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The Morning Cup of Jo - Ever-changing market dynamics, or is it? - A Take Home!


Very interesting Tickles; very, very interesting!


Trademark Pending

Click here to view the chart...

Good afternoon.

Before venturing through this epic endeavor, it's important I address a few points. First, posting this 'Morning Jo' in the afternoon was intentional - the reason, selfishness. In my humble opinion, this very well could be one of the most, if not 'The Most,' important and informative pieces I've ever decided to commit to paper (or computer for that matter). In other words, if I was to place a level of importance on every 'Morning Cup of Jo' I've written from 1 to 10 (10 being the most important), this would be a 20 - no shnitz! For this reason I felt it is vital readers take a considerable amount of time absorbing this particular column's content.

Therefore, if at this moment you don't have 'serious focus time,' I recommend you print this piece, put it in your briefcase and take it home. There you can read it once, twice or even thrice; for this interpretation of the markets past technical connotations and ensuing valuation levels may dramatically change your long-term decision-making process for market investments. I know when I first uncovered this mega long-term historical trend a few years ago, while studying past bear markets, it sure changed mine.

As a market technician, this illuminating and shocking discovery not only played a major role in altering my investment decision-making process, it convinced me to conceive and design a new course for my career in money management. The first step I took toward this career shift was the creation of a new IPS (Investment Philosophy Statement) in early 2000, which enhanced my definition of "Risk." In turn, this set the groundwork for how I managed my "long-only" GP (Growth Portfolio). If this seems somewhat puzzling initially, don't worry. Once you start to assess the subject matter in this column, I believe the reasoning behind this undertaking will become very apparent.

Now that we've gotten through the preliminaries, let's begin.

The foundation for this particular article has been brewing for almost a year now - much prior to opening my own firm with my partner John DuBrule. Actually, the content herein is in fact one of the contributing factors to that choice. Anyhow, the actual birth of this document occurred on May 13th when I read Toddo's article called, "Give yourself a hand." This is an excerpt from that column...

"I would like to digress for a minute and address the palpable and collective frustration. This isn't a Minyan observation as much as a broad acknowledgement that the learning curve has gotten steeper. I wrote a piece four years ago called The Long Hard Road that discussed how the entire dynamic of trading - and business in general - was gonna be an uphill climb. Indeed, it now takes thrice the effort to make half the money (if that) and it's increasingly difficult to maintain that pace.

This particular column isn't about the next few ticks, it's about preparing ourselves for the future. When I explain Minyanville to people, I talk about the need to build a syndicate - a network - that will surround us with good, honest and forthright people who watch each other's back. The isolationists who try to go it alone aren't doomed but they're certainly operating at a disadvantage. We're gonna need all the help we can get and the sooner we understand where we are, the better we'll be able to prepare for where we're going."

After reading his column, twice, it prompted me to e-mail a quick response prior to leaving for the day that Thursday afternoon. In turn he posted this e-mail in that Friday's Minyan Mailbag. In this response I thanked him; for his dream, vision, insight and intuitiveness into the business where all professional money managers strive to become triumphant; in other words, his creation of Minyanville. Why? Because at that very moment I realized I wasn't alone in my thoughts regarding the ever-increasing complexity of the markets' dynamics and its obvious amplification within the foreseeable future. This gave even more credence to the technical market theory I've been subscribing to over the last few years. In my own mind, it was third party confirmation.

With all of that being said, this is in fact not the point to this article. It is only the groundwork to my thought process on why I chose NOW to pen this column and bring to light my forward looking opinion of the markets, what may transpire over the next 5 to 10-years and how I plan to successfully navigate myself, my clients and any Minyan who is willing to listen through it.

What I'm about to present is not solely technical in nature. I have also incorporated the Price/Earnings ratio over the same period of time, which encompasses to some extent, the markets' fundamentals. Before continuing, if you haven't already, please print out the graph of the Dow Jones Industrial Average from 1900 - 2004 (posted just prior to this 'Jo'). The next section will be much easier to understand if you follow along with the graph.

I do realize the graph may be somewhat illegible on this small of a scale. In my office it hangs on a wall and covers 5 ½ feet x 2 ½ feet, so I can image your frustration. Not to fret - Toddo and I are working on a way Minyans will have the ability to purchase this graph - hopefully in any size they wish.

The Graph

For disclosure purposes...

The data on the graph accompanying this article is considered to be factual in nature and the sources reliable.

Important factors about the graph...

The Dow prices are in logarithmic form and the Price/Earning ratio is arithmetic. This was done, well simply because it wouldn't have fit on the paper. This also has no effect on the interpretation henceforth.
(Logarithmic - Graph increases equally by percent not price/points)
(Arithmetic - Graph increases equally by points)

Also, there are two implicit definitions I use when analyzing this chart on a macro basis.

1. Consolidation - A period of time in which the market hit a new high it could not surpass (except January 1937, which I'll discuss later) and vacillated in-between that point and a relative low point for an extended period of time - a channel per se. (Red Type)

2. Up-Trend - A period of time in which the market broke above a consolidation period (except August 1932, which again I'll discuss later) and continued its trend for a considerable amount of time. (Blue Type)

One last thing... A lot of what I'm going to say is a matter of opinion and should be considered as such.

