Earlier this week I've looked long-term (secular) market trends, focusing on duration of these patterns, and I've applied some regression trend lines to them. Today we'll look at the annualized returns for these epic market cycles and tease out the contribution of dividends to the overall gain/loss.

Let's begin with a look at the top chart, which is my monthly update of the S&P Composite and its dividend yield since 1871. As we can readily see, dividends have been shrinking over the past few decades, for reasons I mention in the update.

The second chart highlights the secular bull and bear markets since 1877. Obviously I'm ignoring individual 20% declines, the classic definition of a cyclical bear market, to keep our focus on the big picture. For example, the "Black Monday" the Crash of 1987, so stunning at the time, was little more than a nasty pothole on the steep climb from the 1982 bottom to the top of the Tech Bubble.

The Dividend Difference
So let's do some simple math on our table of annualized real returns for the secular trends in the second chart. The highlighted column shows the contribution of dividends by subtracting the annualized returns ex dividends from the annualized return with dividends included. The last column shows the percent change in the dividend yield from the previous trend.



The dividend return during the first cycle was right at 5% (4.99% in the table). The 14-year bear market from 1906 to the end of 1020 actually dividends increase by 8.4% (5.41% divided by 4.99% minus 1). The Roaring Twenties saw the dividends increase by 22.4%. During the Great Depression, the dividend yield fell slightly, but it still averaged above 5% for those twenty nasty years. But he decline in dividends continued. And during the last secular bear, they've been cut in half from the previous bull market.

The old strategy of living off dividends clearly isn't as feasible today as it was during previous secular trends.

As I've pointed out previously, even though our data covers a timeframe of nearly 140 years, there have been too few of these mega-cycles to make meaningful generalizations. Prior to the current bear, the shortest was the 14-year 1968-1982 bear. If last year was truly the bottom of the bear, it will take the record for brevity.

The latest weekly issue of the Retirement Income Journal is now available, and this week's issue is especially interesting:

• The cover story asks the intriguing question, Black Swan or Black Turkey? We've all heard about black swans, those improbable catastrophes that defy prediction. But we've had no shortage of black turkeys — events that are entirely consistent with past data but that no one thought would happen. The financial crisis was but one of nearly a dozen such episodes over that past century.
  
  
• Next up The Joy of Illiquidity takes an unintuitive look at the benefits of investing in illiquid assets. This article reports on the a presentation by legendary financial wizard Robert Ibbotson suggesting the idea that illiquidity, either in stocks or in bonds, should be viewed as an investment style distinct from capitalization, value/growth, maturity or credit risk. This article includes the first reference I've seen to the illiquidity discount and the liquidity premium.
  
  
• My favorite article in this week's issue has a reassuring title: If You're Human, You Have Capital. In contrast to financial capital, human capital consists of "the present value of future earnings, the present value of future savings, and even the present value of Social Security and anticipated pensions." Your human capital changes over time, and it should definitely be a factor in your investment strategy.

For a free 30-day trial, visit the subscription page and use dshort as your coupon code.

The S&P 500 closed the day up 0.45%, which puts the index up 2.7% for the year. The index is 69.3% above the March 9, 2009 closing low, which is 26.8% below the peak in October 2007.

Here is a StockCharts.com snapshot showing the relationship of the S&P 500 to its 50- and 200-day simple moving averages.

Click here to review the previous rallies during the current bear market, and here's a table showing the 1929-1932 Dow rallies.

Since inflation is a favorite topic on this website, I now regularly update a set of charts to facilitate a comparison of the nominal and real declines. See also my logarithmic scale view of the "Four Bad Bears" comparison.

For charts of other bear market recoveries, see The Bear Bottoming Process.

For a better sense of how these declines figure into a larger historical context, here's a long-term view of secular bull and bear markets in the S&P Composite since 1871.

For a bit of international flavor, here's a chart series that includes the so-called L-shaped "recovery" of the Nikkei 225. I update these weekly.

These charts are not intended as a forecast but rather as a way to study the current market in relation to historic market cycles.

This chart is an offshoot of my Four Bad Bears. It shifts the point of alignment from the pre-bear highs to the bear bottom in the Oil Crisis and Tech Crash, the first major low in the 1929 Dow, and the March 9th closing low for our current Financial Crisis.

As the chart illustrates, the S&P 500 lows in 1974 and 2002 marked the beginnings of sustained recoveries. The Dow low in 1929 failed 11 months later.

Here is the same chart adjusted for inflation.

For a more optimistic alternative view, suggested by an investment professional and visitor to this website, see this post.

Here are two new charts illustrating the growth of earnings over time. The underlying concept was suggested by Arto Nissinen, an investment advisor at Osuuspankki, one of the major banks in Finland.

