Geoff Gannon October 10, 2008

On a Return to Normalcy

It might not feel like it, but yesterday marked the Dow’s return to normal.

Normal valuations that is.

A little under two years ago (December 2006), I wrote a series of posts on normalized P/E ratios. In my most important post in that series, “In Defense of Extraordinary Claims”, I argued that future returns would not match historical returns, because normalized valuations from 1996 to the present were too high:


Stocks are not inherently attractive; they have often been attractive, because they have often been cheap.


That statement neatly sums up my argument. Buying stocks blindly worked during most of the 20th century because stocks were cheap during most of the 20th century.

That all changed in 1996. In every year from 1996 through 2007, the Dow was more expensive relative to its normalized earnings than it had been in any year from 1935 through 1995. The closest comparison was 1965. But every year: ’96, ’97, ’98, ’99, 2000, 2001, 2002, 2003, 2004, 2005, 2006, and 2007 was more expensive than ’65.

As a result, historical return data from the 20th century was an inappropriate guide for expected returns on an initial investment made at any point from 1996 – 2007.

We were in unchartered territory.

Not any more.

Yesterday, the Dow dropped below 8,750. That number is the point at which the Dow would be trading at the average 15-year normalized P/E ratio for 1935-2005. In those seven decades the Dow posted a compound annual point gain of 6.6%. Back it up ten years to 1995, the last year before the paradigm shift I wrote about and you still get annual point growth of 6.2%.

So at yesterday’s close of 8,579 the Dow is priced to grow at a quite historical six to six and a half percent a year.

That may not sound like much to those weaned on the 1982 – 1999 bull market. However, it’s a lot better than the “new paradigm” market that began in 1996. Since we broke into unchartered territory twelve years ago, we’ve done something like 3.4% in point terms.

And over the last ten years: zilch.

Here’s what I wrote about the possibility that the post 1995 (i.e., permanently higher normalized P/E) environment could be maintained:

Is it possible that the surge in normalized P/E ratios beginning in 1995 was simply the culmination of a crisis within the investment discipline? Maybe normalized P/E ratios have reached “a permanently high plateau” now that a new paradigm has taken hold.

I won’t dismiss this argument entirely. There is some logic to it. After all, stocks have been an unbelievable bargain for most of the 20th century. Why should that continue to be the case? Eventually, won’t enough investors wise up to this fact and cause the so-called “equity-risk premium” to disappear.

If the normalized P/E ratio remains extremely high, there will be no need for stock prices to fall. Of course, these higher valuations must necessarily cause future

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