Given the prior information and definitions, the graph shows that over the last 100 years the Dow Jones Industrial Average has been through three - possibly four - major consolidation periods, one major downtrend and four growth cycles or up-trends. Now remember, this interpretation is from a mega macro scale and point of view. Obviously, on a more micro view, there have been numerous periods of deterioration, consolidation and growth. However, for the illustration of my underlying theory, we only need to take into consideration the larger macro point of view for now.

To make things simpler I have inserted this table (Below), which shows the different time periods discussed and the corresponding price action on the graph. In the course of going through the data and examining the chart, you'll want to keep a mindful eye on the Dow's price action and its relationship to the Price/Earnings multiple trends. Once again, for the next section you'll want to have your graph handy.

I] The First Consolidation and Ensuing Up-Trend (1906 - 1929)

The first, and longest, consolidation period on the graph started in January of 1906 and lasted almost 19-years. During this period the Dow fluctuated in a channel between 105 and 70 respectively. Meanwhile the P/E (Price/Earnings) multiple was in a downward trend and dropped from the above-22 to the below-10 range. Some fundamentalists may look at these two P/E ranges to be indicative of the market being at extremes in valuation (over and under).

This consolidation ended in December of 1924 when the Dow finally broke above and sustained the 105-price level. This also corresponds to the P/E multiple breaking its downward trend and going back above 10. At this point the Dow went on to increase over 300% (from just over 100 to just under 400). Then POW! "The Great Depression."

II] The Extreme Downtrend and Resulting Up-Trend - Bounce (1929 - 1937)

This extreme downtrend, beginning in 1929, and corresponding up-trend, beginning in 1932, does not fit the 'typical' consolidation/up-trend technical price pattern and is a bit more difficult to interpret. Nonetheless, the corresponding P/E multiples do however fit the "above-22 and below-10" trend cycle of valuation changes.

When I first looked at the Great Depression data, I interpreted the consolidation period to start from the 1929 peak. However, I changed this thought process on the grounds of valuation (i.e. the P/E multiple). Therefore, I decided to interpret the extreme downtrend and corresponding up-trend of 1929-1937 to have the same overall effect as the longer-term consolidation/up-trend periods throughout history.

In other words, the vast drop-off during the Great Depression achieved the same result as a longer-term consolidation - it wrung out the extreme overvalued condition of the market. The downtrend only lasted approximately 3-years verses the other consolidation periods, which lasted from 13 to 19 years. However, the resulting up-trend (1932-1937) only endured for just over 4-years before entering a second and much longer consolidation.

III] The Second Consolidation and Subsequent Up-Trend (1937 - 1966)

After the short-lived bounce off the bottom of the Great Depression's debacle, the market was ready for another consolidation. Hence, I interpret the next consolidation period to take place from the 1937 high and last just under 13-years. During this consolidation the market fluctuated in a channel between 195 and 110 respectively. Once again the P/E multiple followed its crossover and downtrend cycle until 1950. In January of 1950 the price movement changed from consolidation to up-trend while the P/E multiple crossed back above 10. This subsequent up-trend lasted 16-years and provided over a 400% return.

IV] The Third Consolidation and Largest Up-Trend (1966 - 2000)

In the beginning of 1966, as the P/E multiple crossed back below 22, the Dow stalled out just below 1,000. This consolidation lasted almost 16-years and oscillated between 1,000 and 720. By 1982 most of the P/E multiple had diminished and the market began its largest up-trend yet. This up-trend lasted about 17-years and provided over a 1,000% return. How's that for impressive? Although, during this massive up-trend, the P/E multiple has gone to "never seen before" extremes and truthfully, still hasn't dropped back to the below-22 level; which leads me to my next statement, or should I say, "Question?"

V] The Fourth Consolidation ??? (2000 - ?)

In January of 2000 the Dow topped out around 11,750 and has since consolidated back to a 7,200 low. It has been over 4-years and even though the Dow may be approaching the upward region of this possible consolidation range, it is still very far away, fundamentally, from being in an undervalued position to take-on a new up-trend.

What does all this mean?

Lets review some simple facts...

--- After every major up-trend there has been a major consolidation period
--- Consolidation periods have ranged from 13 to almost 20-years in length
--- P/E multiple valuation trends have corresponded to every market trend and consolidation
--- Breakouts from consolidation periods or new up-trends have not begun without first having the P/E multiples drop below the "undervalued" level

In other words, I'm saying, "Excesses in market valuation, due to extreme price movement upward over extended periods, may take years to work off the valuations and let earning catch up to prices!"

There are many people on Wall Street who, for whatever reason, will argue the market dynamics have changed and the P/E valuations will never return to historical levels. Maybe they believe this because of the vast amount of assets flooding the marketplace and the limited supply of equities. Maybe it's because of the decrease in the amount of equities paying dividends - which creates higher valuations. Or maybe it's just a bad case of "straight-line thinking." Whatever the reason, it is what it is. The valuations are higher than ever before, even after the start of a major consolidation in the stock market.

