Rauch: Is the Bubble Returning?

George Rauch: Is the Bubble Returning?

No. The bubble never left. The above chart is interesting because it tells a story of the market's performance since 1920. Keep in mind this is the Dow Jones Industrial Average, which, for this period, represented at least 25% of the value of all U.S. stocks, most importantly including a cross section of the shakers and movers that reflect the direction of the U.S. economy.

The market's increase from 1982 to 2000 was out of proportion to prior increases in value.

Support levels are created by prices, which represent historical average yields and price earnings ratios.

If we were to reach support immediately, the market would go to a price/earnings ratio of 14.4 times earnings and dividend yields of 4.3%, the level of which would be between 6,600 (the historical average Dow P/E ratio of 14.4 times) and 4,500 points (the historical average yield of 4.3%).

Levels representing historical values are what Wall Street and the government is trying to avoid, even though the historical average P/E ratio existed only seven years ago. The Fed is flooding the market with new money and desperately attempting to avoid a panic sell-off of the Dow taking it below average historical yields and P/E ratios.

From 1942 until 1962 there was a 20-year bull market in which the market increased in value by a multiple of eight. From 1962 until 1982 the market went nowhere. Because of inflation, investors owning stocks during that period lost money. From 1982 to 2000 the market increased in value by a multiple of 14 fueled by deficit spending and ambitious money creation by the Federal Reserve System.

The best our government can hope for is that the market remains within the current trading range and that corporate earnings catch up with the market. As corporate earnings and dividend yields grow over the years, they will become commensurate with historical averages, and the stock market is likely to go nowhere. The government fears a sell-off, taking the market to low levels of support that existed in the 1930s, or even to 1982 levels when gold reached its zenith.

Technical analysis indicates logical support at around 6,000. A lot of bright analysts are looking at 4,000. A potpourri of analysts is looking at 3,000 and 2,000, which does not seem realistic, even from the point of view of statistically analyzing the mathematical potential of this bell shaped curve.

Look hard at what we call the "step" created in 1996 at level 6,000. That "step" is the logical corresponding downside stop of the right side of the parabola. Technical analysis concludes a 6,000 Dow is in our future.

Wall Street and the Federal Reserve know this, too. What they want to continue to do is flatten out the right side of the curve and maintain a trading range until corporate earnings and yields increase over time. Should they be able to do that, the next 20 years on this chart would look much like 1962 to 1982, where, as mentioned above, it is unlikely investors will make money in stocks, particularly if there is inflation. During 1962 to 1982, most money was made in real estate - we had real asset inflation.

What are we seeing now in real assets such as gold, real estate and rare objects? Asset inflation.

The Standard & Poor 500

The DJIA current P/E ratio is 22 times earnings. Look at historical information available on the S&P 500 when the P/E ratio is 22. The S&P 500 10-year results following a P/E of 22 or more are as follows:

What does this mean?

First, studies indicate that when the DJIA is at 22 times earnings or higher, like the present, the 10-year compounded median returns were 5%, including dividends. While this is better than the S&P 500 results, for all the risk that exists at these levels, it's simply not worth it to hold stocks unless we are holding stocks that have a current dividend yield of 5%, which dividend is well covered. The stock should be A-rated and selling at 12 times earnings or less.

Second, because the government will have to create inflation to keep the markets at these levels and because the behavior of the Fed indicates they are committed to creating inflation, assets such as real estate, gold and silver and rare objects are likely to enjoy returns far greater than returns on stocks over the next 10 years.

Third, three-to-five-year government paper and A-rated municipal and corporate bonds provide security on the downside, security to income and more safety in these turbulent times. Further, investors position themselves to take advantage of values that will exist if the market has a huge sell-off.

Conclusion

History indicates the risk in this stock market bubble is so great as to limit returns over the next 10 years. It is likely that sometime during this period investors who have positioned themselves conservatively will benefit three ways:

1. They will not lose principal;

2. They will receive a reasonable return on their cash;

3. They may have the opportunity of a lifetime to pick off great values in stocks at the point when stocks become reasonably priced again, or, God forbid, way, way undervalued.

Caveat Emptor!

George Rauch, Longboat Key, is CEO of Bradenton-based General Propeller and a former Wall Street investment banker.

Year PE wasFollowing

22 or more10 year return (*)

1929- .9%

1930- .4%

1962+4.0%

1965-.9%

1966+1.4%

1969+ .7%

Historical Avg.+ .7%

(*) Includes Dividends

% INCREASECORRESPONDING % DECREASE

PERIODIN DJIABEAR MARKET OF BEAR MARKET

1924-1929432%1929-193291%

1932-19374721937-194252

1982-20001,4802000 - ??

P/E

DJIA LEVELRATIO (x)YIELD (%)

6,00014.0x3.5%

4,0009.35.2

3,0006.87.0

2,0004.710.5

Historical Average14.44.3