Stock Boom Fact #1 — There is a strong correlation between low stock valuations and time-periods in which stock prices continue generally upward for a long time.
Many are looking forward to the day when we again see big increases in stock prices. Those days will return, but probably not until we first experience a big price drop.
The obstacle standing in the way of a stock boom is that prices are so high that it is hard for them to go much higher without the economic realities pulling them back down again. A stock crash would bring prices down to the levels where stock prices could rise for a long time without the economic realities forcing a cessation to the upward ride.
If we were to see a 68 percent drop in stock prices (that’s the average percentage drop in stock prices we saw on the three earlier occasions when stocks reached the levels of overvaluation that apply today), would that be a good thing or a bad thing? It would of course be a very bad thing for those who failed to make downward adjustments in their stock allocations when stock valuations got out of hand. It would be a good thing for the rest of us. A long-running stock boom can only be born at a time of low stock valuations.
In fact, there has not been a single case in the history of the U.S. stock market in which we dropped to the valuations levels where we would be after a 68 percent drop in stock prices and in which we did not experience a highly profitable stock boom in the years that followed.
Stock Boom Fact #2 — A 68 percent drop in stock prices would bring us to valuation levels likely to set off a stock boom.
A 68 percent price drop from the prices that apply today (this article was written in late September 2006) would bring us to a P/E10 level of just under 9. There have been three occasions at which valuations have gone lower: (1) 1921 (P/E10 of 5.1); (1) 1933 (P/E10 of 8.7); and (3) 1982 (P/E10 of 7.4).
The 1921 trip to valuation levels near those that would apply after a 68 percent stock crash generated a rise in the S&P 500 Index level from 7.11 in January 1921 to 24.86 in January 1929 (or from 70.99 to 275.78 in mid-1983 dollars). The real return on stocks for the following 20 years was 9.53 percent.
The 1933 trip to valuation levels near those that would apply following a 68 percent stock crash generated a rise in the index level from 7.09 in January 1933 to 93.32 in January 1966 (or from 104.26 to 556.69 in mid-1983 dollars). The real return on stocks for the following 20 years was 8.40 percent.
The 1982 trip to valuation levels near those that would apply following a 68 percent stock crash generated a rise in the index level from 117.30 in January 1982 to 1425.59 in January 2000 (or from 235.97 to 1602.10 in mid-1983 dollars). The real return on stocks for the following 20 years was 11.32 percent.
Stock Boom Fact #3 — The added returns paid to middle-class investors with money to invest at times of low stock valuations permit them to win their financial freedom years sooner.
The average of the three P/E10 levels noted above is 7.0. The average 20-year return is 9.8 percent. That’s a full 3 percentage points higher than the average long-term real return of 6.8 percent!
Stock Boom Fact #4 — The next boom might begin within the next ten years.
For the long-term investor, a stock crash would be a good thing. How could that be? It is the huge price drops we see in stock crashes that make the hugh price increases we see in stock booms possible. The investor with a long-term perspective views a stock crash as the natural time for planning to profit from the stock boom that follows.
The average time from bull-market top to bull-market top is 33 years. If we presume that the next bull market will top out about 33 years after the Year 2000 top of the most recent one, the next top will come somewhere near the year 2033. That means that we will start seeing movement up from the stock-crash lows long before then, perhaps sometime within the next 10 years.
The historical stock-return data shows that it is impossible to pick either the highs or the lows of a crash/boom cycle. So those following the Valuation-Informed Indexing approach to investing need to begin increasing their stock allocations long before we reach the sorts of valuation levels likely to set off a long-term stock boom. Valuation-Informed Indexers may well begin increasing their stock allocations sometime within the next five years.
The time to start planning for your participation in the next stock boom is now.