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March 22, 2002

Curse of the Dow Trading Range
by Adam Hamilton

In our current hectic and somewhat surreal financial markets, most market participants today seem to believe that "the long-term" is only about six months out or so.

Corporate managers in the US now maintain an almost fanatical zeal for being hyper-focused on the current quarter's results. Wall Street analysts revel in spending vast amounts of time trying to prophesy those same current quarterly earnings. Meanwhile, the financial media spends endless hours dissecting minute-by-minute movements in the major US equity indices. Intra-day stock charts are prominently paraded constantly on Bubblevision, but when was the last time you saw a five-year stock chart presented on television?

We are traveling through a peculiar era of history dominated by what could be called the Cult of the Short-Term. The Cult of the Short-Term has grown so omnipotent these days that if one dares to challenge its orthodoxy by uttering words about market events more than six months away they run the risk of being labeled a stark raving lunatic by the investing masses.

In a wonderful break from the phalanx of short-term data with which we are continually bombarded, I am blessed right now with the great pleasure of reading Adam Smith's incredible classic "An Inquiry into the Nature and Causes of the Wealth of Nations". Adam Smith of course was the legendary Scottish philosopher who is universally regarded as the very founder of the disciplined study of modern free-market economics. Smith published "The Wealth of Nations" in 1776, a glorious year for the advancement of freedom on many fronts, disregarding Adam Weishaupt's maniacal ravings.

The phenomenal wisdom that Adam Smith lays down in "The Wealth of Nations" is breathtaking. He thoroughly explores the fantastic blessings that true economic freedom can unleash for people and nations. He discusses the magnificent power of the specialization of labor and how individuals working for their own best self-interests provide the ultimate way to fairly allocate scarce resources and raise the general wealth of everyone in a nation. Smith talks about the crucial functions of free markets and the international implications of laissez-faire free-market economics. His seminal work established economics as a dedicated branch of study and in a very real sense launched the wonderfully liberating economic doctrine of free enterprise.

As I read and attempt to absorb the vast wisdom of Adam Smith handed down through the ages, I am struck with how long-term his focus truly is. Today, few market participants can even be bothered with using six months of data to draw their conclusions about the markets. Adam Smith, however, taking the invaluable strategic long-view, used six-hundred YEARS of historical data to buttress his points and define his immortal free-market theories!

Just as today, in Adam Smith's time there no doubt existed a powerful industry of hype based solely around selling stocks to suckers regardless of underlying fundamentals. The notorious South Sea Bubble speculative mania had run its disastrous course in England about 55 years before Smith published "The Wealth of Nations". Taking into account Russian genius Nikolai Kondratieff's later work illuminating great market cycles of roughly 60 years in length, another speculative mania was probably brewing in London when Smith's wisdom was published.

Smith, unlike the contemporary equivalent of the Wall Street propaganda teams of the age, the London "stock-jobbers", focused almost exclusively on the strategic long-term in defining his powerful theories. He wrote extensively about how capital will only be deployed by rational investors if they can achieve reasonable earnings and profits with their capital. In today's lexicon, Smith sounded like a hardcore fundamental value investor like Warren Buffet.

Provocatively, centuries later we all remember the brilliant genius of Adam Smith and his careful methodical analytical approach which included using six-hundred years of data to help define his wonderful free-market economic theories. Yet, today no one even remembers the names of the stock hypesters of the era, the conmen like the folks on Bubblevision today that gleefully spit in the face of fundamentals, logic, and long-term analysis.

Adam Smith's prudent strategic focus helped form the powerful ideas that made him a legend. I suspect that there is not a single serious economics textbook on earth today that fails to mention Smith's ground-breaking work!

Unlike Smith's carefully reasoned prose, today's rampant Cult of the Short-Term is immensely dysfunctional and it will ultimately cost naïve investors vast amounts of capital. Today, just as in March 2000, people are once again uttering nonsense claiming that earnings and fundamentals don't matter for stocks. They are once again brazenly claiming that valuation is irrelevant in our brave "New Era". The percentage of bulls versus bears is approaching an all-time high once again. Adam Smith would have laughed at the folly!

These same perma-bulls have lately been zealously proclaiming that the Dow Jones Industrial Average is locked comfortably in a new trading range. They don't consider this anything to be concerned about of course, as they perceive the trading range as merely a temporary mustering point on the way to a vast new bull market in equities.

Looking at the current Dow 30 trading range when only a few months of history are considered is not very enlightening. Yet, what if the trading range of the DJIA is viewed through the objective lens of longer history? What hard lessons regarding Dow trading ranges have investors had to learn through much bloodshed and tears in the recent past? Can we avoid the dangerous pitfalls that wounded the investors before us by learning from their errors?

Unlike Adam Smith's impressive six centuries of historical data, we only need about 66 years of historical Dow 30 data to craft this essay. In today's investment world dominated by the fanatical Cult of the Short-Term, 66 years may seem like a very long time, but the great Adam Smith probably would have considered it barely acceptable for a meaningful strategic analysis.

The perma-bulls today seem to blissfully believe that the Dow trading range is a blessing heralding a rapidly approaching new bull market. Are they right? Or is the current Dow trading range really a vicious curse that will ultimately exact far more than its pound of flesh from unwary investors?

Can the past be useful in defining a probable course for future market direction? Does history repeat itself in the financial-market arena? If history indeed can be useful for handicapping the future, what are the potential implications of the Dow 30's current trading range in light of hard historical data?

To begin, we will attempt to deploy Adam Smith's time-tested methodology of using rock-solid historical data to build a logical point of embarkation. The data in this essay was largely drawn from our earlier "Century of the Dow" essay that outlined, among other things, the amazing symmetrical continuum between the past, present, and future in the world's premier stock index. In "Century of the Dow", two major strategic market truths became readily apparent.

First, major bull and bear markets tend to each run for roughly 17 years or so in the last hundred years of Dow Jones Industrial Average action. Check out our second graph in "Century of the Dow" for an illustration of this phenomenon.

Second, the 20th century can be divided into uncannily comparable thirds in terms of stock market behavior. In these 33-year cycles (roughly double the 17-year bull or bear cycles), the first half is always defined by sideways choppy trading while the great bull markets don't erupt until the second half. The last three graphs in "Century of the Dow" illustrate this point. Just as Nikolai Kondratieff indirectly predicted, every other bull/bear cycle ends in a speculative mania, roughly every 66 years (two 33-year cycles), but the mid-Kondratieff wave bull market can also be incredibly compelling even though it doesn't balloon into a speculative mania.

Our first graph compares the most recent two 33-year cycles of Dow 30 action in the US. The DJIA daily closing price from 1968-2001, the second-half of which produced the last great bull market we are all familiar with since 1982, is plotted next to the DJIA daily closing price from 1936-1969.

The price-to-earnings ratios shown at specific points in history in this essay, however, are not Dow 30 P/E ratios but broad market S&P Composite P/E ratios. The S&P Composite usually accounts for 85%+ of the total market capitalization of all US equities so its P/E is a great broad-market measure of overall US stock market valuation. By comparing Dow 30 closing data with broad-market P/Es, we can gain a strategic understanding of how the DJIA performs relative to general current stock market over or undervaluation.

In the graph below, note the incredible symmetry of the behavior of the DJIA over the two most-recent 33-year periods.

It is very interesting that in both historical Dow periods the first half of the graph, roughly the first 17 years, witnessed generally sideways trading action. As time relentlessly marched forward valuations gradually descended as corporate earnings caught up with stock prices, but for the most part there were no spectacular moves in the Dow 30.

In striking contrast, roughly near the halfway point of each 33-year cycle, the DJIA exploded upwards with great fury in both great bullish cycles. Note that both of the Y-axes above are zeroed which helps illustrate that the raw magnitude of both the 1960s and the 1990s bull markets in the elite Dow 30 were very similar.

Provocatively, both great bull markets launched after a long and boring 17-year basing period in a massive sideways trading range. In addition, and this is a rock-solid historical fact that the perma-bulls are deathly afraid of investors knowing, both great bull markets in the second half of the 33-year cycles began marching northwards from very undervalued broad-market P/E valuation ranges!

As we explained in "Century of the Dow", on average over the last century the US equity markets have traded at a P/E of 13.5 times earnings, which equates to a reasonable return of 7.4% per year. As all the ultimate wisdom in investing can be distilled into four simple words, Buy Low Sell High, it makes great sense to buy into the stock market when it is undervalued (buy low) and sell when it becomes overvalued (sell high). Giant oscillations between periods of general stock market undervaluation and general stock market overvaluation undulate through financial history with great regularity. The time periods compared above drive home this crucial historic strategic truth.

Just as Adam Smith realized and discussed, there are great pricing cycles that run through history. And while history never repeats itself exactly on a micro-tactical level, it does have stunning strategic symmetry in macro-financial terms. Smith reasoned that when greater than normal profits could be made in an industry, meaning low P/E valuations, investors would rush into the industry and bid up stock prices until the profits were once again normal. Smith also reasoned that when only lower than normal profits could be achieved, as when P/E valuations are too high, investors would pull their capital out of an industry to seek higher profits elsewhere and stock prices would be sold down.

The enormous effects of free-market supply and demand on everything from labor to capital to commodities was the very cornerstone of Adam Smith's brilliant free-market theories. Untold multitudes of citizens each acting solely in their own rational economic self-interest would unknowingly in aggregate create titanic macro-economic market forces that Smith called "The Invisible Hand". As I eagerly devour Adam Smith's brilliance published centuries ago in 1776, I feel an incredible sense of déjà vu as his words apply perfectly to the economy and market environment today. True wisdom is timeless!

We created the graph above as a simple illustration of how the ridiculous Cult of the Short-Term today blinds investors to crucial strategic market truths that could help them earn far higher returns on their investments and suffer far fewer losses. By over-focusing on meaningless day-to-day market noise, today's investors are being led down a very dangerous path and they are completely oblivious to the monumental risks lurking all around them.

If you are an investor and all you are exposed to are worthless intra-day charts and you are led to believe that "the long-term" is only six months, how can you thrive in an environment where major strategic market cycles take roughly 17 years (major bull OR bear), 33 years (major bull AND bear), and 66 years (Kondratieff Wave) to run their courses? Obviously, the answer is you can't! Rather than helping investors reach new levels of sophistication and understanding, which would eventually create vast wealth, today's Wall Street hype industry is dooming investors to relearn the hard and painful lessons of the recent past, at great risk of massive losses of scarce capital.

As Adam Smith understood well, and history has rightfully placed him on a very high pedestal because of his amazing wisdom and insights, true economic analysis requires careful, logical, and rational study of long-term data. The crushing and oppressive chains of the Cult of the Short-Term are one of the great financial market tragedies pervading our surreal post-bubble era.

As the Dow 30 tends to repeat itself in a macro-strategic sense over 33-year cycles, what implications does the now widely heralded Dow trading range have for the potential DJIA trajectory in the coming years? Is the trading range that is being widely discussed today a blessed harbinger of a great new bull market starting later this year or next, or is it a cursed omen foretelling much great pain and wailing and gnashing of teeth for many years into the future?

At the apex of the great bull cycle of the 1960s, the Dow 30 challenged the at-the-time lofty level of 1000 and general market P/Es became far overvalued at 24.1x earnings. Rather than crash as in 1929 (which incidentally witnessed a peak broad-market P/E much higher of 32.6), after the DJIA challenged 1000 in February 1966 it rolled over into a brutal roughly 17-year trading range. Stock prices had ballooned so outrageously high in the late 1960s that it took corporate earnings almost 17 years until 1982 to fully grow into stock prices!

Historical trading ranges after major bull market runs generally take 17 years to resolve themselves, a sobering prospect. Interestingly, after the DJIA first approached 1000 in 1966, it took roughly 17 long years until 1982 until the big round psychologically-imposing 1000 number was left in the dust forever!

As we rapidly approach the three year anniversary of the Dow 30 first closing above 10,000 on March 29, 1999, it is ominous to behold that the Dow 30 is still not trading much above 10,000 even three years later! Do you remember all the mega-hype when the Dow 30 first broke through 10,000 in March 1999 predicting that it would continue to soar to the heavens with 20%+ gains per year? If that flawed prophecy had proven true, we would have a DJIA of 17,280 today, not 10,000!

Today, nearly three years after 10,000 first fell, are we trapped in the Curse of the Dow Trading Range?

Our next graph is merely a hypothetical flight-of-fancy, like a pro-forma earnings release, so please don't read too much into it. On February 9, 1966, the Dow 30 topped at the lofty level of 995.2 which marked the end of a great bull market. After that peak it took 17 years of brutal sideways trading before corporate earnings finally caught up with stock prices and laid the foundation for the next great bull market which began galloping in 1982. On January 14, 2000, the Dow 30 topped again at 11,722.98 after a spectacular roughly 17-year run from 1982.

As it is extremely difficult for investors today to really visualize just how ugly a standard 17-year DJIA consolidation trading range truly is, we decided to take a flight-of-fancy and create a hypothetical Dow future using real past historical data. Lining up the two daily respective bull-market tops in February 1966 and January 2000, we applied the actual daily percentage gains and losses of the DJIA from 1966-1982 on a daily basis starting in January 2000 and ran the series 17 years into the future.

The blue line below is actual DJIA closes since January 2000. The yellow line is the hypothetical projected Dow 30 using daily trading data of the DJIA from 1966-1982. White P/E ratios are actual P/E ratios for today's broad US market, while the yellow P/E ratios are the historical broad-market P/E ratios from the 1966-1982 timeframe.

PLEASE realize that this graph is totally useless for tactical trading! The actual peaks and troughs in the Dow 30 in the coming years will certainly not play out to this precise tactical timing. This fantasy-graph is ONLY useful as a general broad strategic tool to help visualize what an honest-to-goodness 17-year consolidation trading range in the Dow 30 would look like starting from the last great Dow top of 11,723. The results are not pretty and should cause all buy-and-hold automaton Dow 30 investors some serious pause.

Imagine the fun of buying the Dow 30 now at 10,000 or so, patiently waiting 14 more years, and still having the Dow trading range-bound at 10,000 or so? To me it sounds like the kind of horrible nightmare from which you wake up drenched in cold sweat and are so relieved that it was only a nightmare and not reality!

The whole horrific idea of a true historical consolidation trading range after a great bull market ought to utterly terrify all buy-and-holders. Long trading ranges are wonderful for smart speculators who are willing to actively buy and sell specific stocks, but are extremely dangerous for long-term buy-and-hold investors who think they can deploy capital and then blissfully ignore it.

Our current massive Dow 30 trading range has already been running for 3 years since March 1999, so if the expected historical 17-year consolidation trading range once again rears its ugly head, we are potentially looking at 2016 or so before the DJIA gets really interesting again from a bullish perspective. 2016?!?! Yes, that is a LONG ways away!

The perma-bulls are right that today's Dow trading range could be a basing period for a great new bull market. The big question is when? Next year? 14 years from now? The sideways trading range will probably continue until US corporate earnings catch up enough with stellar Dow 30 stock prices to leave the general US equity-market P/Es undervalued.

In 1966, the great Dow bull peaked at a general market P/E of 24.1. After trading sideways for 17 years, the Dow 30 ultimately reached half fair value in March 1982, with general markets trading at 7.0x earnings, which happened to herald the very birth of one of the greatest 17-year bull market cycles in history. In 2000, the next great Dow bull peaked at a far higher general market P/E of 44.2. It may indeed again take 17 years in total, about 14 more years, for the earnings of the US stock market to catch-up with astronomical stock prices and lay solid fundamental foundations for the next major Dow 30 bull market.

