US Stocks—An Aussie View & Betty Liu

“I am just an average guy who sits at home and trades the stock market. I hardly drink but this is my poison. Understanding why the markets move the way they do is somewhat of an obsession of mine. I have just developed a system that enables me to time and price stocks (stock prices are easier to work with) and indices. It has taken me 5 years to accomplish and I believe it is about 90% accurate. I am allowed in Australia to give financial advice, but I do not. I am not looking to sell anything, but I have admired the level-headed way you administer advice and I find this refreshing.

Thank you for writing back, as I know you are busy.”

Kind regards, Glenn,

Thank you, Glenn, and thanks for permission to quote you openly. You may get a little email as the price of losing your anonymity.

Glenn revealed his technical analysis in another email, which I have edited and quote below. He wrote:

“I saw your interview with Betty Liu, and I immediately pricked my ears when I heard you refer to the S&P500 at 1600 in a couple of years. Only 2 weeks prior I was looking at my monthly chart of the S&P500 (wondering if I could see what was coming in the future) and I noticed that there was an unusual pattern forming. Normally it would be called an expanding triangle. However, as this was at the end of a very long run (the run started in 1932), to me it would have to be a broadening top that commenced (at the top of the dotcom bubble) in 2000. If you extend a line across the tops and the bottoms and you measure the time between each top, you then find that by adding 7 years on to 2007 you get 2014 and the price is (depending on where you draw the line) approximately 1600. For me the real problem comes after this top. If I am correct, then things are going to get wild. With this type of pattern, which is rare (most TA’s would not even recognize it) the fall from the top line to the bottom line drawn on the chart projected out to 2017 (my time projection from another method) shows numbers around 500. The other less likely scenario is that the S&P500 doesn’t go to the top in 2014 but goes down to the 500 level. I would find that extremely bullish. However, for now we are off until early June, a new high for the S&P in July, and then down until Feb 2013, probably a 20% pullback. Then up to 2014, approx 1600. Thought you may be interested in seeing a different approach to get the same answer from someone on the other side of the world.”

Glenn, we are not technical analysts. We get lots of email from technicians. Nearly every one of them is sure of his or her forecasts. Most of them are made by drawing and forecasting the movement of lines on charts. We admit that we do not know where to draw these lines. To us, they seem to be determined by looking backwards.

We do look at some technical work, and we do find it helps stay us in a trend longer than we otherwise might do. If you looked at our new book, you saw many relative-change charts. They all dealt with trends. However, knowing when to change trends before they peak or trough is impossible, in our view. We don’t think an investor can know until after the fact.

To avoid a whipsaw or a trap, we use levels and relationships among economic terms to help with these difficult issues. Let’s look at one of them, in your context of dates and levels. We will use the level of the aggregate stock market value and compare it with the GDP of the United States.

Why GDP? It gives us a consistently measured total annual output of the country. We know that the profits of American business have to come out of that GDP, for the most part. And we know that there is serious academic work that supports this macro view. So GDP is what we will use for these historical questions.

We will also use the aggregate value of the US stock market. Here we have very accurate historical data. Our reference source is Ned Davis’ database. It is one of the most comprehensive data sets in the country. We will use monthly data points.

The ratio of stock market value to GDP has been rising steadily for the last century. That reflects the ongoing shift of capital investment from privately owned businesses to publicly traded corporate shares. It is enhanced by the post World War 2 expansion of foreign investments by US companies. Currently, about half of US business activity is represented by publicly traded companies.

The ratio was about 32% in the early to mid-’20s. It reached 87% at the top of the stock market in 1929. It subsequently sank to a low of 26% in June of 1932. This marked the Great Depression ratio bottom.

The lowest point in the ratio occurred in the early phase of World War 2. The United States was in a fight for its existence, and the outlook was bleak after the December 1941 Japanese bombing of Pearl Harbor. In April of 1942 the ratio hit 20%. That coincided with Jimmy Doolittle’s bombing raid on Japan. The raid demonstrated that Japan was vulnerable to attack by the US Air Force. The successful raid turned the morale of the United States at that point in the war. From that all-time low, the US stock market started to recover.

Other low ratios were 36% in 1974, 32% in 1982, and 48% in 1990. For the sake of ease, let’s call the average strategic low ratio during the entire last century 40%.

Now, Glenn, we will apply that low to your forecast of the S&P 500 Index reaching the level of 500 to 600. We want to see if there is any reasonable case that can be made for such an extreme low.

We know the GDP level at the end of this year will be about $16 trillion. While we do not know with certainty what it will be in the future, we can project a baseline of low growth and low inflation, based on presently known low interest rates and presently known policy. That would suggest a GDP of $17 trillion to $18 trillion in the time frame of your longer-term triangle charting technique.

We can turn that GDP estimate into a reference for the denominator of the ratio. We have a pretty good idea of the stock market aggregate value, and we can estimate that the S&P 500 Index will price itself at about 80% of the total market.

Working backwards, we can derive a numerator estimate and reach a conclusion. It appears that in order for your S&P 500 level of 500-600 to be reached in the time frame you outlined, the US stock market would need to fall to its extreme low ratio vs. GDP that marked the lowest point in the darkest hour of World War 2. Or maybe just to the lowest level in the Great Depression, as an alternative.

Is that possible? Of course, anything is possible. We could have another world war, with nuclear weapons and mass casualties. We could have a bird flu pandemic and experience millions of deaths. There are lots of imaginable scenarios that could be as bleak as the world wars of last century, not to mention the movie thriller about an asteroid strike.

Should an investor position his portfolio based on these extreme outlooks? We think not. We see events unfolding at a more moderate pace and project a centrist result.

Without going to extremes of overvaluation and by using this strategic history as a guide, we project an S&P 500 Index of 1600 within the next two years. For the longer term, we project a level of 2000 by the end of the decade. We get that guidance number using slow-growth assumptions for US GDP. If we get a faster recovery, the number will be higher, maybe much higher.

We actually believe the slow-growth assumption is too low. We think the US is on a path of resurgence and that growth will accelerate for the rest of the decade. Three sectors will enhance this growth outlook. Manufacturing in the US is on an expansionary course. It is producing higher-paying jobs. Energy, too, is expanding, especially in the natural gas arena. And housing is bottoming. Put these three growth engines together and things could really get interesting. We think they add about 1.5% to annual growth over the decade, and that will be a gradual but steadily accelerating process.

By the way, the politicians will all claim credit for this nice outcome. They do not deserve it. This good news will happen in spite of them, not because of them.

Thanks, Glenn, for exchanging views and agreeing to be quoted. Good luck.

S&P 1600 vs. 600? By the end of the decade, I will take the over.

We are scheduled to be on Bloomberg TV again with Betty Liu at 8 am on May 30th. Until then we wish Glenn, our other global friends and all of our American readers a Happy Memorial Day weekend.

by David R. Kotok
Cumberland Advisors
May 24, 2012

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