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Registered with the SEC and CFTC
September 11, 1981
Long Term Perspective
Over the recent years, investors have been stunned by inflation, high interest rates and the volatile bond and stock markets. The United States has entered a period of great uncertainty, which is affecting everyone and from which there appears to be no safe haven. This country was built by men and women who refused to recognize limitations. Through inventiveness and persistence, the United States has succeeded in offering the best standard of living in the world. Now, there are many who are telling us the dream is over. The popularity of the gloom-and-doomers has been exemplified by the success of their books, seminars and market letters. They spin a logical tale. The pyramid of an expanding debt is an ever increasing danger.
Past economic history has shown that there have been similar cycles, all of which have ended with a depression and bankruptcies. But timing is everything. Financial independence can be obtained through the proper timing of your investments. There is a time to buy and a time to sell. The recent changes investors are facing means an opportunity is being created. If it were easy to make money in the markets, everybody would be rich. The obvious is most likely obviously wrong. Today, where do you think the average investor believes the best return on his or her money can be achieved? The most likely answer is obviously against the bond and stock markets. Investors often base their decisions on past criteria. After all, why would anyone invest in the stock or bond market during these uncertain times when a good safe record high yield can be achieved in money market funds? I think this obvious answer is wrong. I believe the bond and stock markets to be a clearance sale on already discounted prices. Don't expect to see a headline in the paper saying: "The Stock and Bond Market Is Ready To Bottom", with a sub headline stating: "Buy Now And Sell At A Much Higher Price Later".
The markets don't operate that way. By the nature of markets, the majority can never be right. A market bottom is formed when all the negative news is fully discounted. That is, when everyone that could be frightened into selling, has already done so. Discouragement,, disappointment, apathy, fear, frustration, and the most important ingredient, panic, are all part of a typical market bottoming scenario.
I believe the persecuted bond and stock market to be one of the best investment alternatives available for today's investor. In the next several years, I foresee a rise in the Dow Industrials to record levels and a large rise in the bond market. What makes me so bullish? First, a little background is needed to more clearly understand my conclusions.
Gaining an historical perspective of the past is important in obtaining an ability to forecast the future. Many investors and most money managers were not investing during the last series of bull markets. What was it like? Well, bull markets double, remember? The Dow Industrials doubled from 160 in 1949 to 300 in 1952 and doubled again from 250 in 1953 to 524 in 1956 and doubled again from 400 in 1957 to 750 in 1961. (Stocks then sold at a record high of 22 times earnings.) It then doubled again from 524 in 1962 to 1000 in 1966. Can this kind of performance repeat itself? Yes.
Psychological patterns tend to repeat themselves in cycles. Whereas the news in every cycle is different, the way investors react emotionally appears to follow a pattern. The Dow Theory and the Elliott Wave Theory is based on the premise that price is the end result of all economic and psychological pressure and that future price movements rise and fall in recognizable patterns. Based on these theories and my own observations, Figure 1 denotes a typical cycle. A new series of bull markets begin after negative news and a large drop in the market has panicked investors into selling.
At the bottom of a Bear Market, the future can look so bleak that the future of the country is in question. Bull Market I occurs in anticipation that things will get better. Although the news during Bull Market I continues to be negative, the market usually doubles in value. (Figure 1 #1)
A correction then follows which is approximately 50% to 62% of the Bull Market I upmove. (Figure 1 #2) Nature and the market show some consistencies over time. One such consistency is the tendancy to regroup and pause after a movement or a series of movements. Corrections can be associated with the pressing down of a spring. A spring must be pushed down if it is to spring upward. So it'is with the market. The correction after Bull Market I occurs because there is doubt if news items and the economy will in reality get better.
Bull Market II actually reflects the improvement of events. This phase of the market can be elongated by the positive outcome of events. (#3) After Bull Market II, there is usually only a 38% to 50% correction of the Bull Market 11 upmove (Figure 1 #4) The Correction occurs because investors doubt if the good news can continue.
Bull Market III can be attributed to the overexhilaration of investors. Prices obtain unrealistic levels as investors are attracted to the market only because it has risen in the past.
After all the possible money that can be attracted into the market is invested, the Bull Market is over (Figure 1 #5) and a Bear Market begins. "Sell, to who?" becomes a problem, as prices drop to more realistic levels (Figure 1,A). After a big drop, there is usually an upward retracement in what appears to be a good buying opportunity. (Figure 1, B) This upmove can sometimes go higher than the top created by Bull Market III. After testing recovery prospects and finding support only temporary, the final phase of the Bear Market begins. This phase is usually accompanied by negative news and usually leads to panic selling from 50% to 62% of where Bull Market I started (Figure 1, C).
During the 1932 depression, prices almost fell to nothing. This usually happens every other cycle. Individual issues also follow this same pattern, which may or may not coincide with the general market cycle. Although the above explanation is rather simplistic, I believe it to be basically a realistic explanation of how markets move.
For the following, use Figure 2 as a guide.
Let's relate the above to what happened in the past to see if we can identify what phases have transpired, and what phase the market is now in. Then, we will tackle the future. The Dow in 1932 was 41 and was the beginning of a series of Bull Markets that finally ended in 1966 at 1000. After 1966 the small investor began to step away from the market because pension funds, mutual funds and professionals managed their money.
Also at that time, discounted commissions were only available to the large investor. The professional money manager's philosophy was such that they would only invest in issues having a large equity and a good record of increased earnings. However, there were only some 50 issues that qualified. Money poured into these stocks and they rose, while everything else fell. Since the large institutions were making large paper profits, they attracted more money. So the favorite 50 issues rose to 20, 50 and over 100 times earnings, while the rest of the market fell.
Officially, the Dow Industrials made its high at 1067 in 1973. However, that was just an artificial high for a few Dow types and the 50 institutional favorites. Between 1966 and 1973, most stocks topped out. For instance, General Motors hit its top at 110 in 1966 and a low of 30 in 1974. Whereas IBM (one of the institutional favorites) made its high of 91 in 1973 and its low of 38 in 1974. Somewhere in between 1966-1973 (depending on the individual issue) the old Bull Market died and a Bear Market began. The old joke of sell to who became a reality for the large institutional investor.
When stocks began to fall, they dropped very quickly. During the drop, the "professional" money managers decided to diversify and index. Indexing is where the money manager tries to match his portfolio to the general market. To me, indexing was an excuse for mediocrity. With the help of the oil embargo in 1973 and a series of negative-news items, the Dow averages fell from the 1973 high of 1067 to the 570 low in 1.974. This was about a 50% drop of the gain since 1932. Some stocks like MGIC fell from 100 to 8, Polaroid from 140 to 18, Control Data from 160 to 10 and so on. The favorite 50 joined the other issues, which had already fallen. More than 90% of the issues traded formed a bottom in 1974. Such was the devastation of a major Bear Market bottom. The 1974 bottom was not as bad as had happened during the 1932 depression, but never the less, a significant low. Catastrophes do not end every cycle. There are some advisors who believe that the stock market is still in a Bear Market. I believe the Bear Market ended in 1974. No one wanted to own stocks. The Vietnam War and Watergate were tearing the country apart. Major brokerage firms were going out of business. Inflation and interest rates were accelerating at record rates. New York City was going bankrupt. The country could not adjust to skyrocketing oil prices. The dollar was selling at a record low. The U.S. had lost its prestige throughout the world.
A perfect bottom and the place I chose to start this stock market letter was on January 3, 1975. The "Lone Bull" had a good start. Just about everybody else was bearish.
Through seminars and the Five Point Investment Strategy Letter, I have forecasted the beginning of a new series of Bull Markets, such as outlined earlier under my cycle explanation. Bull Market I did a typical job of doubling as the Dow Industrials went from 570 in 1974 to 1026 in September, 1976. The market also typically rose on expectation, because negative news continued throughout most of the upward cycle. The biggest and fastest rise occurred during the first quarter of 1975. In that first quarter, the Dow Industrials rose 300 points, even though the Gross National Product declined 11%, (the largest single quarterly decline since the depression) and interest rates and the inflation rate hit record levels. Such things are Bull Market I's made of. The correction, when it came, was also typical. The Dow corrected 62% of the 570-1026 upmove to bottom at 740 in February, 1973. However, untypically, the market double bottomed at 740 in April 1980. These corrections occurred under quite a few fears. Investors were faced with a record inflation and high interest rate, a sagging economy, energy extortion, Soviet aggressiveness, low confidence in leadership and a loss of national prestige.
