"Be brave when others are afraid, and
afraid

when others are brave." - Warren Buffett

HOME

ARCHIVES

CAREERS

FORUMS

SEARCH

SITE MAP

ABOUT US

Home -> Archives -> Adam Hamilton -> Long Valuation Waves

Talk
Back

Printer
Friendly

eMail
Article

October 18, 2002

Long
Valuation Waves

by Adam Hamilton

Almost two millennia ago some of the
most important events in world history unfolded near the Temple Mount in
Jerusalem, the ancient capital of Israel. The Pharisees, religious
authorities of the era, were trying to trap Jesus Christ into breaking the
Jewish Law with a series of cunningly-devised questions.

After Jesus deftly parried their first
attempts with displays of dazzling wisdom, one expert in the law tested
Jesus by asking, "Teacher, which is the greatest commandment in the
Law?"

The Pharisees fully assumed this
thorny question would trip up Jesus, as he was expected to fall head-first
into the temptation of elevating one part of the Law above another,
effectively blaspheming the Tanakh, the Jewish Holy Scriptures known today
by Christians as the Old Testament of the Bible. Jesus blew the Pharisees'
minds with his amazing answer.

Jesus replied, "Love the Lord
your God with all your heart and with all your soul and with all your mind.
This is the first and greatest commandment. And the second is like it: Love
your neighbor as yourself. All the Law and the Prophets hang on these two
commandments."

Jesus Christ, by far the most
important man ever to grace humanity, stunned the Pharisees. He had
brilliantly and perfectly distilled the essence of the whole Tanakh down
into two immensely powerful, elegant, and eloquent sentences.

This was no small feat, considering
that the Tanakh would later be divided into 929 chapters to become the
Christian Old Testament, almost 80% of the Bible. Jesus perfectly expressed
the deep core message of 593,493 words in only 24 exquisitely chosen words!

This amazing account recorded in the
22nd chapter of the gospel of Matthew has always had a very powerful impact
on me personally. In addition to blessing us with two crucial overriding
life principles that everyone should always strive to live by, Jesus deftly
condensed the long and complex Hebrew Scriptures down to their very
fundamental essence.

Ever since I first read and marveled at
these ancient words as a boy, I have become increasingly aware during my
life that some the greatest truths in history can be distilled down into
simple words which even a child can easily understand. Not surprisingly,
the core essence of investing can also be stated in similar condensed
terms.

The whole goal, mission, idea, and
concept of investing can be refined into merely 4 words which everyone can
easily understand…

Buy Low Sell High.

That's it! The core essence of
investing is exceedingly easy to comprehend. Even kids can wrap their minds
around this simple idea and walk away with the pinnacle of investing
knowledge treasured in their brains.

While simple in concept, execution is
a whole other matter!

Loving your neighbors is easy on
paper, but when they wake you up at o-dark-hundred some Sunday morning with
a raging out-of-control party and beer cans strewn all over your yard, the
only loving that comes to mind is dispensing some swift 12-gauge justice.
The hot emotions of the moment obscure Jesus' Greatest Commandments and
make actually living them very challenging in real-time.

The same timeless truth applies to
investing. While buying low and selling high sounds effortless on paper, it
is extremely challenging to execute in real-time. First, the great mystery
arises of whether a price on any given day is low, a buy, or high, a sell.
Second, investors must wage a continual jihad against their own emotions
because emotionally-based buy and sell decisions are almost always the
exact wrong ones to make at any given moment in time.

While the latter emotional challenge
to investors is something each one must individually struggle to overcome
over many years, the former mystery can simply be unlocked academically. In
this essay I would like to share some crucial foundational strategic
information on buying low and selling high that is incredibly important for
all investors to understand. Out of all 125 essays I
have already penned on investing and speculation, I believe the information
presented here is the most important and valuable.

Interestingly, investors today
struggle with the same emotions that plagued people in Jesus' day.
Unfortunately there is no room for love in the financial markets, as they
are utterly dominated by the perpetually-warring titanic emotions of greed
and fear.

In the markets, when the popular
emotion of choice is greed, investors are consumed with visions of alluring
wealth and bid up stock prices to very high levels. Conversely, when fear
reigns supreme, investors dump stocks like they are radioactive and want
nothing to do with the infernal instruments, bludgeoning prices to very low
levels.

These popular periods of general greed
and fear oscillate through market history like a massive sine wave around a
straight line. Our first graph stylizes these long waves of greed and fear
that inevitably lead to over and underpriced markets through history.

