Was 2013 a Record Shattering Market Top?

There have been three stock rallies in 89 years comparable to 2013’s. These were 1945, 1958, 1989 to compare to 2013.

In 2013 the market had a 34% Total Return and the 12 month CPI was 1.5%. In 1989 inflation was 4.8%, so deflating 1989’s 36% Total Return by the amount that its inflation exceed 2013’s, about 3%, means that the 36% Total Return of 1989 was more like 33% versus the 34% of 2013, so truly 2013 was a record shattering rally. In 1989 there was huge global bubble top caused by Japan which inflated U.S. real estate and other assets.

In 1945 PCE inflation was 4.6% which would deflate the gain down by roughly 3% (to equalize it with the low inflation of 2013) from 35% to 32%, making it less than 2013’s 34% gain. Also the war’s end was an outlier event that justified a price rally.

1958 had a 42% total return (or 30% if smooth out the starting point which was just after a 20% correction. In 1958 inflation was 2.2%. If you adjust for the correction then 1958 rallied less than 2013. Thus the 2013 rally was truly ridiculous. Also lack of correction for 38 months since September, 2011 is very rare. Current year PE (not the ten year PE) of 18.7 versus normal PE is 15.5 which is 17% lower than the current year implies stocks will at least go down to 1650 for SP, if so then bonds will have caught up with stock.

Based on a PE10 of 25 and accounting adjustments that need to be done to reduce earnings manipulation that brings the true PE10 to 30. If so then stocks are priced at roughly double their fair value, implying they need to go down 50%. They went down 57% in 2007-2009.

Because stocks have rallied so much some experts are claiming that this is a new era and rallies will continue for several more years. The “new era” theories assume that the increase in corporate profit margins by a factor of 2.9 since 1992 is a permanent trend that will grow to infinity and these margins will never experience a reversion to the mean.  Bullish advisors claim that a new era started about 20 years ago and they claim that average PE’s since then are much higher than the 100 year average, so they want to only use the past 22 years PE10 which is 23, which implies the market is close to fair value. This wrong because the 1998-2000 tech bubble created gigantic spike on a chart which warped PE’s and ended in disaster.

Once corporate earnings management is properly adjusted and internet rates rise to normal then corporations will have a lot lower income.

The bulls claim that PE10 is too slow to recognize the value of a company growing by 5% a year. However, PE10 is inflation adjusted so it merely misses the real growth which in the case of large cap companies may be close to GDP, which was only 1.6% real since 2000. Taking an average between zero and ten years times the missing 1.6% real growth is about 8% missed value, but PE10 can never be a perfect “land on a dime” formula, it is merely guideline to smooth out the worst fluctuation in earnings. Further, PE10 has worked until the most recent 17 to 25 years when the huge debt bubble warped it. During the 1925 to 1992 era it trended between 5 to 25 (rarely below 10) with a median of about 16. If it was undervalued by 8% during those many years then that would have been “priced into” the formula. For example the 1966 cyclical high f PE10 was a good tipoff, so if it was off by a mere 8% so that’s not a reason to be concerned.

But what about the modern era where an enormous amount of debt has warped PE10? Does that mean it is not useful? It is still useful because it offers a warning that prices may come down to the lows of 2009 and 2002. The reason why it hasn’t worked well in modern times of because of Federal Reserve bubble blowing which has created the myth of the Central Bank put option, plus declining interest rates, also many of the survivors of the Great Depression who were old enough to invest in 1930 are no longer around so today’s investors are less motivated to be careful and are too convinced of the implied promise of government bailout. Eventually these beliefs will be tested when corporate earnings decline, the EU and Japan suffer further hardship, low GDP leads to global recession and junk bond defaults trigger a recession. I firmly believe that stocks are significantly overvalued and all it will take is fear for the masses to panic and sell off their stocks. It is not necessary for a recession to make stocks go down.

Investors need independent financial advice about the risks of misunderstanding PE10 during an era of bubbles. I wrote an article “Amazing stock bubble”.

 

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Don Martin

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