Since the beginning of this century there have been basically three types of environmental measurements (valuations) for trying to determine or forecast future weather. These are barometric pressure, humidity level and the temperature. While it is indeed true the meteorological science of weather prediction has seemingly become very sophisticated in recent years by employing satellite pictures of the cloud structure enveloping our earth, the factors which most influence our clime in the not too distant future STILL REMAIN THE OLD TENETS OF MEASUREMENT: Barometric pressure; Humidity Level and the Temperature.

In this same regard I feel comfortable in making an analogy to the tried and proven valuation methods employed to predict the stock market climate for the future. The three classical evaluation methods are Dividend Yield, Price Earnings Ratio (EPS) and Book to Market. Although there are a host of esoteric valuation methods developed in recent years - which are too numerous to count or describe, I would prefer to use the traditional approach to determine whether the stock market is over-valued or under-valued from a historical basis.

Rather than waste my time redescribing how the "wheel was invented," I have relied heavily upon the work published in one of the best books ever written on this subject: "Stock Market Logic" by Norman G. Fossback. I use his words in most of the following rhetoric, because I could not say it with greater clarity and logic. However, I wish to point out that all the work done in preparing the historical graphs for the period of 1925-1997 is to be credited to the Technical Staff of the GOLD-EAGLE.

Traditional Market Valuations -

The relationship between price and value is clear, but is exceedingly difficult to measure. While price can be observed with certainty, no one can ever be sure what constitutes true value. Although it may be impossible to objectively determine current value, in the light of hindsight it is clear that price does not tend to revolve around it. Consequently, several indicators have been developed which purport to measure value and thereby provide a reference point for the relationship of price to value. The logic is simple: if the market is undervalued, BUY; if the market is overvalued, SELL. Following are the three most trusted long-time valuation methods for determining the relative degree of undervaluation and overvaluation.

Dividend Yield -

Among the three valuation methods to be discussed, the Dividend Yield is by far the most important. Long the most popular of valuation measure, the Dividend Yield is calculated by dividing the indicated dividend rate by the current price. In this century common stocks have provided an average annual dividend yield of about 4 1/2, ranging from a low of 2 1/2% (i.e. before 1997) to a high of 8%.

At times investor enthusiasm has been so great that the market has accepted a much lower dividend yield than normal. When yields are very low, stocks prices are by definition high - and frequently overvalued as well. The market, then has no where else to go but down, so it is not surprising that, historically, a low dividend yield has usually been followed by declining market prices. Conversely, when the market place is rife with pessimism, investors demand a much higher than normal dividend yield to induce them to buy stocks. Since an excessively high yield means that stock prices are abnormally low relative to dividends, and are therefore undervalued, the market frequently responds to such situations by climbing higher.

A simple test of the dividend yield as a forecaster of future stock prices is presented in the table below (courtesy of "Stock Market Logic"). Shown are the one year returns which have ensued from various DJIA dividend yield intervals since 1941.

During the 35 year period the dividend yield was under 3% only 17 weeks (in mid-1959 and early 1966) - and in every case the average ensuing one year market return was sharply negative.

Based upon probabilities determined by the results of the period 1941-1975, and the recent all-time record low Dividend Yield of 1.95, the S&P 500 Index will probably decline a minimum of 10% during the next 12 months. Per the same statistical results there is 0% (zero percent) chance of rising prices. It looks grim for the stock market.

The chart below shows the S&P 500 Index's Dividend Yield from 1925 to the present. There is much to be gleaned from this historic picture, but we will only comment on the more significant periods of 1929 (and aftermath), 1973-1974 and late-October 1987. Please notice the Dividend Yield just prior to the Great Crash in 1929 fell to about the 2.9% level. Then in early 1973 just prior to the second most devastating stock market debacle in history, the Dividend Yield had sunk to only 2.7% level. And in late-1987 the Dividend Yield slid to 2.7% again, just before the "blitzkrieg bear-market," which witnessed the DJIA free-fall 506 points in ONE SINGLE DAY - for an unprecedented one-day's loss of more than 23%!!

And Where are We Today?

In February 1997 the dividend Yield sunk to an all-time low of 1.95%.

Price Earnings Ratio (PER) -

Many tomes have been written about the significance and predicting powers of the PER. The following is the meaning I have forged from all my readings.

As all market students well know, the PER is simply the market price of the stock or index divided by the corresponding earnings per share. Conventional interpretation says the stock is dear when it is selling at a relatively high PER, and conversely, is cheap when selling at a relatively low PER. However, this is a too simplistic interpretation, because it does not take into account the average PER of the particular industry, nor the prevailing PER level of the market as a whole. In any case here are a couple of unconventional ways of interpreting the PER of a security.