The charts illustrate the relationship between the stock market, adjusted for inflation, and the real wealth created by companies in the form of earnings. Over the past year I've featured a monthly update of market valuation with a focus on the P/E ratio itself. These charts essentially use the average trailing-year and trailing 10-year P/E ratios to provide a greater focus on the growth of earnings with the more volatile market price hovering around those earnings.

First Chart. The blue bars in this chart show the real (inflation-adjusted) annualized earnings of the S&P Composite for the past 138 years. I've multiplied the values by 15.5, the average P/E ratio over the 138-year history, to align the two data series for a more useful overlay. The red line (inflation-adjusted price) shows how the market fluctuates around this real value. We can also see the occasional volatility of earnings at major economic inflection points: the earnings declines in 1894, the multi-year dips that started in 1916 and 1929, and the more recent bad years in 1991, 2001, and the earnings cliff dive in 2008, which included the only quarter of negative returns in this 138 year series.

Second Chart. Here the blue bars are the rolling averages of 10-year trailing returns multiplied by 16.3, the average P/E10 over this extended time frame. Now the long-term earnings growth becomes clearer against the more volatile annual price of the stock market.

Thanks, Arto, for the suggestion!

Incidentally, Arto classifies people according to three psychological investment profiles: Wealth Growers, Wealth Preservers, and Money-Amount Preservers. See below for his fascinating profile of the three types. Arto endeavors to educate Wealth Preservers who misguidedly think that Money-Amount Preserving is the best way to preserve wealth.

1. Wealth Growers
   Want: To grow wealth in the long term
   Accept: Strong fluctuations OR spend a lot of time with their investments
   Motto: "Fortune favors the bold (even statistically)"
   Example Solutions: 100% buy and hold global stock weight OR trading
   
   
2. Wealth Preservers
   Want: Primarily to preserve the wealth in the long term
   Accept: Moderate fluctuations
   Motto: "The golden middle way always works"
   Example Solutions: 50/50 wealth management OR Portfolio of 40% global stocks, 40% Euro fixed-income, 20% EMD local currency, no market timing at all, no activity requirement.
   
   
3. Money-Amount Preservers
   Want: The feeling of security that comes from seeing the Euros in the account
   Accept: Greatest risk of long-term decline in wealth
   Motto: "I get a feeling of security from the solution that I am used to"
   Example Solution: Renewing bank-deposits (they are government-backed in Finland)
   
   Note: EMD = emerging market debt

Here's a brief email from market technician Chris Kimble accompanied by his latest chart of the interest rate on the 13-week T-Bill. He writes:

This is a first since March of 2004, a break above the 200-day SMA. T-Bill rates fell BELOW ZERO at the height of the credit crisis.

Could this upside rise in T-Bill rates be a sign of confidence coming back?

Yesterday CNBC featured a Good News article that had some cheerful things to say about the dollar:

Now that stocks and the dollar are moving in tandem again, it could be a signal for investors to put more money into US assets.

For much of the 2009 rally off the March lows the two entities had been in reverse lockstep. When the dollar would fall, stocks would rise and vice versa....

But with some upward trends in the economy and the likelihood that the Federal Reserve in the coming months will begin implementing policies to boost the dollar, the two have risen together this year. Analysts see the trend as less a dollar play and more a recovery move, and as a return to normal after the inverse correlation between the stocks and US currency. Jeff Cox, Staff Writer

Let's put this optimism in a larger context, say a decade or two, courtesy of Chris Kimble, a 30-year+ market technician and student of Sir John Templeton, who hails from outside of Kansas City, Kansas.

With his trusty Metastock software, Chris has given us a fascinating overlay of the US Dollar Index and the S&P 500 since 2000 (top chart). Indeed the correlation between the two has often been inverse — very much so over the past two years. As the CNBC article points out, the two have approximately tracked each other for the past two months. Is this synchronization really significant in this on-and-off relationship?

Let's look at another factor. Note the line at 80, a level that, give or take a point or two, has served as support during the 1990s (second chart). It offered support again at the end of 2004, and the dollar rallied for the better part of a year before the onset of another decline. The dollar finally dropped below 80 in September 2007, only a few weeks before the US market peaked.

After bottoming out in the early months of 2008, the dollar has played both sides, with 80 alternating between support and resistance. We're hovering there again — this time against a backdrop of several markets colliding with key trend lines, as this set of four key indexes illustrates.

Today is one-year the anniversary of the S&P 500 recovery following its ominous 666 intraday low on March 9th 2009. What comes next? Will the dollar and the market turn resistance into support and rally higher? Take a breather? Or consolidate sideways? Only time will tell. But the proximity of these trend lines makes for some technical excitement.