General investor psychology, popular
greed and fear, leads to periods of alternating over and undervaluation
throughout market history. The orange area above represents fair value, the
historical average valuation for stocks. The blue line represents Long
Valuation Waves over decades.

The wave begins as investors, after a
long hibernation, start getting excited about the markets again and a boom
is born, carrying stock valuations from cheap levels up through fair-value
ultimately up to richly-priced levels. Sometimes, if the participation in
the markets is wide enough and general enthusiasm is high enough, a boom
morphs into a spectacular speculative bubble.

These mania times mark extreme
systemic greed, when all anyone ever talks about is how rich they will
become from the rocketing stock markets. Sound familiar? ﾠEventually the bubble mysteriously
starts fading and soon crashes, usually for no apparent news-driven reason. The
bubble bursts and greed bleeds away fast and eventually general fear takes
command which leads to a market bust.

Then, like the stylized saw-teeth
above, the strategic psychology/valuation cycle arises anew like a phoenix
being reborn from the ashes. Boom bubble burst bust. Boom bubble burst
bust. The Long Valuation Wave continuously echoes through the sands of time
of market history.

To achieve the core investing goal of
buying low and selling high, your highest probability of realizing great
success is to buy the fear-laden busts and sell at the greed-ridden bubble
tops. This idea inevitably leads to the crucial question… How does
one know in real-time, while neck deep in mud and blood in the trenches,
when the markets are overvalued or undervalued?

The answer is valuation.

The word valuation, in the investing
context, simply involves understanding how much a stock index or individual
stock is truly worth based on its underlying fundamentals. Obviously if an
investor knows whether the stock markets are overpriced or underpriced at
any given time, he or she will be able to make far superior capital
deployment decisions than another investor who has no understanding of
valuation.

Understanding valuation is truly the
key to long-term investment success!

There are many ways to value stocks,
but two primary methods have steadfastly withstood the ravages of time and
have emerged unscathed through all the trials and tribulations of history.
While often maligned in today's greed-laden post-bubble atmosphere, the
mighty price-to-earnings ratio and humble dividend yield still remain the
ultimate long-term strategic valuation tools.

P/E ratios are easy to calculate in
theory, but in today's environment of ubiquitous earnings and accounting
games one must be cautious on what earnings to use. Generally the most
conservative possible "E" should be used, SEC-reported GAAP
numbers. To compute a P/E ratio, the price of a stock is simply divided by
its latest annual earnings per share. If a stock is trading at $50 today
and earned $5 per share last year, its P/E ratio is 10.

Publicly-traded companies often make
quarterly cash payments directly to their owners, the stockholders. Some
percentage of corporate earnings are paid out in cash dividends. To compute
a dividend yield, all one has to do is find out how much a company has paid
in cash dividends over the last year and then divide this by its current
stock price. If a stock is trading at $50 today and paid out $2 per share
in cash dividends to its shareholders last year, then it has a dividend
yield of 4%.

Long-term strategic valuations of
stock markets can always be discussed and understood in terms of P/E ratios
and dividend yields. Fortunately, both P/E ratios and dividend yields are
virtually immune to distortions from the ravaging effects of the inflation
plague the Federal Reserve has shamefully unleashed upon the
American people. Stock prices, earnings levels, and dividend streams are
all influenced more or less equally by inflation over the long-term, so
these two valuation tools thankfully do not require inflation to be
explicitly considered in the calculations.

If valuation truly matters, indeed it
is everything for the long-term investor, and P/E ratios and dividend
yields can measure general valuation levels, we also need to understand
where fair-value lies. Without the blessing of the vast wisdom of market
history, a rookie investor will have no idea whether a P/E of 10 or 100 is
a better omen for the future prospects of the stock markets.

To determine baseline fair-value P/Es
and dividend yields, we need huge amounts of historical price, earnings,
and dividend data. The farther back in time we journey, the more difficult
this information is to assemble. Thankfully, a gentleman has already done
the massive amount of back-breaking research necessary to unearth the raw
numbers.

I am deeply indebted to one of my
personal financial heroes, the brilliant Professor Robert Shiller of Yale
University, for painstakingly assembling raw earnings and dividend data
from over 130 years and graciously making it available to private investors
and analysts for further studies.