Over the years I've been in this career, I have heard many things. "Invest for the long haul." "You can't time the market." "Just buy and hold, you'll be better off." Now, given the fact that I started my career in the midst of the largest and most magnificent up-trend the market has ever produced, some of these comments made sense - when they were said. But let me ask you this, "What if you were a new investor, or for that matter old, and bought in 2000 based on that theory?" Ouch!

This thought process is called 'straight-line thinking.' This occurs when a trend has been set for an extremely long period of time and people forget the other periods when it didn't occur. They unconditionally and wholeheartedly believe everything will remain status quo. I'll give you a real life example of how long-term trends can change a person's psychology.

My Grandfather, Rocco, was born in 1912 and is 92-years old, God bless 'em. He was 17 when the Great Depression hit. Back then 17 was a whole lot different than it is today; full responsibility as a workingman, and he was just that - a hard working man. Remember the Bank Rush in 1930? Well, until this day, he still puts his money in a tin coffee can hidden in the basement! True Story. Did he miss any opportunities because of his straight-line thinking? Yes. Did he care about the 1933 Banking Act FDR persuaded Congress to pass once being elected? No. His mind was set! 'You can't trust the banks.'

How about this... What if you turned 45 years old in 1966 and started planning for your retirement in 15-years? For the past 16-years (1950-1966) you've seen the market do nothing except increase over 400%. Hence, you purchased equities representing the index, expecting similar results, and held on until you retired - 'Straight-Line-Thinkin'. However, over this period you would have paid taxes on any gains and received the same amount of principal back - plus any dividends paid over that period of time - minus inflation. By the way, inflation back in the mid to late '70s was hovering around 10 to 15%. It would be safe to say, "You would have lost real money (inflation adjusted) over that period."

This phenomenon occurred 3-times over the last 100-years and could, very possibly, happen again!

Where does it leave you - A Minyan?

What should you do going forward? Do you have a long-term plan, or even a basis for one? Is a "long-only" portfolio going to get you where you need to go? This is truly a tough question. We all know what we would do if the market was to breakout and continue its upward trend, it's the other question that needs answering. This 'Jo' is here to help you do just that by merely bring this theory to your attention.

At last, I've finally gotten to my point.

Clearly, no one can predict what will happen over the next 5, 10 or even 15-years. But what I do know, with absolute certainty, is every successful money manager must have a plan, a strategy for that plan and a foundation for that strategy. This philosophy, and only this philosophy, will allow a good money manager/investor to survive and become a great money manager/investor during these potential turbulent times.

So what's the plan you ask? Believe it or not, it's simple. For the "long-only" money managers/investors, it's now time for the next evolutionary step. If this theory is correct and the next 5 to 10 years turn out to be a mega long-term consolidation, you have to agree, unequivocally there has to be a change. This change must allow the ability to take advantage of both sides of the market. In other words, the change must have the ability to utilize strategies not currently available in "long-only" portfolios.

Don't get me wrong; there will continue to be an abundance of opportunities for "long-only" money managers to make money in the marketplace over the next 10-years. Nonetheless, the idea is not to repeatedly swim against the tide or sit it out when the tide is going the other way. It's to have the ability to make the gains more consistent. For this reason, we need to have the capacity to swim in both directions, assuming this theory plays out.

Looking back at the chart you'll notice during the consolidation periods there were, on a more micro view, plenty of price fluctuations, which produced massive opportunities in both directions. Just for example, the 1906 - 1924 consolidation made a round trip from 70 to 105 at least 6 times during its existence and the 1966 - 1982 consolidation made a round trip from 720 to 1,000 at least 5-times. These were all decent money-making swings.

For this reason, I solemnly promise my "Morning Cup of Jo," along with all the other professors' columns and articles, will give our greatest efforts here in Minyanville to help navigate any and all Minyans through these times. Just remember what Toddo said in the prior piece I mentioned...

"...when I explain Minyanville to people, I talk about the need to build a syndicate - a network - that will surround us with good, honest and forthright people who watch each other's back. The isolationists who try to go it alone aren't doomed, but they are certainly operating at a disadvantage. We're gonna need all the help we can get and the sooner we understand where we are, the better we'll be able to prepare for where we're going."

On a statistical side note...

Did anyone else see the statistical anomaly (possibly a pure coincidence) in the chart? Look at the major consolidations from 1906 - 1924, 1966 - 1982 and the potential beginning of a consolidation in 2000. Look at the channel highs and lows. See anything familiar or how about just plain uncanny.

On another side note...

If any readers would be interested in purchasing a larger and more defined print of this graph, for your wall, desk or just a carry-around piece, please e-mail me at the link below and Todd and I will work something out.

I genuinely hope this 'Jo' helped - it meant a lot to me to write it!!!

Todd - sincerely, thanks again. I am proud to have my name and work associated with "The 'Ville!"

Once again - I have to apologize about my scattered appearances in "The 'Ville." My contributions will be back on track after the July 4th Holiday. Thanks again for your understanding.

Until next time...


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