Luca Varani, a biophysicist from Switzerland, emailed me with some interesting comments about the regression trend lines in this commentary on historic market price and dividends. He writes:

I have a hard time believing the post 1982 regression line. I believe that the similar trend lines through the 20s and 60s do make a strong point. It is equally difficult, however, for me to believe that everything has been the same for 139 years. After all you are using an arbitrary start point (yes, I know it's the earliest, but still arbitrary); for instance, fix your initial measure at the bottom in 1920 and, I suspect, you will have a different trendline to compare with.

First, a quick note on the regression trend lines in my charts. Since I use a logarithmic y axis for the market price, the Excel-drawn regressions are of the exponential variety. The lines essentially bisect the monthly values using the least-squares method so that the total distance of the data points above the line equals the total distance below. The regression, then, is sort of a hypothetical equilibrium, but it by no means implies that everything has been the same for the past 139 years. On the contrary, the market rarely hovers around the long-term trend. My main point in the earlier commentary was to suggest that the 1982 bull market was not the start of a new economic order but a reversible trend similar to historic market cycles.

The two thumbnail charts (click for larger versions) have regressions drawn through the secular bull and bear markets in the S&P Composite over the past 139 years. For the mathematically inclined, I've included the regression equations and R-squared. To calculate the annualized slope of the regression trend, I've multiplied the coefficient highlighted in color (red or blue) by 12 (monthly data) and formatted as a percent.

The table below combines the data from the charts. I've also added a more conventional measure of performance, annualized returns, with and without dividends reinvested for each of the secular periods. For these numbers I used the fabulous tool on the Political Calculations website (click the link and scroll down).

For each trend, the closer R-squared is to 1.0, the better the fit. For example the bull regressions for the Roaring Twenties, the 1949 "baby boom" bull and the 1882 "adult boomer" bull are close fits to the regression. In contrast, the bear market regressions are relatively poor fits, which is not surprising in light of the much higher volatility during secular declines (see this table). Thus, the extreme volatility of the Great Depression gives us a very low R-squared. Had I plotted the regression through the 32-month crash of 1929, it would probably have been closer to 1.0. The regression since 2000 has an even lower R-squared — not surprising given the back to-back cyclical bears in which the S&P 500 experienced nominal declines of 49.2% and 56.8% in less than nine years. The accompanying table also documents the secular annualized returns, with and without dividends — a topic I'll address in more detail later this week.

As I've pointed out before, even though our data stretches back nearly 140 years, there have been too few of these mega-cycles to make firm conclusions or reliable forecasts. But by drawing a regression through the data and one for each of the major bulls and bears, we get an inkling of the potential magnitude, duration and frequency of these secular trends.

Paul Hanly from Sydney Australia emailed me about the time frames in this monthly update on market valuation. He writes:

It seems that the cycle has been roughly 12 to 20 years (plus or minus 3 years), although there can be violent sub-cycles (e.g., 1930-1950) where the lowest low was actually 1932 rather than 1950. But the tops were in a downtrend.

Here's a new chart with the duration of those secular trends documented. The chart is based on the S&P Composite monthly averages of daily closes, so the time frames will vary slightly from the peaks and troughs on a daily chart. For example the 2000 daily closing high was on March 24th, but the monthly high (average of daily closes) occurred in August.

The accompanying table documents the secular annualized returns, with and without dividends — a topic I'll address in more detail later this week.

Note that there are two entries for the 2000 bear — the first with the March 2009 low and the second from the 2000 peak to the present. The question, of course, is whether the 2009 low was a secular bottom, in which case we're a full year into the new bull market. Or is the real bottom yet to come?

Even though our data covers a timeframe of nearly 140 years, there have been too few of these mega-cycles to make meaningful generalizations. Prior to the current bear, the shortest was the 14-year 1968-1982 bear. If last year was truly the bottom of the bear, it will take the record for brevity.

It's time again for the weekend update of our "Real" Mega-Bears, an inflation-adjusted overlay of three secular bear markets. It aligns the current S&P 500 from the top of the Tech Bubble in March 2000, the Dow in of 1929, and the Nikkei 225 from its 1989 bubble high.

This series is consistent with my preference for real (inflation-adjusted) analysis of long-term market behavior. The nominal all-time high in the index occurred in October 2007, but when we adjust for inflation, the "real" all-time high for the S&P 500 occurred in March 2000.

This chart series now includes a nominal version to help clarify the illusion of market performance created by inflation.

For those who prefer the overlay aligned with the 2007 S&P 500 peak, here is the nominal Mega-Bear Quartet charts and commentary.

