Stock Market Historical Valuations
1925 to 2007
Part 1: The Stock/Bond Yield Gap
1 November 2007
Our present era's standard of reporting financial issues is atrocious; a clipping from REUTERS by Burton Frierson illustrates my point.
NEW YORK, Oct 19, 2007 (Reuters) - By Burton Frierson
"The main dissimilarity, which I think is the most important story these days, is that the market in '87 was dramatically overpriced before all that happened," said Bill Tedford, director of fixed income strategy at Little Rock, Arkansas-based Stephens Capital Management.
By a common method of measuring stocks' value, Tedford said, Wall Street was 35 percent overvalued in October 1987.
"Fast forward to today and by the same measure the market is 35 percent undervalued," Tedford added.
- End of REUTERS Clipping -
What was 35% over valued in 1987 but now 35% undervalued today? The problem with this, and other articles feed to the investing public is the absence of empirical facts allowing readers to come to their own conclusions. The two most common measurements of the stock market's valuations are Price to Earnings Ratios (P/E) and Dividend Yields for the Dow Jones Industrials or S&P 500 index. Here is a table listing this information for October 1987 & 2007. Note that high market valuations are indicated by high P/Es and low Dividend Yields.
The Dow Jones's valuation measurements are more reasonable than before the crash of October, 1987, but historically any dividend yield below 3% was a red flag for over valuation in the stock market. The S&P 500's P/E is cheaper now than it was in 1987, but not by 35%, while its dividend yield is actually 33% over valued from where it was in 1987. If looking at dividend yields, by Mr. Tedford's analysis, the market is currently giving a strong sell signal. Examining the above table with the two most common indications of market valuation clearly indicate that the REUTERS article was not very informative, maybe actually misleading. It did not give a bench mark for measuring historical average values, nor named its "common measurement of stock values."
When one is armed with statistical data from the past it is apparent that financial reporting in 2007 is often a conspiracy of ignorance between the financial journalist, his chosen expert and the public that knows no better than to take at face value what the media presents to them. If this is the typical financial information provided by REUTERS, Burton Frierson & Bill Tedford, I recommend investors look elsewhere in the future for their market information. You might start with a big picture historical study of the market, like my article below.
When people have surplus money to invest, and choose to invest in financial assets, they have two choices: stocks or bonds. The below chart is from data published weekly in Barron's since its 01-January-1938 issue. Each data point is derived from the following formula:
DJIA Average Dividend Yield - Barron's Best Grade Bond Yield
This data's original intent was to provide for a comparative evaluation between stocks and bonds. When the dollar was perceived as "good as gold," meaning that the future purchasing power of the dollar was not a risk the financial markets needed to factor for, yields on high grade bonds were usually lower than the dividend yield on the high grade stocks that made up the Dow Jones Industrial Average (DJIA). When best grade bonds yields were equal to or even higher than the DJIA's dividend yield, the stock market was over valued and subject to a near term fall in share prices.
When someone wanted to invest in AAA assets back in 1910, they meant the blue chip companies such as those listed in the DJIA; companies like AT&T, US Steel, or General Electric. These companies had both stocks (fractional ownership of corporate property and profits), and bonds (debt owed to investors) available for capital investments. Why would investors chose lower yielding bonds instead of higher yielding stocks?
During the gold standard capital gains, while welcomed, were not as important as income from an investment, mainly because capital gains are based upon volatility. Prior to 1913, and the creation of the Federal Reserve, the opportunities for capital gains from stocks were not as great as after the US Congress created the Federal Reserve.
With the creation of the Federal Reserve, the monetary inflation it generated increased the volatility in the financial markets, making possible greater opportunities for capital gains - and losses as we can see below in the DJIA from 1914 to 1944.
What seemed like a great idea in 1929 (central bank managed credit & currency creation) became a nightmare in 1932. In 1932 there were times when stock holders of major blue chip American companies were not sure if they could find buyers for their shares of AT&T or GE, even after these shares took a huge 90% fall from the market's highs of 1929. No one was 100% sure if GE would be in business in 1933. The crash of 1929-32 was that bad. But twice a year, when that check from AT&T or GE came in the mail, it meant food on the table and being able to pay the rent for tens of thousands in depression era America. But not all checks were created equal. It did make a difference if your check was from a bond's coupon or a stock's dividend payment.
Many decades ago (1885-1913) income from investments was the prime motivator of investors and dividend yields paid out at a higher rate than bond yields. As investing in stocks was a greater risk than investing in bonds, stocks yielded more income to compensate for the assumption of the increase in risk to capital. Never forget the one iron law of the market - the higher the potential return, the higher the risk assumed. "Reaching for yield" always seems reasonable when times are good, but as the 2001-2006 sub-prime mortgage purchasers are discovering in 2007, there was a reason why sub-prime paid a higher coupon than prime.
