Compare that relationship to the one in Chart 4, which reflects the attitude of investors to those earnings in the form of the Cyclically Adjusted Price Earnings (CAPE) ratio as published by Robert Shiller. A reading in excess of 22.5 indicates a high level consistent with a secular bull market peak. During the course of the subsequent secular bear this measure of valuation retreats to the 7 or 8 times level. At that point, the psychological foundation for a new secular bull is in place. It is important to note that when the P/E is excessive, investors are placing a very high valuation on those earnings. That means they are expecting them to continue to grow and are oblivious to the sustainability of that trend. In short, the only reason that investors are willing to buy at those levels is because they are extrapolating recent price trends into the future. In short, they are optimistic, excessively optimistic.
Chart 4 – Inflation Adjusted Stocks versus the Shiller P/E
By the same token, total disgust of equities sets in at secular lows because market participants have experienced 18 or so years of lower inflation-adjusted equity prices. Each rally brings hope, which is only dashed as prices sink to new lows. Under such an environment, it is only natural that investors demand to be paid handsomely for the huge risk they believe they are taking. Hence, the 18-20 year swing from exuberance and euphoria at the peak of the previous secular bull to despondency and despair at the start of the next one. The alternation of the red and green arrows in Chart 4 show this pendulum swing in crowd psychology has repeated with the consistency of clockwork over the last 114 years. Since secular bears are associated with structural problems, it is not surprising that they are characterized by numerous and frequent recessions. Is it any wonder that investors end such periods in a state of deep depression? Compare this environment to that of the 18-year secular bull market between1982-2000, which only experienced one period of contraction in 1990.
Returning to the current situation, the chart clearly shows that recent readings at the 27 level are closer to those at historical secular peaks than any previous secular low.
These giant swings in sentiment are not limited to P/E ratios, but can also be observed in similar swings in dividend yields from 2-3% at peaks to 6-7% at secular lows. For the record, the yield on the S&P in December 2014 was around 1.98%.
Chart 5 shows the Tobin Q ratio, which monitors swings in replacement value of US equities. This measure also moves in generational movements from around $1.05 at tops, to a discount whereby stocks sell at 30c on their replacement value at secular lows. According to the excellent Doug Short web site, the Tobin Q ratio was recently at $1.14, which is higher than any other secular peak except for the final years of the tech bubble. If past is prolog, we would expect to see these measures of valuation/sentiment return to levels closer to extreme pessimism before a solid foundation could be laid for a new secular bull. With the three valuation indicators at extreme levels, it makes sense to closely examine the state of the primary bull market. For if that is in the process of maturing, it is possible the secular bear might be about to resume.
Chart 5 – The Tobin Q Ratio