Here's the latest in a series of updates from Serge Perreault, a Chartered Accountant and market technician located near Montreal, Canada. Serge anticipated the S&P 500 pullback that began in January, and he has nicely annotated the 8.1% decline and apparent recovery in a series of weekly updates: Jan 19, Jan 24, Jan 31, Feb 5, Feb 12, Feb 19.

The S&P 500 closed the week up 3.1% and is positioned on downtrend resistance dating from the market peak in October 2007. Serge's latest chart adds sideways resistance lines for the index price, the rate of change, and the relative strength index (labeled A, B and C on the chart). For the S&P 500 price, that sideways line is around 1150.23, the interim high on January 19th.

Click the chart for a close-up view and Serge's annotations.

• ROC (Price Rate of Change)
• RSI (Relative Strength Index)

Last September I received an email from Rebecca Mitchell, an Investment Analyst in the UK with an irresistible suggestion. Here it is again, with updates to my charts and commentary.

Rebecca: I was looking at your Short History of Stock Dividends. I like the chart, but was wondering if it would be possible to provide an updated one with two different exponential regression trend lines, one for each period (1870-1982, and 1982-present) to match the two averages for the dividend yield?

If one is to think of the focus on dividend yields as having shifted, the focus on price might also have shifted!

Click the first chart to see a larger version incorporating Rebecca's suggestion. The intersection of the two regression slopes does generally coincide with the decline in dividend yield. As I suggest in my monthly dividend update, this change largely resulted from a convergence of demographics and tax policy — the Boomers looking for growth, not income, and the advent of tax-deferred savings plans, which further blurred the distinction between price appreciation and dividend yield.

This chart with the two regressions reminds me of this optimistic chart published a couple of years ago by Jeremy Siegel. Siegel was focused on real operating earnings per share, a different but related topic. He used a regression from the early 1980s to support a bullish market forecast. Along the way he observes that "Finance theory predicts, and historical data confirms, that if a firm pays a lower proportion of its earnings as dividends, then these unpaid earnings must be used to either repurchase shares, lower debt, or invest in capital."

Unfortunately, investors are now beginning to understand that this redirection of earnings from the investor's pocket to the corporate coffer was a slow-motion exercise in wealth destruction. Price growth was partially offset by the decline in dividend yields. But when price growth reversed, dividend yields were far less accommodating than they were during the Great Depression.

In my view, as illustrated in the second chart, a regression trend line through the market from the early eighties to the 2000 peak merely highlights a reversible secular trend comparable to regressions through the 1920s and from 1949 to 1966.

We're now well into the post 2000 cycle, with many investors hopeful, if not confident, that the March 2009 low was the beginning of a new secular bull market. Time will tell.

The most common questions I get in emails are about my data sources, how I make my charts, and requests for permission to reuse charts and other content. Here are the answers to those questions — also permanently available above in the "Odds & Ends" link in the header menu.

Yahoo! Finance (Daily, Weekly & Monthly Data)

• S&P 500: Data from 1950
• Dow: Data from October 1, 1928
• NASDAQ Composite: Data from February 5, 1971
• NIKKEI 225: Data from January 4, 1984

Yale Professor Robert Shiller's Website

• S&P Composite: Monthly averages of daily closes from 1871

Various Government and Private Services

• Budget of the US Government: Federal Debt, GDP, etc.
• Bureau of Labor Statistics (BLS): Inflation, unemployment, etc.
• Federal Reserve Bank of St. Louis: Federal Reserve Economic Data (FRED)
• National Bureau of Economic Research (NBER): Business cycle data
• Political Calculations S&P 500 Calculator: Excellent tool for historical statistics
• Shadow Government Statistics: Alternate economic data
• Standard & Poor's: S&P 500 dividend and earning updates
• STTA Consulting Inc: Dow daily data from 1900 to October 1928
• Statistics Bureau of Japan: Japanese Inflation
• Wren Investment Advisers: Miscellaneous historical data

All charts and tables are created with the Office 2007 version of Microsoft Excel.

Visitors to this website are welcome to link to, copy, or otherwise distribute my content on condition that a reference to dshort.com is included.

The monthly unemployment rate for February remained steady at 9.7% — the same as January. The peak for the current cycle was 10.2% in October 2009. The chart here shows the pattern of unemployment, recessions and both the nominal and real (inflation-adjusted) price of the S&P Composite since 1948.

Unemployment is usually a lagging indicator that moves inversely with equity prices (see chart). Note the increasing peaks in unemployment in 1971, 1975 and 1982. The inverse pattern becomes clearer when viewed against real (inflation-adjusted) S&P Composite, with its successively lower bear market bottoms. The mirror relationship seems to be repeating itself with the current and previous bear markets.