Bonds are debt, and exactly like a home mortgage, specified payments must be made on a set schedule or the bond issuer is in default. Many decades ago, companies that could not pay their debts would soon find themselves in a forced liquidation with the proceeds going to the bond holders. Usually the stock owners were left with nothing when companies defaulted upon their bonds. Stock dividend payments are a totally different thing. Dividend payments could be reduced or even stopped at the whim of the company with no legal penalties occurring to the company or legal recourse to the investor. For this reason, in a recession when income becomes very important, bond holders were much more secure in their income than stock owners. Take for example the dividend payments on the DJIA during the Great Depression - they fell by 80%. It is a fair guess that money designated for dividends in 1929, was diverted to bond interest payments in 1933.
The chart on the Stock / Bond Yield Gap (my first chart) was used for a gauge on the animal sprits in the market place for timing purposes. Prudent investors wanted to know when to get into or out of stocks and seek the safety of the bond market. When the DJIA dividend yield approached that of the Barron's Best Grade Bond Yield, the Stock / Bond Yield Gap plot would fall towards the zero line, or went negative indicating that the stock market was fully valued or over valued. At such times share holders were not being paid for the additional risks the stock market presented to invested funds, so it was prudent to sell stocks and purchase high grade bonds yielding approximately the same. This secured their income source, greatly reduced their risk and yes created capital gains on sold shares. As long as there was no inflationary, or currency risks, this data was an excellent tool for market timing for prudent investing.
But that was then and this is now - and now is nothing like it was back then as everything has been turned upside down because inflation and currency risks have been introduced into the financial markets by governments and central bankers.
The chart below plots the two inputs that Barron's used to create the Stock/Bond Yield Gap from 1938 to 2007.
Look again at the above chart plotting the actual yields for the DJIA Dividend & Barron's Best Grade Bond Yields; since the early 1960s the Barron's Best Grade Bond's yield has maintained a junk bond yield differential between itself and the DJIA Dividend yield. As I mentioned before, one iron law in the money markets is that the higher the potential gain the higher the risk assumed. This law took its toll on bond holders starting in the early 1960s. Looking at the prices of bonds and stocks since 1938, we can see that high grade bonds have grossly underperformed the stock market.
But even today bonds are commonly understood as a safer investment, and should have a lower yield than riskier stocks - right? Not anymore!
Fifty years ago in 1958 when the Stock/Bond Yield Gap went negative, it signaled the market's recognition of the new financial regime where decisions made by politicians and central bankers were more important considerations for investors than sound management by a company's board of directors and corporate officers. This is a reality that one has to deal with in 2007.
Listen to what politicians say during an election, listen to what "experts" say when the Federal Reserve Open Market Committee is about to meet. Seldom does the market rise on its own virtue, nor ever fall due to some "policy failure" by politicians or The Fed. And what is the tool that makes the market rise? Politically inspired monetary inflation, the above charts tell a tale of woe for bond owners. Since the late 1950s, with the rare exception of 1981-2000 when interest rates fell by double digit percentages, every bond sold in the market place was a junk bond thanks to official US Government policy.
Since 1958, monetary inflation has made high grade AAA bonds an obscenely riskier investment than blue chips stocks. The Stock/Bond Yield Gap did its duty in recognizing the reality of the situation.
Unfortunately for the stock investor, the money supply as measured by Currency in Circulation has increased even more than the Dow Jones Industrial Average. So if you don't count capital gains taxes and commissions on the stock market, the "buy them and hold them for the long term" stock investor at best only broke even over the past 70 years.
Now consider what a million dollars would buy when the DJIA was at 130 in 1938 and what a million dollars can buy with the DJIA at 14,000 69 years later in 2007. In 1938, a millionaire with $30,000 could purchase a mansion on several acres in an elite neighborhood in New York or California and leave $970,000 to generate interest, and dividend income to pay for a millionaire's lifestyle. The children of that millionaire could still live that lifestyle in 2007 if the 1938 millionaire used stocks as investments. Had he invested his million 1938 dollars in AAA grade bonds he and his children would now be a 2007 millionaires. In 2007, millionaires can't afford to live in elite neighborhoods anymore and they need a day job to pay for a much reduced lifestyle. What happened here is clearly a confiscation of the property of bond holders by the US Governments via monetary inflation.
So what do I recommend people do with their money? I would recommend that they leave the financial markets completely and go into a market sector where few experts would recommend - natural resources stocks or gold and silver bullion. In my opinion, these companies, and gold and silver coins will be the next to benefit in price appreciation from monetary inflation that politicians and central bankers have inflicted upon the world. I would also stay there until the market comes down to much cheaper values as measured by the DJIA dividend yield and Price / Earnings Ratios.
In my next article in this series I will examine the Dow Jones Industrials and their earnings from 1929 to 2007. Much is said about earnings growth in the stock market. But as we will see, there is also much not said.
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