Barron’s – 02/07/2011
If history is any judge, the stock advance that began in March 2009 is hitting valuation levels that are cause for concern.
The bull market is fast approaching its second birthday. In just four weeks—on March 9, to be exact—it will have been precisely two years since the Dow Jones Industrial Average hit its closing low for the 2007-2009 bear market, at 6,547. The S&P 500 index on that day closed at 677. Both averages today are nearly double where they stood then.
In preparation for what no doubt will be lots of celebrations and self-congratulatory back-slapping among the bulls, I am devoting this column to comparing the current bull market to its predecessors over the past century. How many of them even lasted two years? Compared to those that did, how does the current one’s valuation stack up?
Answers to these historical questions can help us determine whether this bull can stay with us for much longer. The first step in answering these questions was to construct a list of past bull markets. I followed the precise definition employed by Ned Davis Research, the institutional research firm: For them, a bull market requires one of three conditions to hold: (1) at least a 30% rise in the Dow in 50 calendar days, (2) at least a 13% rise in the Dow in 155 calendar days, or (3) at least a 30% reversal in the Value Line Geometric index. Since the beginning of the last century, using this definition, there have been 27 bull markets prior to the current one. The current bull market’s age is right in line with the typical length of those prior bull markets. The median length of the 27 bull markets is 1.9 years, which is exactly how old the current one is. That means that half of those prior bull markets didn’t even make it to their second birthday.
How does the current bull market’s valuation compare to those prior ones that did live to be at least two years old? Unfortunately, the comparison is not an encouraging one for the bulls.
Consider a modified P/E ratio that was made famous in the late 1990s by Yale University professor Robert Shiller, particularly in his book Irrational Exuberance. This modified P/E is one in which the denominator is average inflation-adjusted earnings over the trailing 10 years—sometimes called P/E10, or CAPE (for Cyclically Adjusted Price Earnings ratio). The CAPE has a markedly better forecasting record than the simple P/E. Another reason to prefer the CAPE: The simple P/E gets artificially inflated during economic downturns, when trailing earnings are depressed. The current CAPE, according to Professor Shiller’s website, is 23.7. The average of comparable levels for this valuation metric at the two-year point of those prior bull markets that lived this long is 18.0. At least according to this measure, therefore, the stock market’s current valuation is 32% higher than where it stood at the comparable points of prior bull markets. To be sure, the stock market’s valuations over the last half of the 20th century were higher than during the first half. One might therefore wonder whether, by extending my analytical net so far into the past, I am biasing my conclusion. If I am, it’s not by much. If I had focused on just those bull markets that have occurred since 1950, the average CAPE at bull markets’ two-year anniversaries would have been 19.7 rather than 18.0. Even compared to that higher level, the current bull market would be 20% more richly valued.
Maybe you’re thinking that a comparison to prior bull markets is not the most helpful, and that we should judge the current bull market in light of averages across all years. Unfortunately, that avenue of inquiry doesn’t reach a more optimistic conclusion either. The average of all CAPEs since 1880, according to Professor Shiller’s website, is 16.4. Since 1950, the average is 18.6. The current CAPE is markedly higher than either of those averages.
An even more alarming comparison comes when focusing on those prior occasions when the CAPE was as high as it is currently. Over the last 100 years, there have been only three other occasions when the CAPE was that high: In the late 1920s (right before the 1929 stock market crash), in the mid-1960s (prior to the 16-year period in which the Dow went nowhere in nominal terms and was decimated in inflation-adjusted terms), and the late 1990s (just prior to the popping of the internet bubble). To be sure, a conclusion based on a sample containing just three events cannot be conclusive from a statistical point of view. Still, regardless of the historical comparison, it will be hard to argue that the current stock market is undervalued or even fairly valued.