The second chart shows the unemployment rate for the civilian population unemployed 27 weeks and over. This measure gives an alternate perspective on the relative severity of economic conditions.

Incidentally, I'm now showing the lastest recession as having ended in June 2009, following the lead of the Federal Reserve Bank of St. Louis. The "official" end will be a rear-view mirror call by the National Bureau of Economic Research (NBER).

The third chart is one of my favorites from CalculatedRisk. It shows the job losses from the start of the employment recession, in percentage terms (as opposed to the number of jobs lost).

Here is a link to the Employment Situation Summary released this morning by the Bureau of Labor Statistics.

The start date of 1948 was determined by the earliest monthly unemployment figures collected by the Bureau of Labor Statistics. The best source for the historic data is the Federal Reserve Bank of St. Louis.

The new issue of the Rule Your Retirement newsletter is now available.

• The latest Perfect Your Portfolio feature article gives a succinct rationale for diversification — what it really means and how you can accurately measure the diversification in your portfolio.
  
  
• The Expert Corner, How the Pros Create Financial Plans, is an astonishing collection of key insights of 18 fee-only advisors in the Garrett Planning Network from across the US. This item alone merits a 30-day free trial to Rule Your Retirement.
  
  
• The Financial GPS section focuses on how to set down your goals, prioritize them, and get started on the most important ones. My favorite part of this article is the discussion of three goals that really motivates people.
  
  
• This month's Asset Focus is on International Stocks, an asset class that belongs in every portfolio.
  
  
• Champion Funds advisor Amanda Kish's Follow the Money article highlights "The World According to Charlie Munger," the Berkshire Hathaway Vice Chairman who thinks the US is living out its last days before financial ruin — unless we mend our ways.
  

Like many blogs, dshort.com has context-sensitive ads controlled by third parties. Rule Your Retirement is the exception. It has my full endorsement. If retirement planning is a topic you want to know more about, consider a 30-day free trial.

Note: The latest Standard & Poor's earnings spreadsheet (March 3) puts the annualized dividend yield at 1.94% and the indicated rate at 1.95% (The indicated dividend is the estimate for the next four quarters, based on what was paid in the most recent period).

What happened? Investors shifted their focus from income streams to price appreciation. As a first-wave Baby Boomer, I see this shift as a result of three things:

A New Investor Class
The 401(k) plan was introduced in 1980. The following year the Economic Recovery Tax Act permitted all employees, in addition to those not covered by an employee retirement plan, to contribute to an IRA. The result has been the massive growth of a new investor class with a limited understanding of markets and risk. The bulge of Boomers became a windfall for Wall Street (the oldest having just turned 35 in 1981).

The popularity of tax-deferred savings vehicles reduced the appeal of dividend income. The goal of retirement savings is to grow the nest egg. Thus, the distinction between dividend yield and price appreciation quickly lost relevance. New companies saw little need to pay dividends. Many existing companies reduced their dividends and redirected those earnings to corporate growth (not to mention executive compensation).

The Disappearance of Risk
From the market bottom in 1982 to the peak in 2000, the S&P 500 increased by an astonishing annualized rate of 15% in nominal terms. Investor optimism flourished, and the perception of risk disappeared along with the secular bear that had savaged the market from the mid 1960s to 1982. The crash in 1987, which seemed so terrifying at the time, sparked the shortest bear market in modern history — a mere three months in duration with no accompanying recession.

The Gaming of the Market
With risk in hibernation, these accelerating market gains triggered an appetite for speculation. "Why invest only in my company's plan? I need a brokerage account!" For many people, trading replaced investing, encouraged by the likes of CNBC's Mad Money, Fast Money, and the Million Dollar Portfolio Challenge. In taxable trading accounts, dividends became little more than a recordkeeping nuisance. In IRAs, tracking dividends was completely irrelevant. In-the-know investors moved their IRA accounts to online brokerages for easy trading on the Internet.

But, the investment world has undergone a dramatic change. Risk has returned with a vengeance. Aging Boomers may finally recognize the value of dividend income, especially as their paycheck days draw nearer to a close. Perhaps dividends will someday reemerge as a mainstay of investing. The one certainty is this: it won't happen overnight. But if the flight from equities resumes, publicly traded companies may eventually rediscover the power of dividends to coax a risk-adverse generation back to the markets.

For further thoughts on investor psychology, see Robert Shiller's Irrational Exuberance. Chapters three and four offer a compelling analysis of the factors shaping our current market climate.

Here's the latest update of my preferred market valuation method using the most recent Standard & Poor's "as reported" earnings and earnings estimates and the index monthly averages of daily closes through February 2010.