The double bottom at 740 in 1978 and 1980 reflects a problem solving period. It is similar to the problem solving periods after the Depression and after World War II. Between 1936-1942 and 1945-1950, solutions to major problems were being formed. During those periods, the market moved sideways. Since 1978, solutions are being formed for this country's major problems of energy, productivity, inflation and military weakness. After the 1936-1942 and 1945-1950 problem solving periods, the stock market exploded on the upside. I expect Bull Market II to reflect the solution of this country's major problems.
I believe Bull Market II began in April 1980 with the Dow Industrials at 730. At that time once again, almost everybody was bearish. I was quoted in Barron's as being one of the few bulls and predicted a runup from 730 to 980. The first phase saw the market rise from 730 to 1030 (April 1980 to April 1981). The stock market has since fallen to 850. 1 believe the stage is now set for a big stock market rise.
Before I explain, let's take a look at the negative side. If there is a large profit potential, there must also be risks. The enemy must be known if it is to be conquered. The market's enemy is fear. Shall we proceed?
First let me remind you that market bottoms are not formed under periods of good news. Market bottoms are formed during periods when the news is so negative and the market is dropping so fast, that positive factors seem to be ignored and are considered almost pointless. Price drops scare investors into selling. Price rises intrigue investors into buying. That's why most investors sell close to bottoms and buy close to tops. Obviously, the process should be reversed, but it is difficult to hear logic when prices are tumbling. Investors presently fear an economic crisis. Tight monetary policies could have a devastating effect on the weak areas of the economy. Investors doubt the outcome of the Reagan plan and fear that the medicine may kill the patient. Confucious was known to have said: "Good government results when the near approves the distant approach." However, investors are not patient when it comes to the distant approach.
The Reagan administration has initiated plans to cut government spending, reduce taxes, reduce government interference, encourage capital goods investments and to make the U.S. militarily secure. The problem is that government cost cutting will not not immediately offset increased military spending and reduced federal income because of tax cuts. Large government borrowing and deficits are bound to result. Without a tight fiscal policy, an ever tighter monetary policy must be maintained. The administration hopes that tax cuts will inspire more revenue. (Previous tax cuts have resulted in higher incomes.) Until more difficult cost cutting can be accomplished, or increased revenues are achieved, huge government borrowing will be needed. The Treasury expects to borrow some $40 billion in the fourth quarter of 1981. The uncertainties outlined above have caused a crash in the bond market. I use the word crash, because the decline of bond prices can be compared to the drop of stock prices in 1929. Investor skepticism has turned to panic, so bond market activity has almost come to a standstill. Issues that have come to market have yielded over 17% for corporate bonds and up to 15% for tax free municipal bonds. Because of the inaccessibility to the bond market, corporations and municipalities are being forced into the short term interest rate market. The effect on short term rates is still being felt. Corporations, municipalities and individuals are finding it increasingly difficult, under slowing business conditions, to keep cash flow high enough to meet interest and principal payments. The Savings and Loan Industry (S & L) finds itself in an equally perilous situation. If the S & L's were to mark their mortgage portfolios to the market, the S & L's would have a negative net worth. Also, because of the reduced prices of real estate, there may be little equity to back up loans. California is reported to have an 8%, 60-day delinquency rate.
To compound the situation, money has been flowing out of the S & L's into the more flexible money market funds. Even knowing all these negatives, I still believe that the stock and bond markets have a big upside potential. Markets are like a big offsetting equation. If there is a big profit potential, there has got to be a big risk. There is a very difficult economic period ahead of us. The stock market usually discounts the future by about six months. That's why markets usually go up during negative news periods. Negatives can be discounted by the market before the event. The first quarter of 1975 was given as an example, when the market skyrocketed, while news continued negative. Another example happened in 1980, when the Dow rose from 730 to 1000 while interest rates rose from 10% to 21%.
At some point the negatives become fully discounted and anyone who was going to sell has already sold. At some point, investors will look across the valley of our present problems and begin to see the next mountain top. Presently, investors fear the light at the end of the tunnel might be an oncoming train. This is a very critical stage for this country. Our survival as a capitalist system may be at stake. There is certainly no profit potential in that outcome.
Anyway, I am certainly more optimistic than current stock and bond market evaluations. Here's why.
