Explanation requested by John
Do you have any explanation, in either generational or
non-generational terms, why the market fell from 1966 to 1981?
Yes, here is an explanation which has a generational theory component, at least in part. Much of what follows I have extracted from work done by Crestmont Research.
Firstly, consider the following ‘decade’ table of the correlation between economic growth and DJIA (Dow) growth:
AVERAGE ANNUAL CHANGE (COMPOUNDED)
(All figures in nominal value)
The first conclusion is that economic growth is not driving stock market prices. Something else is at play here.
The idea that the economy will recover so stocks will go up in price is an erroneous conclusion.
So what is it? Before we answer that lets look at the BULL and BEAR cycles of the DJIA from 1901 to 1999:
From this we see that the “valuation instrument” of the stocks is the PE ratio
Let me explain: Lets take the Bear cycle of 1966 to 1981.
During this period company earnings within the DJIA grew at 6.4% per annum compound, only a little slower than GDP economic growth of 8.8% per annum compound.
The PE ratio at the beginning of the period was 21. So on a share with a price of say 100, if it were to grow at the same rate as company earnings of 6.4% per annum, in 1981 the price should have been 269.8 but in fact this didn’t happen. The price had gone down by 10% !!! Not up by a large amount which you would have expected from the earnings growth.
Why? Because the PE ratio had dropped from 21 to 7 over the 16 years.
The PE ratio is the mechanism that investors use to value shares in the longer term. (Short and medium term can be bedevilled by insane investor sentiment)
How does the PE ratio work?
Well here is a scatter plot chart done by Crestmont Research. The X axis is the inflation %, both positive and negative, and the Y the PE ratio. There are 109 plots for the period 1900 to 1909.
With your math you will clearly see the Y curve, which gives the message that when inflation is low and positive there tends to be high PE ratios, and when inflation is high or negative the PE ratio tends to be low.
This is further substantiated by sophisticated financial models showing returns versus inflation and interest rates. I haven’t covered this here.
Clearly the bull and bear cycles are substantially influenced by various factors from the economic cycle (but not GDP growth as demonstrated above) but also and in particular to investor sentiment related to the generational cycle.
The compound growth from in the Dow from 1921 to 1928 was 15.5% per annum. This is a typical bubble situation of investors losing restraint and behaving irrationally. i.e. creating a serious bubble. In my view bubbles and generational theory have a high correlation, for the all reasons that you have put forward over time.
Now have a look at 1933 to 1936, a compound annual growth of 18.9%, even higher. These guys hadn’t learned their lesson; there was an insatiable desire for more bubble! The party must go on. Sound familiar?
The next strong growth period for the Dow was 1942 to 1965. Much more restrained at a compound growth of 8.9% and in the context of a strongly growing economy, but nevertheless a mini bubble. I lost every cent I owned, plus borrowed money as well in that 60’s mini crash. It’s made me a wiser investor.
In fact, the 60’s mini crash hurt a lot of people but not nearly as badly as the 30’s. It wasn’t uncommon to attend a dinner party in the 70’s to be told by one of the guests that never again would they put money into a stock market. A retired and widowed aunt of mine lost 94% of her savings in that mini crash.
Now comes the bull market of 1982 to 1999. Here we are back to a compound annual growth for the period of 14.9% with a PE ratio of 42 at the end of the period. The bubble characteristics are very similar to 1929. (The bubble formed in 1995) Investor insanity is surely the correct interpretation? But like the aftermath of the 1929 crash, with a 200% growth shortly afterwards, these bubble investors of the 21st millennium, had another go and pushed the Dow up to a 2007 peak. Same insane pattern of the 30’s?
I do hope that this provides the explanation you were looking for, John.