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 returns to fall short of historical returns. But, there’s no logical reason why normalized P/E ratios must revert to the mean – future returns can be adjusted down, allowing current prices to remain high.

That’s true. In fact, the Dow could theoretically trade around a normalized P/E ratio as high as 40-50 without making stocks so unattractive as to completely eliminate them as a possible long-term investment (all of this assumes the equity-risk premium can disappear).

At around 50 times normalized earnings, the math gets terribly unforgiving. As a result, it’s hard to imagine any likely circumstances under which a market trading at close to 50 times normalized earnings could be a viable investment option – though it’s theoretically possible if long-term interest rates are very, very close to zero.

But, at lower normalized P/E ratios, such as 30 (and certainly 20) stocks could still compete with other investment opportunities. Stocks might lose most (or all) of their edge over other asset classes; but, stock prices wouldn’t necessarily have to fall – they could simply offer much lower returns than they had in the past. This could continue indefinitely – in theory.

I say “in theory”, because that seems a rather unlikely scenario. There is absolutely no evidence for it in the data. Before 1995, the Dow’s normalized P/E ratio had ranged from 6.88 – 17.40. The average (mean) normalized P/E ratio from 1935-1994 was 12.31. The median normalized P/E ratio was 12.41.

So, a permanent jump to normalized P/E ratios above 20 would be quite a departure from the past. Could the leap be permanent? Could these new, higher normalized P/E ratios become the new norm?

Maybe. If we really are in a new era, the old historical return data isn’t relevant – it applies only to an era of low normalized P/E ratios. New, higher valuations must necessarily lead to new, lower returns. On the other hand, if we aren’t in a new era, the old historical return data is relevant – and normalized P/E ratios must fall.

And they have fallen. Like a rock.

And saved us a lot of time.

Eight and a half years by my calculation.

Without a severe multiple contraction, the Dow would have had to move sideways for something like eight and a half years to give us the same future return increasing effect of the fall from just under 14,280 to just under 8,580.

Of course this only makes sense if you believe as I do that in the long-run your returns in stocks are derived from the relationship between the price you pay and the earnings power you get for your money.

What about earnings power impairment?

Won’t the current financial panic and the (possible) resulting global recession cause a major contraction in earnings power?

Not really. Actual earnings will be impaired. However, “normalized” earnings won’t move much (certainly nothing like the 40% drop in price) – unless we see conditions considerably worse than anything post 1935.

The Dow has been outperforming its expected earnings for a very long time (since the early 90s). That was never going to last.

The Dow’s actual earnings overshoot and undershoot its “expected” (i.e., 15-year normalized) earnings quite frequently; however, the overshooting and undershooting have tended to cancel each other out over long periods of time as you can see here:

From 1935-2005, the percentage difference between the Dow’s actual earnings and its 15-year normalized earnings ranged from (62.12%) to 65.14%. The average (mean) difference between actual and normalized earnings was 0.44%. The median difference was 0.09%.

The swings have been huge, but their net effect has been small. Basically, the Dow’s EPS chugs along at about 6% a year. Although it has managed some remarkable hot and cold streaks (none longer than the one that’s ending now) it’s basically a mirror image of underperformance and overperformance.

The Dow gives you 6% earnings growth. What you get depends on what you pay.

Starting today, you’re paying par. You haven’t had that chance in over ten years.

What do I mean by par? Since the Dow is now at (actually a bit below) its average 15-year normalized P/E ratio for 1935 – 2005, your long-term returns should match the Dow’s long-term EPS growth.

Both should be around 6% (ex-dividends).

Long-term future returns should once again be similar to long-term historical returns.

Could the future be different from the past?


But I wouldn’t bet on it.

The last ten years turned out to be nothing new.

Just a detour on the road to normalcy.


All this brings up an interesting question – and I know a lot of people may not agree with my strict either/or dichotomy between a price drop or a stock market that does nothing for many years – but assuming the Dow’s normalized P/E had to revert to the mean for it to offer its historical returns once again…

Which would you rather lose: Forty percent or eight and a half years?