The "price" part of the P/E calculation is available in real time on TV and the Internet. The "earnings" part, however, is more difficult to find. The authoritative source is the Standard & Poor's website, where the latest numbers are posted on the earnings page. Click on the Index Earnings link in the right hand column. Free registration is now required to access the data. Once you've downloaded the spreadsheet, see the data in column D.

The table here shows the TTM earnings based on "as reported" earnings and a combination of "as reported" earnings and Standard & Poor's estimates for "as reported" earnings for the next few quarters. The values for the months between are linear interpolations from the quarterly numbers.

The average P/E ratio since the 1870's has been about 15. But the disconnect between price and TTM earnings during much of 2009 was so extreme that the P/E ratio was in triple digits — as high as 122 — in the Spring of 2009. At the top of the Tech Bubble in 2000, the conventional P/E ratio was a mere 30. It peaked north of 47 two years after the market topped out.

As these examples illustrate, in times of critical importance, the conventional P/E ratio often lags the index to the point of being useless as a value indicator. "Why the lag?" you may wonder. "How can the P/E be at a record high after the price has fallen so far?" The explanation is simple. Earnings fell faster than price. In fact, the negative earnings of 2008 Q4 (-$23.25) is something that has never happened before in the history of the S&P 500.

The P/E10 Ratio
Legendary economist and value investor Benjamin Graham noticed the same bizarre P/E behavior during the Roaring Twenties and subsequent market crash. Graham collaborated with David Dodd to devise a more accurate way to calculate the market's value, which they discussed in their 1934 classic book, Security Analysis. They attributed the illogical P/E ratios to temporary and sometimes extreme fluctuations in the business cycle. Their solution was to divide the price by the 10-year average of earnings, which we'll call the P/E10. In recent years, Yale professor Robert Shiller, the author of Irrational Exuberance, has reintroduced the P/E10 to a wider audience of investors. As the accompanying chart illustrates, this ratio closely tracks the real (inflation-adjusted) price of the S&P Composite. The historic P/E10 average is 16.3.

The Current P/E10
After dropping to 13.4 in March 2009, the P/E10 rebounded above 20. The chart below gives us a historical context for these numbers. The ratio in this chart is doubly smoothed (10-year average of earnings and monthly averages of daily closing prices). Thus the fluctuations during the month aren't especially relevant (e.g., the difference between the monthly average and monthly close P/E10).

Of course, the historic P/E10 has never flat-lined on the average. On the contrary, over the long haul it swings dramatically between the over- and under-valued ranges. If we look at the major peaks and troughs in the P/E10, we see that the high during the Tech Bubble was the all-time high of 44 in December 1999. The 1929 high of 32 comes in at a distant second. The secular bottoms in 1921, 1932, 1942 and 1982 saw P/E10 ratios in the single digits.

Where does the current valuation put us?
For a more precise view of how today's P/E10 relates to the past, our chart includes horizontal bands to divide the monthly valuations into quintiles — five groups, each with 20% of the total. Ratios in the top 20% suggest a highly overvalued market, the bottom 20% a highly undervalued market. What can we learn from this analysis? Over the past several months, the decline from the all-time P/E10 high dramatically accelerated toward value territory, with the ratio dropping from the 1st to the upper 4th quintile in March. The price rebound since March has now put the ratio at the top of the 2nd quintile — quite expensive!

A more cautionary observation is that every time the P/E10 has fallen from the first to the fourth quintile, it has ultimately declined to the fifth quintile and bottomed in single digits. Based on the latest 10-year earnings average, to reach a P/E10 in the high single digits would require an S&P 500 price decline below 600. Of course, a happier alternative would be for corporate earnings to make a strong and prolonged surge. When might we see the P/E10 bottom? These secular declines have ranged in length from over 19 years to as few as three. The current decline is now nearing its tenth year.

In response to my latest S&P Composite regression to trend update, Donald from New Zealand writes:

If I'm reading the chart right, from 1901 to 1982 the index was breakeven? Amazing!!!

That's right. Excluding dividends, in real (inflation adjusted) value, the 1982 index low was about the same as the high 81 years earlier. Let's see .... Interim event included the Wright Brothers at Kitty Hawk, two World Wars, and the first man on the moon. It was a roller-coaster ride, but in very slow motion — about the same time frame as a human lifespan.

Of course, dividends would have made a difference. The real annualized rate of return ex dividends over that 81-year period was -0.01%. With dividends it came to 5.01%. Unfortunately the current S&P has a dividend yield hovering around 2%.

I received an email today from William "Bill" Bengen, the distinguished financial planner whose pioneering work on retirement savings withdrawal rates revolutionized the financial planning industry. His book Conserving Client Portfolios During Retirement should be mandatory reading for all financial planners.