As mentioned earlier, when the stock market starts dropping, investors tend to think of the positive aspects as pointless. In my opinion, the biggest factor that is being ignored is the value of stocks. Major U.S. corporations are selling below 5 times earnings. To more fully understand the significance, please note figure 3, which is a chart of price earnings (P/E) ratios since 1949. Missing in the chart is the previous P/E peak of 20.5 in 1946. The present P/E ratio' is 6.7. The record low P/E ratio in 1978 and 1979 reflected the problems of energy independence, inadequate defense, low respect for leadership, runaway inflation, record high interest rates, a stagflation economy, growing government interference and lower productivity. Some of these problems are being solved. Inflation is now running below 10%, government spending and government interference is being reduced, productivity should be encouraged by the tax incentives and the U.S. is regaining its leadership role and respect. In my opinion present evaluations on stocks have already discounted every fear except an economic catastrophe. Stocks, based on their P/E ratios, were not overvalued before the correction from 1030 began. That's why I earlier likened this period to a clearance sale on discounted prices. A recession will probably cause some revision of earnings estimates. However, it appears to me that these earnings revisions have already been discounted by lower prices.
What would happen if the Reagan plan begins to work? The market has discounted fear, but it hasn't discounted the hope of a positive outcome. Should investors begin to discount the positive outcome of this country's problems, the stock market could sell at an historically reasonable P/E of 15. Using a 15 P/E ratio at present earnings levels, the Dow Industrials would be above 1700 and the Dow transports above 550. Stock prices are also cheap when compared to book value.
Presently, the price to inflation adjusted book value of the Standard and Poors 400 Index is about 70% of the market price. This compares to about the same evaluation during the devastating 1974 period (look back to page 3 to see how negative the news was then). This 70% of book value valuation is historically low, as since 1959, bear market bottoms have averaged 118% of book value. It can be argued that P/E and asset evaluation is useless because of the inflationary impact, which cannot truly be measured.
But then again, remember, all positive factors appear to be pointless at market bottoms. It is only after the market rises that one can say: "Of course, the market was a bargain then." Between 1978 and 1980, corporate earnings have increased 13.6% a year and dividends 11.7% a year. Although value is a judgmental factor, the low evaluation of U.S. equities becomes more than elementary when acquisitions are made. During the sale of a company's division, the parts can suddenly become worth more than the whole. Also, entire companies are being bought out at prices much higher than the market price. Many acquisitions are presently being held off because of high interest rates. When rates do begin to fall, I expect a buy out mania to strike the market.
Technically, I believe the primary trend of the market to be strong up. Since 1974, new all time highs have been made in such places as the Dow Composite Average, the NYSE Composite average and the Standard and Poor's 500. So far, the correction since 1030 has been nothing more than a standard 62% correction of the Dow 740 to 1030 upmove to 840. Should the market fall further, I still believe the primary trend to be up. The uptrend in the Standard and Poor's 5OO is shown in figure 4 as an example of how bullish the primary trend is.
Helping my bullish attitude is the position of the Birkelbach Indexes. All three of the Dow Industrial Birkelbach Indexes (Short, Intermediate and Long Term) are in oversold territory (below 70). These indexes in the past have been a very accurate indication of a major market bottom. (See Figure 5). The last time all three indexes were in oversold territory was at the 730 bottom in 1980. The Birkelbach Index is shown weekly in this letter and is updated daily on the telephone update service. Other overbought/oversold indicators are also in oversold territory. In addition, the Dow Industrials are selling at approximately 10% below the 200 day moving average. Support is usually found at that level. A measure of market bearishness can be seen in the Investor Intelligence index of investment advisory sentiment. Presently, the percentage of bearishness has been above 50% for eight weeks. This usually means that the bearishness is fully discounted and a rally is due.
Now, let's take a look at the upside projections. I calculate my objectives by determining the past down moves and multiplying these amounts by 1.62 and 2 for upside objectives. This is my interpretation of the Elliott Wave and the Fibonacci golden ratio of .6182. (For a further explanation, obtain the following books: The Elliott Wave Principal and the Major works of R.N. Elliott by Prechter from New Classics Library, P.O. Box 262, Chappaqua, N.Y. 10514.) The last big downmove was from 918 to 737 in 1980. Using this method to calculate the next minimum and maximum objective is as follows: 1.62 times the 918-737 downmove of 181 points calls for a 293 point minimum upmove to 1030. No further calculations for the maximum objective is needed. This minimum objective calculation predicted the 1030 top made April, 1981. Again, using this method, let's gauge the upside potential of the downmove from 1026 to 737 in 1976/78. 1.62 times the 1026-737 downmove of 289 points calls for a 468 point upmove to 1205 (minimum objective). The maximum objective is 2.0 times the 1026-737 downmove of 289 points, which calls for a 578 point upmove to 1315. The upside potential of the 1067 all time high down move to 570 in 1974, obtains a maximum objective for the Dow Industrials of 1S64.
