The market dropped today; the SP was down 1.91%, the DJ Transports index broke through a support line on a chart and reached new lows for the year. The ValueLine Geometric index (Ticker VALUG) broke through 500 and closed down at 493, slightly below its 1998 and 2007 highs. The sharp decline destroyed its uptrend and started a new downtrend. The index is not adjusted for inflation and doesn’t consider dividends. If one netted a dividend yield of 2% against a roughly similar amount of inflation then the inflation adjusted total return since 1998 (when it was trading at 500 points) was zero for the stocks in the index.
Finance theory teaches that stocks should provide an Equity Risk Premium (ERP) of roughly 4% a year total return over bonds. If bonds yielded about 3.5% nominal over the past 20 years they would have provided a real return of about 1.5% a year, (assuming 2% inflation) which is 1.5% a year more than the ValueLine Geometric index. Thus the market produced a negative ERP over 20 years that was 5.5% a year below an expected ERP of 4% a year. However, the index is hypothetical; in the real world one would encounter index tracking error, commissions, fees, bid-ask spread costs, etc. and thus get a lower return, thus resulting in actually losing money in stocks despite the headlines that the economy had a huge bull market. If count actual trading costs, then the inflation adjusted rate of return of zero is really slightly negative.
This index is an equally weighted index of all domestic stocks. The message it is sending is that in 20 years the aggregate of many small and medium stocks has done poorly and the handful of giant companies that had outstanding returns acted to push up the SP index, which is a market capitalization weighted index. By contrast, as a company gets bigger in the SP it has more influence in that index.
A study by professor Hendrik Bessembinder
Do Stocks Outperform Treasury Bills?” showed that 80% of stocks’ share prices didn’t make a profit and only 4% beat bonds, so the bottom 96% were not worth owning. This reminds me of studies saying that 80% of small businesses fail in five years. It is hard work and risky to start or to run a company. The average life of a stock has dropped from over 50 years to only 17 years. 80% of the members of the Dow Jones Industrial Average 30 stocks have been removed from the index in the past 40 years; now with the loss this summer of GE that makes it about 83% that have been removed.
Since so many equities will fail to reach the forecasted ERP and instead fail to beat bonds then one solution is to be a very picky, strict buyer of stocks who only buys during deep crashes. Also one should focus on just a few high quality stocks with the intent of avoiding excessive, uncompensated risk. This means paying up for quality (such as quality of earnings, honest accounting systems, strong steady growth of sales), becoming aware of corporate moats, etc.
Investors need independent financial advice about the risks of rapidly heading into a crash. Stocks went up too much since 2012 because of excessive, wasted liquidity from Quantitative Easing. As of this week the ECB has ended QE and Japan is eventually going to end their QE, thus reducing the global supply of liquidity. When people can’t get liquidity they may be forced to sell liquid assets (stocks) to pay their debts, thus making stocks go down. Instead of the cliché “cash on the sidelines” pumping up stocks it will be “debt on the sidelines” putting downward pressure on stocks. Debt can sometimes grow faster than cash on the sidelines.
I think the damage to the chart pattern for ValueLine Geometric and the Dow Jones Transports are a strong hint that the bull market has reversed course and is going into a crash. For a chart of ValuG see: