Tuesday, April 21, 1998

So 9,000 on the Dow isnt good enough for you? How about 10,000? Or 12,000? Then again, why not throw sanity to the wind and go for 18,000? Long ago, people joked that happiness was a stock that doubled every 12 months.

Now we expect all stocks to make us happy.

To give you an idea of our collective enthusiasm for common stocks, the Investment Company Institute recently announced that investors put some $37.5 billion into mutual funds in March with $27.5 billion of the total gushing into equity funds. Thats more into equity funds in a month than was attracted in any year before 1991.

So this must be a top, right? Isnt this about the time that high-flying Icarus notices the feathers falling out his wings of wax?

Maybe. Maybe not.

Consider my cautionary tale:

Back in the late seventies, as it became legal for Americans to own gold, your columnist became convinced that gold was cheap. So while gold was selling in the range of $75 to $125 an ounce I bought gold coins. Just before visions of myself as a descendent of Scrooge McDuck became too intense, I started researching gold mining and bought a bunch of South African gold mining shares.

It was a good move. The coins and the shares doubled, tripled, and quadrupled Instead of being crassly happy, I started to worry. I honed my analytical tools and made calculations about the most an ounce of gold could possibly be worth. Answer: Gold would be overpriced somewhere between $300 and $350 an ounce.

When gold hit $350 an ounce I sold. I emptied the bureau drawer where I had kept my little hoard. And I called in a sell order on the shares. I was clearing out. Gold might go still higher, I told myself, but it wouldnt be rational. There was no reason for gold to sell at more than $350 an ounce.

The gold market took little heed. Gold hit $400. Then it went through $500; $600; and $700. Finally, it hit $800 and made the cover of Money magazine.

Then it went to swim with the fishes.

Markets dont operate on reason. They operate on collective perceptions and moods, stampeding up and down with additions and removals of money.

By historic measures, this market has been overpriced for years. Market strategist Steve Leuthold, for instance, regularly provides his institutional investor clients with a series of measures to compare current market values with normal market values. He believes that stock prices tend to "regress to the mean" and that periods of high returns are followed by periods of low returns.

The question is how long this period of high returns can continue. The answer: long enough to embarrass everyone who likes to think they are rational. Here is a summary of what the very rational Leuthold indicators have been saying in recent years:

  • In late 1994, with the Dow just over 3,700 the indicators said the Dow could fall 25 percent, to 2,810, if prices only fell to their long term median valuation level.
  • In late 1996, with the Dow just over 6,500, the indicators said the Dow could fall 43 percent, to 3,711.
  • Last month, with the Dow at 8,800, the same indicators said the Dow could fall 52 percent, to 4,214. Limiting the historical base period to 1957 on rather than 1926 on softens the blow somewhat— the Dow might only fall by 45 percent to 4,807.

Even for periods of low inflation, Mr. Leuthold points out in his most recent client communication, price to earnings ratios are high. In all the periods of low inflation (0 to 3 percent) between 1926 and the present, the median P/E for the S&P 500 was 17.6. On April 3 it was 29.6, the highest ever recorded.

Does that mean we should sell and wait for lower prices?

No. The market has only outrun reason. It has yet to outrun the supply of money chasing it.

What to do?

Try something simple. Set a percentage of your assets that you will keep in equities and a percentage in bonds and cash. Then sell as rising prices change the portfolio. If you had had $100,000 invested in both stocks and bonds three years ago youd have $200,000 in stocks and $122,000 in fixed income today. Youd need to sell $39,000 in equities to get back to the original 50/50 allocation.

You wont ever make the perfect call using this method. But youll be moving in the right direction and youll always err on the side of safety.