Dr. Shiller wrote the phenomenal book
"Irrational Exuberance" and published it before the
equity bubble topped in March 2000. In his awesome tome, Shiller warned and
meticulously documented the case that stocks were overvalued, the bubble
was ready to burst, and intermediate-future returns in the stock markets
would be poor. I suspect that a century from now this amazing book will be
widely recognized as the most prophetic book about the markets ever penned!

Shiller's book is one of the most
important books on investing I have ever read and I highly recommend that
every serious investor purchase and carefully study a copy immediately. It
greatly deepened my own understanding of the financial markets and how they
really work through history. You owe it to yourself to buy it today if you want to build legendary wealth
through prudent long-term investing.

Dr. Shiller, in the admirable selfless
interest of advancing general market knowledge, generously placed his
research data on his website ( http://aida.econ.yale.edu/~shiller/ ) for the world to use. Without his
hard work, great wisdom, and careful studies, this essay wouldn't be
possible. The earnings and dividend data used here are gleaned from his
landmark research.

In Shiller's data, the average
historical P/E ratio for the general US equity markets (the S&P
Composite Index) from 1895-1995 was 14.6x earnings. This number is slightly
higher than other historical studies I have seen, indicating a 13.5x historical US equity P/E, but the
core message of the data is still loud and clear. Fair-value for stocks is
right around 14x earnings, a P/E of 14.

Why 14 you wonder?

Profits are everything for equity
investors. Nothing else matters over the long run. When you choose to
purchase a company, the only reason you make the buy is because you expect
it to earn profits. As a stockholder, you are entitled to your fractional
ownership share of corporate profits. If a company does well, its profits
will translate into a higher share price and higher dividends and you will
reap a good return on your investment.

Over centuries of equity investing in
the United States and Europe, public companies have had average share
prices hovering around 14 times their annual earnings. It has been the
long-term fair-value around which stock markets have faithfully oscillated.
A P/E of 14 suggests it will generally take 14 years, not considering
growth and compounded returns, for a company you purchase to earn back your
full purchase price for you.

A P/E of 14 corresponds to a simple
annual return of about 7% (1 divided by 14), which is fair. It was fair a
century ago, it is fair today, and it will still be fair a century from
now. 7% is a reasonable return to earn for a saver, an investor, and a
reasonable "cost" for a "borrower", a company. Imagine
if you could only make 1% in the stock market, it would feel far too low
right? What if your mortgage cost you 20% like credit cards? It would feel
far too high right? 7% is like Goldilocks' legendary porridge, just right!

Interestingly, the long-term
historical return for the US equity markets averages right around 7%. The more one studies valuations, the
more it cements everything else studied on the markets together into a
coherent and understandable whole!

Shiller's dataset showed that the
average dividend yield for the general US equity markets was 4.6% from
1895-1995. 4.6% can be considered historical fair-value for US equity
dividend yields.

Armed with this priceless information,
the prudent investor is able to make rational, intelligent strategic
decisions about when to buy low and sell high!

If general US equity P/E ratios are
around 14, they are fairly-valued, neither a buy nor a sell. If they are
one-half fair-value, 7x earnings, they are a screaming buy indicating very
cheap stocks. Conversely, if they are 50% higher than fair-value, at 21x
earnings, they are expensive and should be sold. If general P/E ratios
explode up to twice fair-value, 28x earnings, they are in speculative
bubble mania territory and extreme caution should be exercised. Stocks
should generally be sold immediately from bubble-level general P/E ratios.

Similar logic applies to dividend
yields, with 4.6% being fairly valued. Dividend yields have an inverse
relationship to P/E ratios however, while low P/Es are strong buy signals
so are high dividend yields. Low dividend yields signal overvaluations and
historic sell signals.

Tying everything we have discussed
together, Shiller's wonderful historical earnings and dividend data
brilliantly illuminate the essence of investing. Buy Low Sell High. With
fair-value general US equity valuations being 14x earnings and 4.6%
dividend yields, we now have a benchmark to know when valuations are too
high suggesting a great sell point or too low suggesting a great buy point.

The following five graphs use Dr.
Shiller's earnings and dividend data to compute historical P/E ratios and
dividend yields for the general US equity markets (S&P Composite Index)
for the entire 20th century, from 1901 to 2000. We decided to use the elite
Dow 30, the most famous stock index in history, as our graph proxy for US
stock prices rather than the S&P Composite because the Dow 30 is much
more widely known. All P/Es and dividend yields below are based and
computed off of the general US markets, but the narrow Dow 30 is used for
the visual price proxy.

