Offering up an unemotional way to look at levels in the stock market. by John Kusumi
(centrist)
Sunday, August 7, 2011
President Warren G. Harding (R-OH) was famous for his campaign pledge of a "return to normalcy" for the United States, so he might approve of the sentiment in this article. The stock market has now earned and merited distrust, along with fear and uncertainty on the part of its participants. Does it seem like the world is flying off the hinges? On some days, yes.
I was 1984's "18-year-old" candidate for U.S. President -- the youngest-ever opponent in the political career of Ronald Reagan, and also the first Generation X presidential candidate. In the time since then, I founded the China Support Network to boost the Tiananmen Square student-led pro-democracy movement for mainland China (standing with Chinese dissidents who continue the Chinese democracy cause in exile); and in corporate life, I became a quantitative marketing analyst, followed by being a software developer.
I could wag my finger against moving the factory floors of America to Communist China; and, Warren Harding would likely approve of that, too. Wikipedia says that Harding's "America first" campaign "encouraged industrialization and a strong economy independent of foreign influence." That may seem quaint in this era of "globalization." CNN would have to censor Harding these days. They can't have such sentiments! --However, such wag of my finger is not the point of my article at hand.
The stock market is about 10% down in a correction that could run to about 22 or 23 percent. In fact, it could go farther down than that due to a psychology of fear and panic -- but then, it would be oversold, in my view.
I cannot be the only person who has looked at the stock market and observed its departures from normalcy. Exactly what, then, is normalcy? Anyone can see both normalcy -- and departures from it -- by pulling up S&P 500 charts of before -- and after -- 1995.
In the seven years previous to 1995, the stock market was almost a straight line, very placidly drifting higher while P/E multiples drifted higher. In that period, the Schiller-adjusted P/E ratio (Schiller adds a smoothing function) averaged 18.04. We can allow those previous seven years to establish our concept of normalcy, in which stock prices are purely a function of corporate earnings, with a "normal" P/E of 18.04. At least that was normal during the first (senior) Bush administration.
Once we have a normal line, we can see radical departures from it as we look to stock charts in the post-1994 period.
It becomes easy to see Bubble 1, Bubble 2, and Bubble 3. Bubble one was the dot-com bubble of the late 1990s. Bubble two was the housing bubble of the '00s. Bubble three is whatever Ben Bernanke can engineer (QE, or quantitative easing) to goose the system. Bubble three is the faulty response to the financial crisis.
As defined above, normalcy gives us a line of justifiable stock prices and shows us where the stock market might have gone if Wall Street were less of a drama queen -- if the bubbles were smoothed out of it. This is what leads me to say that a peak-to-trough correction in the stock market these days might run to 22 or 23 percent.
As I write this, the normalcy line suggests levels of 1,045 on the S&P 500, or 9,975 for the Dow Jones Industrial Average. If you read this when we are above those levels, you might curse this author. But, if the market overcorrects, and we are below those levels, then my article here is cheerful news, because I will feel that the market is undervalued, and it may be time to go out bargain-hunting.
Addendum: How to duplicate this effort
With sufficient spreadsheet skills, you can repeat the construction of this chart. Start with a blank spreadsheet and create a new one as follows:
In column A, arrange the dates monthly from January, 1988 to August, 2011.
In column B, insert monthly levels of the S&P 500.
To obtain the data, go to: http://finance.yahoo.com/q/hp?s=^GSPC+Historical+Prices
Set the Start Date to Jan 1, 1988, and click the choice of 'Monthly'. Then click [Get Prices].
Scroll to the bottom of the table, and at the left find and click a link, 'Download to Spreadsheet.'
You will obtain a text file, "table.csv" with seven columns of comma-separated data. The data comes in descending order (i.e., 2011 - 1988).
Extract the seventh column ("Adj Close") and change it from descending to ascending order.
In column C, insert monthly P/E multiples for the S&P 500.
To obtain the data, go to: http://www.multpl.com/table?f=m
Note: Data at the previous page is in descending order and goes back to the year 1881. Be sure to extract only 1988 to the present, and change from descending to ascending order.
Note also, as the page says, that "Price earnings ratio is based on average inflation-adjusted earnings from the previous 10 years (Shiller PE Ratio, or PE 10)." Robert Shiller is the Yale economist who is responsible for the adjustment as has been made to these multiples. There is an FAQ about his methodology, at: http://www.multpl.com/faq
In column D, insert a formula:
(Bxx / Cxx) * 18.04
This divides column B (the S&P level) by column C (the PE multiple), then multiplies the result by the "normal" PE multiple of 18.04. Note that "xx" is a placeholder for any given row number.
You're done with arranging the data. Now, you can arrange a chart with an "Actual" line drawn from Column B, and a "Normalcy" line drawn from Column D.
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in this article are those of John Kusumi only and
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Posted By: Bill Gee
Date: August 8, 2011 11:13:24 AM
Interesting theory, but unfortunately your analysis does not hold up for a couple of key reasons.
1) Stock price is a poor economic indicator when it comes to overall economic growth, and it's more an indication on the impact of inflation on stock prices. In your chart we see spikes in stock price at exactly the same moments that we saw spikes in inflation, GDP growth, etc. The "Normalcy trend" that is used on your chart can easily be replaced with the so-called "Tyler Rule", which pegs "ideal" economic growth at 2% on an annual basis.
2) Your "Normalcy Trend" suffers from a "Normalcy Bias". That is, it assumes that since investors have never experienced a collapse of the world's "reserve currency", that one will never and cannot ever happen. This is like assuming that we will never die because up until now, we are still alive.