Firstly, the PER is the reciprocal of the capitalization rate of the investment. For example, if a stock has a PER of 20:1 - and assuming the earnings per share remain stable, then an investor is theoretically earning 5% on his investment (1/20 = 5%). Another way of looking at it - but again assuming the EPS remains stable AND all the earnings are paid out in cash dividends to the investor - it will take the next 20 years for the investor to have recouped his entire initial investment. Therefore, the higher the PER, the more time risk exposure the investor is facing. Conversely, the lower the PER, the lower the risk.

How Does Today's PER Compare Historically -

The chart below depicts the S&P 500 Index's PER from 1925 to the present. One may observe that the PER immediately prior to the Great Crash of 1929 was about 17. It is noteworthy to mention that the PER continued to zoom to astronomical heights in the early 1930s. This phenomenon was caused by the fact that corporate profits were falling much faster than stock prices. And just before the second worst stock market debacle in 1973-1974, the PER had risen to 20. And just prior to the late-1987 stocks meltdown, the PER had climbed to approximately 17 again.

In a starling replay of the past, the PER earlier this year (1997) to had risen to the 19:1 level. Any one not suffering from delusions and illusions is obliged to recognize that the stock market is at dangerously high levels. Alan Greenspan calls it "Irrational Exuberance." Moreover, the inimitable Guru of all Gurus, Warren Buffet, confessed to his stockholders in a meeting a week ago that "virtually the entire stock market is over-valued!"

Market to Book -

Still another interesting measure of relative value is the relationship between stock prices and the company's net worth per share. Net worth, or book value per share is calculated by adding all of the company's assets, subtracting all the liabilities, and dividing by the number of shares outstanding. If the price of the stock is far below its book value per share, the stock is considered undervalued and therefore should be purchased. On the other hand, when the Price/Book Value Ratio is high, the stock is considered overvalued, and should be sold. Again, this rule of thumb is too simplistic.

The actual book value of any company vis-à-vis its market value does not take into account the "going-concern" value, nor the value of its "goodwill" - and all that it entails. Nevertheless, the chart below shows what has happened to market values, when Market to Book rose to an unrealistic ratio.

Unfortunately, prior to 1935 there was no data on company book values. But in early 1973 the Market to Book rose to about 1.5:1 - just before the two-year market sell-off. And again in late-1987 the Market to Book was pushing 2.1:1 just prior to 506 point meltdown.

Now, how does this compare with today's Market to Book? As ludicrous as it sounds the S&P 500 Index recently saw a Market to Book of FIVE (LIKE IN 5:1)!!!!! Speculators are paying 5 times the intrinsic net worth of a company - that's more than 3 times the outrageous prices paid in the euphoric market mania of the "Roaring 20s!" I use the word "speculators" and not "investors," because the latter only discount the future, whereas the former are discounting the hereafter in their IRRATIONAL EXUBERANCE in what they are willing to pay for net worth.

Trying to justify paying 5 times book-value will indeed be a tough row to hoe!

But the financial lunacy goes even further. Any reasonably shrewd and market savvy Chief Financial Officer of these companies selling at 5 TIMES BOOK VALUE, should be issuing more shares of the company to raise equity capital at an unprecedently LOW cost of capital. Please remember equity financing goes into the Balance Sheets net worth. The company issues a $1 net worth share, and receives $5 in cash from the outside public. BUT NO, THEY ARE NOT DOING THIS. Too many CFOs are using in-house Pension Funds TO BUY shares of THEIR OWN COMPANY's STOCK AT A PRICE OF 5:1 FOR THEIR EMPLOYEES Retirement Account!!!!!

When the markets begin again to appreciate the exorbitant over-valuation of stocks, many CFOs will be called to account for their lack of prudence in managing the long-term retirement funds of their employees. They may be accused of not exercising their fiduciary responsibility in making prudent investments.

Methinks trying to justify paying 5 times book-value will indeed be a tough row to hoe!

What I Foresee -

Since 1974 major market lows have occurred every eight years: 1974, 1982, 1990; and perhaps now in 1998? Furthermore, since World War II, every economic recession has occurred in the first or second year after a Presidential Election - NO EXCEPTIONS! If the past is prologue, there are some very rough seas ahead for all those hapless souls pouring hard-earned money into stocks.

Based upon historical results as demonstrated above - and per my technical and intermarket analysis, I foresee a slow 1973-1974 type grinding bear market in all financial assets. Furthermore, as witnessed in the same period, there will be a virtual boom in gold and silver stocks - possibly even reminiscent of the late 1970s bull market in the precious metals stocks.

vronsky (Late March 1997)           

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