stocks, in line with Richard’s latest advice, seems appropriate. Whether you prefer ETFs like DIA and SPY, some good no-load mutual funds, or your own mix of individual issues, the weight of evidence suggests that sitting entirely on the sidelines is not the place to be now.
-- Jon Strebler
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