POSITION
REPORT ON THE MARKETS
by Anthony
Cherniawski
The Practical Investor
Submitted
November 30, 2004
The post-election rally carried several stock market indexes above their prior highs for 2004. This was an unexpected event, because as long as the markets stayed below their prior high points the overall outlook remained bearish. It now looks as if the markets have a new lease on life.
But wait a minute…The Dow Jones Industrial Averages (DJIA), composed of the thirty largest companies in the U.S. haven’t participated in this momentous event. It is still struggling below its 10,600 high. The top pattern in play at The Practical Investor is still bearish for the DJIA.
Meanwhile, the Dow Transportation Average (below) is making all-time highs. What can an investor believe? Are we in a new bull market, or are we still in a bear market?
We may arrive at an answer by examining values. The Dow Jones Industrials trade at a multiple of 18.25 times their current earnings. They produce an annual dividend of 2.04%. The Dow Transports, on the other hand, trade at a multiple of 119.59 times earnings. Their dividend yield is .95%.
The question is, which index will prevail? Will the sky-high multiple Transports bring the rest of the Industrials up, or will the stodgy industrials carry the day? Many investors are speculating on the Transports. Which are you attracted to? The fact is, neither the Dow Transports nor the Dow Industrials are priced to produce attractive long-term total returns over the long run.
In an interview in the December 2004 issue of Money Magazine, Jeremy Siegel, who wrote one of the most-read investment books of the ‘90s, “Stocks for the Long Run,” had this to say, “I can’t emphasize enough the importance of dividends and reinvesting those dividends. You’ll find that dividend payers that trade at reasonable valuations are the stocks that did the very best for investors over the long run. One of the things I note in my new book is that the 100 highest-yielding stocks in the S&P 500 have done better than the index as a whole over the past 50 years.”
The burning question today is, “Are today’s dividends sufficient to cushion an investor against a substantial decline?” An examination of history shows that, when dividends exceed 4% and companies pay the better part of their earnings back to their stockholders in the form of dividends, a market low is near. This occurs when the Price-to-Earnings ratios fall below 10. At current prices and dividends, the Dow Jones Industrials must either double their dividend payout or lose approximately one-half of their market value before they have arrived at an equivalent low to be called a bargain. The Dow Jones Transports must either increase their dividend payout by over 300% or see their prices drop by approximately 92%. To the reply that, “It can’t happen today!” my response is that it has happened before. The Dow Jones Industrials dropped by 87% between 1929 and 1933.
In addition, the divergence in prices between the Dow Jones Industrials and the Dow Jones Transports is producing a tremendous conflict within the markets. Sadly enough, investors’ money has been chasing performance in recent times. This is magnifying the divergences between these two indexes. Studies by Crestmont Research show that the average range of returns for the next 20 years where the average beginning Price-to-Earnings ratio (P/E) begins at 18 is only 4.5% to 5.2%. Where the beginning P/E starts at 10, the average 20 year returns range from 11.9% to 15.0%. Think about it…the wonderful returns in the stock market during the ‘80s and ‘90s began with a P/E of 9 and a dividend rate approaching 6% in 1981. The bull market ended in 1999 with a P/E ratio of 42 and a dividend rate of 1.38% in the DJIA. The current bear market has only corrected the P/E ratio to 24 and the dividend rate to 1.74% at the end of 2003. This is nowhere near prior bear market lows. There is a long way to go before this secular bear market is over.
Robert Rhea, an associate of Charles Dow and a well-known Dow Theorist, says, “A Primary bear market is the long downward movement interrupted by important rallies…There are three principal phases of a bear market: the first phase represents the abandonment of all hopes upon which stocks were purchased at inflated prices (sound familiar?); the second reflects selling due to decreased earnings (this one may be just around the corner), the third is caused by distressed selling of sound securities, regardless of their value, by those who must find a cash market for at least a portion of their assets. Each of these phases seems to be divided by a secondary reaction, which is often erroneously assumed to be the beginning of a bull market. Such secondary movements seldom prove perplexing to those who understand Dow Theory.”
A Word of Caution…
The chart below shows the ratio of the S&P 500 index divided by the Volatility Index, often known as the “worry index.” It registers an unusually high complacency among investors that is often found at market tops. Compare the peaks shown in the ratio to the chart of the S&P 500 index. The ratio shows a higher peak today than it did in September 2000, when the S&P 500 registered at 1520.8. The most recent high in the S&P 500 was 1184.2. This chart reveals an all-time record level of complacency among investors. This is where bull markets end, not a new beginning. There is a saying, “They don’t ring a bell when the market turns.” This and other indicators are ringing loud and clear.
Summary:
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Amidst a flurry of calls for a new bull market, The Practical Investor is standing on the information presented as evidence that we are in a bear market correction (rally) that will soon end. The purpose of this Position Report is not to foretell the date, but to tell investors to prepare for the next stage of the bear market. These steps may include the following:
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Raise significant levels of cash (money markets) in your investment portfolio. According to the Elliott Wave Principle, the next decline will be a third wave or a C wave. They share common characteristics in that they are “persistent and broad…It is during these waves that there is no place to hide except cash.” (Source: Elliott Wave Principle, by Frost and Prechter, page 81)
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Eliminate as much debt as possible, especially “variable rate” debt, such as credit cards and lines of credit. Interest rates will be rising, so the elimination of debt offers a “real return” of escaping rising rates by creditors.
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Those who wish to remain invested should be looking for bear market funds or hiring advisors or money managers who are experienced in using them.
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Live within your income, or below it, if possible. The only way that this economy will recover is by increasing our rate of savings. Today’s rate of household savings has dropped to .4% from 7.7% in 1992. This is not enough to jump-start our economy into a new bull market. We need to resurrect the virtue of thrift.
© 2004 Anthony Cherniawski
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CONTACT
INFORMATION
Anthony M. Cherniawski
President and CIO
The Practical Investor, LLC
East Lansing, MI USA
Email
The opinions of FSU contributors do not necessarily reflect those of Financial Sense.