The mighty P/E ratio, along with its
cheap, fair, expensive, and bubble levels, as well as the dividend yields,
are graphed on the left axes. The Dow 30 visual proxy for US stock prices
is graphed on the right axes. All data is monthly. The graphs enable the
data and concepts to vividly leap to life!

Just as contrarian investment theory
suggests, great waves of greed and fear cascade through history. These
titanic emotional forces push general US equity valuations from under to
overvalued extremes and back again, like strong trade winds driving a great
tall ship. Like a giant sine wave, the blue P/E line above slowly
oscillates above and below fair value at 14. Dividend yields do the same,
although they aren't as readily apparent limited to the small vertical
scale shown above.

Over such long periods of market
history it is misleading to graph stock indices on linear scales, as
percentage gains are not viewed as constant across time. Our next graph is
the same data as above, but the Dow 30 visual stock-price proxy is graphed
on a logarithmic scale, which means its percentage changes appear next to a
constant base across decades. The Dow 30 rise from 100 to 1000 appears the
same visually as the Dow 30 rise from 1000 to 10,000, both equal 900% gains
in price.

I strongly believe that out of all the
500 or so graphs we have produced at Zeal thus far, this is probably the
most important one. More accurately, the original large version of this
graph with far more detail and data is numero uno. Our large 1024x768 pixel
enhanced version (5.6x more area) of this graph is available for free at www.zealllc.com/2002/valugraph.htm if you wish to view or download it.

If you diligently study, digest, and
grow to understand this large Long Valuation Waves graph, your probability
of investment success will be very high. It is a veritable treasure map for
the young, protecting them from repeating the mistakes of the past and
showing them the path to legendary stock-market profits in their lifetimes.
It is a safety-net for the old, preventing them from throwing away their
hard-earned capital by making major strategic errors in long-term buy and
sell timing.

Please study this, learn it, love it,
and live it! It truly shows the road to buying low and selling high in
crystal-clear terms.

In a nutshell, the message of the
markets encapsulated in the graph of Shiller's landmark data is this…

If you buy general US stocks when they
are undervalued, a P/E near 7, you are likely to reap astounding profits in
the following years. On the other hand, if you buy the US markets when they
are overvalued, a P/E above 21, you are likely to lose capital or see no
gains for decades. Buy low, when valuations are cheap, and sell high, when
valuations are expensive. Ride the Long Valuation Waves from trough to
peak, but then get off and patiently wait for the next ideal wave!

Our final three graphs this week
divide the 20th century into thirds, and it is amazing and enlightening to
see how buying low and selling high based on valuations leads to
consistently legendary gains for prudent investors.

The first third of the 20th century
climaxed in the most famous bubble and bust of all time. Not surprisingly,
if you were armed with Long Valuation Wave wisdom and invested during this
era, you could have easily bought near the bottom and sold close to the
top.

In December 1920, the general US
markets were trading at an abysmal P/E of only 4.8, incredibly cheap. Even
though stock prices were already much higher than the early decades of the
century, stocks were still enormously undervalued. A prudent investor could
have bought the Dow 30 at 72 when the US markets were trading at 4.8x and
yielding a massive 7.5%.

Almost a decade later in September
1929 one of the biggest stock market booms in history had erupted, leading
to extreme valuations. If an investor of the time understood Long Valuation
Waves, he or she could have exited near the top. The September 1929 monthly
Dow close of 343.5 wasn't the exact daily top of 381.2, but it was darned
close.

A Long Valuation Wave surfer could
have made a relatively low-risk strategic equity trade in the Dow 30 by
buying cheap and selling dear for a magnificent 377% gain in the 1920s!

In the middle of the century, an even
greater opportunity presented itself, two dismal valuation lows followed by
an utterly fantastic stock boom. Even buying at the higher second valuation
low in June 1949 at 167.4 and selling near the overvalued top of January
1966 at 983.5 would have yielded enormous 488% gains.

If you buy at a cheap general US
market P/E near 7 and sell at an expensive P/E above 21 the huge gains are
easy, making any investor look like a superstar!

The big graph mentioned above at www.zealllc.com/2002/valugraph.htm has even more datapoints labeled to
test and observe how Long Valuation Wave Theory discipline leads to
legendary gains for investors.

In the final third of last century
once again the markets reached undervalued extremes at great general fear
during the mid-1970s and later again in the early 1980s. As always though,
the great valuation waves of history inevitably regress to their mean at a
14 P/E, rising if they were cheap and falling if they were expensive. And
they often overshoot fair-value on both sides, creating enormously
profitable opportunities to buy low and sell high.

