Generational bear markets, with losses exceeding 40% are the exception, not the norm. Since 1940, only one in four bear markets reached such a loss.

• The 2000-02 bear market was so severe because of record overvaluation extremes at the start, and the washout of the high-tech bubble with a -78% loss in the Nasdaq (of which many of the largest stocks were also components of the S&P 500).

• Unweighted indexes declined only ~25% in the 2000-02 bear market;

• The 2007-09 bear market was extreme because the collapse suddenly exposed all of the mortgage derivatives on the balance sheets of major banks. The extent of this exposure was not well known — even to CEOs of the banks.

• Bear markets without recessions are more of a rarity. Since 1940, when they have occurred, the declines are usually milder. The 1987 Crash, with a loss of -34% was the exception; but ’87 was triggered in a monetary climate where interest rates were soaring and the U.S. dollar was tumbling.

• Average valuation, as measured by the P/E ratio of the S&P 500 Index, at the start of all the bear markets exceeding 30% was 21.8. Today, the P/E ratio of the S&P equals 14.7.

Currently the market breaks down in the following manner:

#Stocks………………P/E………….As%
733………………….30/higher…….32%
247………………….25/30………..11%
367………………….20/25………..16%
1347…………………Total………..59%

602………………….10/5………..26%
325………………….5/lower……..14%
927………………….Total……….41%

As of the end of September 2011 from January 1871: compounded returns:

Index….+4.03%
Dividends +3.29%
Earnings +3.89%
CPI +2.07%

SPY
P/E 13.44
Yield 2.12%

The data rather suggests that overall, the market is not unreasonably expensive at a P/E of 13.44. It is not ‘cheap’ as has been the case at the ‘bottom’ of major bear markets, viz. below a P/E of 10. It is not unduly expensive either.

The ‘two tier’ market of roughly 50/50 has some very expensive stocks, and some very cheap stocks based upon historical or trailing P/E ratios. With the long term growth rates at 3.89% in earnings over 141yrs, it would seem reasonable to use this ‘earnings growth’ as a baseline assumption to project forwards.

The question then becomes at what capitalization rate? For a reasonable ‘guess’ at this rate, we would need to look at the ‘interest rate’ on government securities. Unfortunately the market is currently heavily manipulated by the Federal Reserve, and yields are at historical ‘lows’.

With some historical context:

From the data, we can see that in times of ‘war’ where the ‘State’ has greater need of funds to pay for increased expenditures, the interest rate has been in a range of 4%-9%. With Iraq/Afghanistan, like WWII, the Federal Reserve is suppressing rates: to do so requires ‘money creation’ or inflation. Once the suppression is removed, rates will likely rise.

The capitalization rate for common stocks would be 4/3’rds of the interest rate. Currently that would equate to 3.06% which provides a P/E of 32, which for the ‘growth stocks’ seems to be already factored into the price.

If however the interest rate rises to 6%, then stocks would require 8% or a P/E of 12.5 which is slightly lower than where we are currently. As we are dealing with the future, and the future is unknown, what else can we glean from the historical record? The primary fact is this: while the bond yield can go significantly higher, it can only fall very marginally.

The conclusion therefore must be, if you are invested in common stocks, common stocks with ‘low’ P/E values provide the probability of higher returns than do common stocks already factoring in above ‘average’ earnings growth rates via capitalization rates.

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