These objectives may sound high, but a Bull Market II can act that way. There are very few investors that remember how the bull markets of the 50's behaved. The fault of the new money managers and individuals in the future may be that they sell too soon. The market spent 15 years trying to break above 100 at the beginning of the century. When the market finally did make the break above 100, the Dow rose 400% in five years. The Dow spent 13 years trying to break above 200 between 1937 and 1949. After the market finally broke above the 200 barrier, the Dow rose 500% to 1000 in 17 years. The Dow has been stopped by the 1000 barrier for fifteen years. When the market does finally break above 1060, expect a big rise that will discount hope.
As can be seen, an objective of over 1500 is not an unreasonable expectation. This rise will merely bring prices back to a realistic P/E ratio. Bull Market III has an objective of over a 2000 Dow and, of course, will reflect an overestimation of value. Timing is little more than guess work. However, I expect a top of some kind (Dow 1300-15OO) by 1984.
You may wonder where all the money is going to come from to propel any big upmove. The money supply is almost twice the size it was in 1966, when the Dow was at 1000. So, it will take no greater percentage of the money supply to get the Dow to 2000 than it did to get it to 1000. Once the market goes up, the upmove itself will attract investors. Buying is also likely to come from outside the U.S. European institutions own less than half the normal amount of U.S. stock. There are several factors that would lead investment dollars back into the U.S. stock market. The U.S. dollar has strengthened substantially and the U.S. inflation rate continues to fall. The tough stances of Volcker and Reagan have regained worldwide respect for the U.S. Also, oil is paid for in U.S. dollars. As the dollar has risen, oil to other countries has become more expensive and has increased their inflation rate, while slowing down business. All this is happening while the European Monetary System is under pressure because of the above items, the socialist French government and the Polish problem. Even if U.S. interest rates do come down, the dollar should remain strong because of the above stated reasons. U.S. dollar denominated investments should be in demand soon. Pension and profit sharing plans are another possible big buyer. These funds are presently growing at some $40 billion a year. Then how about that $150 billion in money funds? A drop in short-term interest rates could cause a buying panic into stocks and bonds.
I don't mean to leave the impression that profits will be easy to obtain. Upmoves usually occur very quickly and leave behind most, thinking they will buy the next setback, which never comes. Somehow, interest is aroused and there is plenty of time to get in just before a drop. Then, there is a thing called rotation. That's where an upmove occurs only in a specific group. About the time you sell your unpopular shares and get the "hot" group, it goes down and your old stocks go up. That's what makes this business so interesting and so challenging. One must constantly update and adjust.
In the bond market, I prefer long term bonds having a coupon of about 10%, currently priced at about $60 to yield 16%. Should corporate bond yields drop to 10% in the next couple of years, this kind of bond offers a 50% capital gains possibility and a high yield, while you wait. In the stock market. I prefer some of the big name companies. If the country prospers, the earnings and dividends of these companies could rise quickly. These kind of issues presently appear so undervalued (5 times earnings) that their stock performance may even outperform some of the high technology companies. Suggestions of stocks and bonds are given weekly in this letter and updated on the daily telephone update service. I approach investments the way a general approaches a battle. A plan of attack is initiated, with an objective in mind. Once that objective is attained, it must be secured. Many a profit has been lost by forgetting to take it. Should the battle go badly, a plan of retreat should be used, so losses will be at a minimum. If the plan is made before the battle, emotions will play a smaller role in the heat of battle. Market timing and proper selection are important. However, discipline may be the most important factor in investing. Discipline is even more important than luck. Just the same, good luck.
Carl M. Birkelbach 9/11/81
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Information for the Five Point Investment Strategy Letter is compiled by Birkelbach Management Corp., registered with the Securities and Exchange Commission as an investment advisor and by the Birkelbach Corporation, registered with the Commodity Futures Trading Commission as an investment advisor. All contents of this letter are derived from original or published sources considered reliable but cannot be guaranteed. Readers should not assume that all recommendations made will be profitable orwill equal the past performance of previously recommended issues. The security positions of our employees, officers, or affiliated companies may in some instances include securities mentioned in this issue.