If a prudent investor bought at the
undervalued 6.6 P/E in July 1982 and sold at the super-bubble top P/E of 44.2
in December 1999, he or she would have reaped legendary 1322% gains! Where
do I sign up?

Dear friends, the key to successful
long-term strategic investing does not rest in attempting to interpret
endless day-to-day market noise. It does not rest in buying high and
attempting to sell even higher, the so-called "Greater Fool
Theory" advocated almost universally on Wall Street today.

The key to long-term investment
success is to Buy Low and Sell High, and general market valuations as
measured by P/E ratios and dividend yields provide the ultimate long-term
buy and sell signals.

Without the proper strategic
perspective of knowing where in the Long Valuation Waves our current stock
prices lie, investors have no way of understanding whether the markets are
cheap or dear based on crucial corporate earnings. Absolute index price
levels are of little concern, what truly matters is whether these index
levels are relatively cheap or relatively expensive compared to the current
earnings power of US companies.

Long Valuation Waves and the
enlightened perspective of seeing the markets through their lens are the
very essence of contrarian investing. Elite contrarian investors, like the
legendary Warren Buffett, steadfastly Buy Low and Sell High, and they ply
their wondrous trade via a careful ongoing study of valuation.

Provocatively, contrarian investors
are the only consistently successful investors over the long-term, so
contrarian investment theory is incredibly important. Contrarians have
learned to harness their emotions and buy low and sell high, buying when
fear is rampant and selling when greed reigns supreme, the exact opposite
of the general public.

I apologize for this lengthy essay,
but I wanted to present the basic Long Valuation Wave Theory and data all
in a single document. We at Zeal
plan to build on these basic valuation studies in coming months and years
and expound in greater detail in future research.

As we zealously want to help our
clients spot and act upon the legendary buying opportunities approaching
after the US equity markets finally bottom in the future, we painstakingly
calculate fresh valuation data monthly. Every month we compute real-time
S&P 500, Dow 30, and NASDAQ 100 P/E ratios and dividend yields so we
and our clients understand exactly where we are in the great Long Valuation
Wave cycles. This precious data is available exclusively to the subscribers
of our acclaimed Zeal Intelligence newsletter.

I am once again very thankful for and
deeply indebted to the great Professor Robert Shiller and his landmark
valuation-data work he has graciously shared with the world. If this essay
intrigues you, you simply have to go buy his book today for some real enlightenment and
wisdom!

Investors ought to carefully learn and
understand the Long Valuation Waves if they wish to succeed in the markets.
If they ignore the Long Valuation Waves it is at their own great peril.

Buying low and selling high, the distilled essence of all
investing wisdom, is only possible with a working knowledge of the massive
Long Valuation Waves relentlessly driving the markets.

Talk Back

Adam Hamilton, CPA

Zeal LLC.com

Do you enjoy these essays? Please help support Zeal Research
by subscribing to Zeal Intelligence today! &www.zealllc.com/subscribe.htm

If you have questions I would be more than happy to address
them through my private consulting business. Please visit www.zealllc.com/financial.htm
for more information.

Thoughts, comments, flames, letter-bombs? Fire away at &
[email-masked] Due to my
staggering and perpetually increasing e-mail load, I regret that I am not
able to respond to comments personally. I WILL read all messages though,
and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst,
publishes Zeal Intelligence, an in-depth monthly strategic and tactical
analysis of markets, geopolitics, economics, finance, and investing
delivered from an explicitly pro-free market and laissez faire perspective.
Please visit www.ZealLLC.com for more
information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm
to subscribe.

Copyright © 2000 -
2006  Zeal Research

« BullionVault.com
-- Buy gold online - quickly, safely and at low prices »

« Opinions expressed at SafeHaven are those of the
individual authors and do not necessarily represent the opinion of SafeHaven
or its management. Articles and Talk Back are available via RSS/XML. Please
visit RSSHelp for
instructions. »

Top of Page

Read
ourDISCLAIMER

HOME | ARCHIVES | CAREERS | FORUMS | SEARCH

SITE MAP | ABOUT
US | LINKS | CONTACT
US

Copyright © 2000-2006 - SAFEHAVEN.com

ColdFusion by COSTAS PILIOTIS

Server Admin by DIGITAL
ADMIN

SafeHaven Web Site FEED

..