Bill wrote:

Your current piece about the Regression to Trend suggests that the market could be considered valued 40% below trend if the alternative CPI is used for inflation adjustment. I imagine that's possible. That means prices would have to rise about 65% to get to fair value. But if that were to happen, with dividends constant, the dividend yield would decline from the current 2% to about 1.2%. That doesn't make much sense to me, even if dividend payouts are less than historical levels.

I believe that the non-adjusted chart is closer to being correct. It is verified by other measures of stock market value, such as the Q ratio. What do you think?

I think Bill makes an excellent point, to which I'd add that the official CPI is has been a key driver for Federal Reserve policy which in turn has had a dramatically positive influence on business operations in the US and elsewhere. The secular bull market from 1982-2000 would have been inconceivable had the alternate CPI measure of inflation (illustrated here) been accepted as reality.

For those unfamiliar with the Q-Ratio, it's is a market indicator developed in 1969 by James Tobin, who later received a Nobel Prize in Economics. Put simply it assumes that the combined market value of all the companies on the stock market should equal to their replacement costs. The Q-Ratio is the main indicator of secular bottoms in Russell Napier's outstanding book Anatomy of the Bear. Some readers may recall Napier's December 2008 Bloomberg forecast that the S&P 500 may plunge another 55 percent to 400 by 2014. For a more recent perspective on the Q-Ratio, including a chart, see this article by Robert Huebscher, Founder and CEO of Advisor Perspectives.

Here's a pair of charts from Chris Kimble, a 30-year+ market technician and student of Sir John Templeton, who hails from outside of Kansas City, Kansas.

Charts in my articles frequently use regression trend lines drawn in Excel to illustrate market patterns. For example, see this chart on inflation-adjusted secular bull/bear markets. In simple terms, a regression trend line is mathematically calculated such that the sum total distance of the closes above the trend is the same as the total distance below the trend.

In contrast, Chris has applied his analytical skills to draw trend lines on nominal charts that approximately connect the bottoms and/or tops of market patterns. The Dow chart shows upper and lower trend lines since the first rally after the Crash of 1929. Over 50 years later, the index finally broke above the upper line. That line appeared to provide resistance in the mid 1960s, with a breakout finally coming in the mid 1990s. The line then seems to have provided support during the Tech Bubble bottom, but it gave way during the Financial Crisis of 2008. We're now at another inflection point. Will the Dow break above the line? Or will it serve as resistance?

Chris's S&P 500 chart covers a much shorter period. The solid trend line served as resistance until the mid 1990s and (like the Dow trend line) became support during the Tech Crash. And like the Dow chart, this one also shows us at an inflection point — one that Chris highlights with the dotted resistance trend line since the nominal all-time high in the S&P 500 in October 2007.

Now that the excitement of the Winter Olympics is behind us, we market watchers can turn our attention to the lines of combat on the charts.

About the only certainty in the stock market is that, over the long haul, overperformance turns into underperformance and vice versa. Is there a pattern to this movement? Let's apply some simple regression analysis to the question.

Here's a chart of the S&P Composite stretching back to 1871. The chart shows real (inflation-adjusted) monthly averages of daily closes. We're using a semi-log scale to equalize vertical distances for the same percentage change regardless of the index price range. The regression trendline drawn through the data clarifies the secular pattern of variance from the trend — those multi-year periods when the market trades above and below trend.

The Bearish View
The peak in 2000 marked an unprecedented 163% overshooting of the trend — about double the overshoot in 1929. The index had been above trend for nearly 18 years. It dipped about 6% below trend briefly in March of 2009, but at the beginning of March 2010 it has risen 31% above trend, down slightly from 35% last month. In sharp contrast, the major troughs of the past saw declines in excess of 50% below the trend. If the current S&P 500 were sitting squarely on the regression, it would be hovering around 828. If the index should decline over the next year or two to a level comparable to previous major bottoms, it would fall to the low 400s.

The Bullish Alternative
A critical factor for the reliability of a regression analysis of stock prices over many decades is the accuracy of the inflation adjustment. The Bureau of Labor Statistics (BLS) has been actively tracking inflation since 1919 and has estimated inflation rates back to 1913 using data on food prices. In 1982, however, the BLS began incorporating changes to the Consumer Price Index (CPI), which is used to calculate inflation. These changes have resulted in much lower "official" inflation rates than would have been the case if the method of calculation had remained consistent.

At his www.shadowstats.com website, Economist John Williams publishes an "Alternate CPI" employing the earlier BLS method. Here is a chart that illustrates the significant difference between these two calculation methods.