Your "market correction" will be very difficult to measure in the coming months. On the one hand, stock prices will drop due to investors fleeing from the market for safer waters. On the other hand, hyperinflation caused by increasing interest rates will cause stock prices to rise. This mixture will make it very difficult for pundants to interpret whether the economy is "recovering" or getting worse. If the currency should collapse entirely, then an entirely new measure will need to be used to monitor the markets, but we're not quite there yet.
Posted By: John Kusumi
Date: August 8, 2011 04:07:27 PM
Bill Gee, I know that you're another columnist here at Nolan Chart. And I know that you've written an article about the Normalcy Bias. In your recent usage of the term, you are saying that the Normalcy Bias is blinding people: keeping them unaware that a currency collapse could happen. That's fine, and that's well and good, as far as it goes.
But, did I ever walk in and take a leak in the comment section below YOUR articles? No! Yet here you are in MY comment section. Your remarks might be taken as "exceptions" or "attacks" for my own article, but they fail to make me feel defensive. Your point #(2) is a restatement of your earlier article about the Normalcy Bias, as remarked above. Well and good. Note that I do not have any bad things to say about your article. You're quite right that normalcy bias prevents people from anticipating trouble. It's simply true that your thesis is for your article. Your concern, or thesis, is about currency collapse.
It's also true that MY article is not YOUR article. MY topic is about stock market collapse (and bubbles), but not currency collapse. You can tell me that I should have written about the U.S. dollar instead of what I wrote about. As your opinion, that's well and fine. Similarly, a devotee of animal rescue could argue that I should have written about animal rescue. As his opinion, that's well and fine, but that does not impugne my article. My article is what it is, and it says what it says. Both yourself, and an animal rescue lover with that hypothetical dissent, have a different topic in mind: The article that YOU would have written.
That's fine, but recall that you are a fellow columnist at Nolan Chart. You can author and put up any article of your choosing -- you can do that directly yourself, you don't need to involve me.
My article is not about currency collapse, nor is it about inflation, nor is it trying to predict the economy. Your point #(1) seems to fault the article as "a poor economic indicator," but try to remember -- the article did not claim to indicate the economy.
There is a basic point to my article. The seven years before 1995 were "Pre-Bubble" years when the stock market was healthy and well behaved. Once we look at stocks AFTER 1994, then we see "The Bubble Years." My normalcy measure draws a line below the bubble levels, and therefore aids us to see all of the bubbles and odd behavior of the stock market, post-1995.
Ultimately, that is all that my article says. My article does not claim to rescue animals, cure cancer, or discuss currency collapse. If currency collapse is an interesting topic, let me refer readers to go and check out the articles by Bill Gee, and other good columnists elsewhere here at Nolan Chart.
Stock values have little to do with anything, other than how much surplus capital is floating around. The vast majority of stock market purchases {and sells} consists of one investor buying paper from another investor. the range of actual "purchases" of company property is below a couple of percent.
The property of every company that is publicly traded was purchased long ago. Physical property depreciates thru time.
The stock market is no different than appreciation in structure or house value. It is pure illusion built upon the sand foundation of fiat currency.
Posted By: John Kusumi
Date: August 9, 2011 01:56:20 AM
The stock market certainly is a secondary market; its ostensible purpose to fund companies happens at IPO time, and all trades after that are secondary. And it's largely a casino, where investors bet on what will be the price tag the next time the paper changes hands. But, share prices are also a function of earnings, plus social convention.
One social convention is for small businesses: If a business (e.g., Joe's Tire Shop, Sally's Coffee Shop, David's Donuts, or Harry's Restaurant) is sold, a rule of thumb says that they get a 5 multiple. (Five years of profits is the takeout price.)
Another social convention is for publicly listed (large) businesses: As we can see above, during the Bush I administration, sale of shares happened at an 18 multiple.
Exactly what "justifies" Wall Street's ability to multiply their earnings at such a high level compared to Main Street? It is only social convention. Wall Street gets the big multiples because of this line: "Rah, we're big!"
"Rah, we're big!" does not logically lead to different laws of gravity, laws of physics, or laws of arithmetic. But, in Wall Street's case, "Rah, we're big!" gets them the high multiples and society lets them get away with it, and that's social convention.
In an egalitarian, democratic society, it should be bull**** when one group (Wall Street) says to another (Main Street) that, "We're special and you're not." (Actually, they hire public relations spin doctors to say that in different words.) Maybe this matter is due for a correction.
Posted By: Bill Gee
Date: August 9, 2011 06:31:48 AM
John,
I'm sorry if I offended you in my commentary, but the point of this forum is to encourage discussion, therefore, when I see an an article that I believe requires discussion or rebuttal, I write. I also encourage anyone else to do the same with my own articles. If you look through the articles I've written since Janurary in this forum, you'll see that some of the commentary on my articles can get quite "heated". However, I do try to keep my comments civil and relevant.
As to the substance of my commentary, your article postulates that investor confidence will be restored once the S&P bubble returns to the normalcy trend. This may be true and under "normal" economic conditions you would very likely be correct. However, I wished to point out that these are not "normal" economic conditions. We have a fiat currency crisis, a collapse of confidence in the markets, and ever-growing political unrest. When I mentioned the Normalcy bias, I was making the point that the very act of calling the market collapse a "bubble" is to ignore many the fundamental economic indicators that are staring us right in the face. Namely, the collapse of municipal authority and judicial independence, the inability of governments (both democratic and authoritarian) to govern, the crumbling of infrastructure, and the inevitable collapse of the bond market.
There is a growing movement in economic circles that outright dismiss the existance of "bubbles" altogether, but instead use these dramatic ups and downs in the market as signs of growing instablity and eroding confidence.