Note above how the yellow P/E ratios for the 1966-1982 DJIA consolidation trading range gradually declined over time as corporate earnings increased and stock prices remained relatively stable. It is sobering to consider that one of the best-case scenarios from a historical and fundamental perspective for the coming Dow 30 action in the next 14 years or so is a similar excruciating sideways trading range!

Worst case, the Dow 30 could easily buck the trading range and head down much faster. Based on the far higher peak P/E reached in this most recent DJIA speculative mania as compared to the mighty bull of the 1960s, we believe that there is a high probability that we could actually see the Dow 30 plunge to the 4000 range at some point in the next few years. In many ways, a quicker washout bottom for the Dow 30 could be less psychologically damaging to investor confidence than a 17-year trading range! Following a washout bottom, a new bull market could commence much sooner than if we all have to suffer through a brutal 17-year sideways moving Dow 30.

The last great 17-year trading range of the Dow 30 followed a normal great bull market that spawned mid-Kondratieff Wave and did not quite reach speculative-mania proportions. By any measure, the most recent great bull market since 1982, however, was a classic speculative mania. In history speculative manias tend to collapse rapidly from broad-market P/Es over 27x earnings (double 13.5x fair value) while non-speculative-mania bull markets tend to fade more slowly into the future from P/Es under 27x earnings in a very long and challenging sideways trading range.

With a staggering peak market P/E of 44.2 in this latest speculative mania cycle, I suspect that the probability of a Dow 30 swoon to 4000 or so is at least equally as likely as the Dow excruciatingly oscillating around 10,000 until 2016. I would assign the chances of both events at about 49% each. The perma-bull hypothesis of a magnificent new bull roaring up from current levels, based on history and fundamentals, probably only has a 2% chance or less of coming to pass in the next few years.

The implications of the potential Curse of the Dow Trading Range might seem overwhelmingly negative, but they are actually quite positive.

Investors today who wish to heed history are probably best off selling the Dow 30 now at very high valuations and investing in other arenas such as the approaching commodities boom in the coming years until general US equity market P/Es once again trade under fair value in a decade or so. After we weather the high potential for a 17-year trading range, the case for the launch of a great new Dow 30 bull will once again be awesome.

The great bull market in the Dow 30 that reached maturity in the 1960s carried it from under 100 to almost 1000, a ten-times gain. The great bull market of the Dow 30 that came of age in the 1990s carried it from well under 1000 to almost 12,000, once again a spectacular run of over an order of magnitude increase in DJIA stock prices. If the 33-year and 17-year DJIA cycles continue to hold sway into the future, and there is no reason to suspect that they won't, we could very well see the Dow run from under 10,000 in 2016 or so to over 100,000 by 2033 or so in the next great DJIA bull! Won't that be a heck of a ride!

Unlike those hopelessly trapped in the Cult of the Short-Term today, investors who study and understand longer market cycles and history will have a huge advantage over all those who don't study markets beyond six months. Just as taking the longview a couple of centuries ago helped Adam Smith craft wonderful free-market truths that will exist and be celebrated forever, investors who maintain the invaluable strategic longview perspective on the equity markets today will vastly raise their probability of achieving enormous investment success.

Strategic perspective is everything in the financial markets as they inevitably richly reward those who seek to understand their dearest secrets, which are only revealed over the long-term!

The Curse of the Dow Trading Range, if it once again comes to pass in the coming decade, is certainly not the end of the world. Prudent investors who plan for it and act accordingly will probably reap legendary profits as they trade out of the Dow while it languishes sideways and wait to buy back in aggressively until halfway through the next 33-year cycle in 2016 or so when the next great Dow 30 bull is due to start galloping. If the Dow swoons dramatically, sub-fair-value levels could actually be achieved well before 2016, giving a much earlier chance for the next immensely profitable Dow 30 buy-in.

Until then, beware of the Curse of the Dow Trading Range!

"It could take 10 years - maybe 20 years - to bring stocks back to their mean levels. But someday, somehow... they'll get there." - Bill Bonner, The Daily Reckoning (www.dailyreckoning.com), March 21, 2002

Adam Hamilton, CPA
Zeal LLC.com

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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.

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