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U.S. Equity Markets are Still too Expensive

October 15, 2001

From a technical viewpoint, the U.S. equity markets had reached an "oversold" position following the post-attack decline so the last two week's rise was not terribly surprising to market pros.

Despite the recent rally in stocks, I remain convinced that this market has many more "miles" to travel on the downside before the bear market enters a multi-year hibernation period. Why am I so sure of that? Because bear markets only end following a true capitulation and when stocks become as undervalued as they were overvalued at their peak. Capitulation takes place when masses of investors call their brokers and order him to sell everything they at any price. We have not seen anything like that yet. To the contrary, the CNBC talking heads continue to pedal the falsehood that because stocks have fallen so far they are cheap. In fact, a glance at a recent "Barron's" showed that stocks were MORE EXPENSIVE on October 1, 2001 than they were on October 2 last year.

Why do I say that? Because in general, you get even less value for the stocks you purchase now than you received when you bought equities one year ago. We typically judge "the market" by the S&P 500 earnings yield, which at the start of this week stood at a mere 3.53% of which only 1.51% is paid out in dividends, the remainder being in increasingly suspect "retained earnings." Last year, the earnings yield for the S&P 500 was 3.61%. THUS DESPITE THE 27.5% DECLINE IN THE PRICE OF THIS INDEX, THE VALUE YOU RECEIVE IS EVEN LOWER THAN ONE YEAR AGO!

But the S& P 500 is not the only index that has become more expensive despite its sharp decline in price over the past 52 weeks. Here are some more examples:

* The DJIA has fallen 16.9%, but despite this decline in the DJIA, you now receive an earnings yield of 4.46% compared to 5.01% last year.

* The DJ Transport values have fallen off a cliff. Although the average has declined by 13%, they are now providing earnings yield of a mere 0.28% vs. 11.27% last year at this time of the year.

* The DJ Utilities, which fixed income people often buy because of their high dividends, are providing an earnings yield of 2.33%, down sharply from 5.83% last year, despite a 24% decline in the price of these equities.

It is true that the utilities are continuing to pay dividends of around 4.15%, but what that means is that the utility companies are cutting into their retained earnings to accomplish that feat. Obviously that cannot go on forever.

Richard Russell is correct when he concludes that we are heading for a period of time when INCOME rather than appreciation will be what everyone will be desperate to gain. As that happens, look for bond yields and dividend yields to continue to decline, especially if as we believe Ian Gordon's view of the Kondratieff winter is correct.

When will we know the bear market is over? We will know it when millions of investors have given up on the market. When they call their brokers and say, "get me out at any price - I just want out!" The other sign will be when the bluest of the blue chips begin offering DIVIDENDS of 6% or so. Those of you who manage to retain your wealth will be in the enviable position of snapping up quality stocks at bargain basement values. But that I believe is at least several years away. With government bail out after bailout, the time required for mother nature to correct the excesses of the markets will be much greater and the decline much deeper than if the government had simply allowed markets to adjust to their rightful equilibrium. Too bad politics have to get in the way of this natural process. Politicians may relieve pain in the short run, but make it much worse longer term.

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