Now, let's take another look at the S&P Composite, this time adjusted for inflation since 1982 using Williams' Shadow Government Statistics. The change is astonishing. The adjustments to post-1982 data alter the slope of the regression that impacts the variance from the trend across the entire time frame, dramatically so in the last two decades. With this adjustment, the S&P 500 has been below trend since 2002. The current bear market low saw the monthly average index price drop to 55% below the trend, which puts us in the territory of those secular market troughs. The current price is about 40% below trend.

So the question is . . .
Are you bearish or bullish about the market? Or for us data drudges, which is more reliable: the Bureau of Labor Statistics or www.ShadowStats.com?

My opinion is that the optimum method for calculating consumer prices is somewhere between the revised BLS method and the historic method preserved by Williams. But for a long-term regression analysis, consistency is essential, which may lend some credibility to the alternate CPI chart as an indication of the current index price relative to previous troughs.

I generally avoid predictions at dshort.com, but a future trough somewhere between the bearish and bullish view seems a reasonable expectation.

Check back next month for another update.

After spending five weeks below the 50-day moving average, with a retest on February 19th, the S&P 500 closed about seven points above this classic indicator. But the volume today was as weak as we've seen year-to-date. I'm keeping the cork in my Champagne.

Note: The chart linked from this thumbnail is a live chart, so the little version won't match after the next market open.

Was March 9th 2009 the end of a secular bear market in the S&P 500, or is there more downside to come? Without crystal ball, we simply don't know.

One thing we can do is examine the past to broaden our sense of the range of possibilities. An obvious feature of this inflation-adjusted chart of the S&P Composite is the pattern of long-term alternations between up- and down-trends. Market historians call these "secular" bull and bear markets from the Latin word saeculum "long period of time" (in contrast to aeternus "eternal" — the type of bull market we fantasize about).

If we study the data underlying the chart, we can extract a number of interesting facts about these secular patterns:

The annualized rate of growth since 1871 is 1.95%. If that seems incredibly low, remember that the chart shows "real" price growth, excluding inflation and dividends. If we factor in the dividend yield, we get an annualized return of 6.63%. Yes, dividends make a difference. Unfortunately that has been less true during the past three decades than in earlier times, a topic I periodically discuss here. When we let Excel draw a regression through the data, the slope is an even lower annualized rate of 1.68% (see the regression section below for further explanation).

If we added in the value lost from inflation, the "nominal" annualized return comes to 8.83% — the number commonly reported in the popular press. But for an accurate view of the purchasing power of our returns, we'll stick to "real" numbers.

Since that first trough in 1877:

• Secular bull gains totaled 2075% for an average of 415%.
• Secular bear losses totaled -329% for an average of -65%.
• Secular bull years total 80 versus 52 for the bears, a 60:40 ratio.

Based on the real S&P Composite monthly averages of daily closes, the S&P is 41% above the 2009 low, which is still 42% below the 2000 high. The 2009 low measures about 6% above the average decline for secular bear markets. Of course, this number is a bit skewed by the bottom in 1932, which saw a greater decline over a much shorter period (three years versus nine).

Add a Regression Trend Line

Let's review the same chart, this time with a regression trend line through the data. This line essentially divides the monthly values so that the total distance of the data points above the line equals the total distance below. Remember that 1.95% annualized rate of growth since 1871? The slope of this line, an annualized rate of 1.68%, approximates that number. The 0.27% difference is largely a result of the rally over the past year.

Regression to trend, as we've seen elsewhere, often means overshooting to the other side. The latest monthly average of daily closes is 31% above trend after having fallen only 6% below trend in March of last year. Previous bottoms were considerably further below trend.

Will the March 2009 bottom be different? Only time will tell.

It's time again for the weekend update of our "Real" Mega-Bears, an inflation-adjusted overlay of three secular bear markets. It aligns the current S&P 500 from the top of the Tech Bubble in March 2000, the Dow in of 1929, and the Nikkei 225 from its 1989 bubble high.

This series is consistent with my preference for real (inflation-adjusted) analysis of long-term market behavior. The nominal all-time high in the index occurred in October 2007, but when we adjust for inflation, the "real" all-time high for the S&P 500 occurred in March 2000.

This chart series now includes a nominal version to help clarify the illusion of market performance created by inflation.

For those who prefer the overlay aligned with the 2007 S&P 500 peak, here is the nominal Mega-Bear Quartet charts and commentary.

Here's the latest in a series of update from Serge Perreault, a Chartered Accountant and market technician located near Montreal, Canada. Serge anticipated the S&P 500 pullback that began in January, and he has nicely annotated its progress and possible recovery:

• Jan 19: Daily chart with correction targets
• Jan 24: Weekly chart with downtrend support and resistance
• Jan 31: Weekly chart marking an up-cycle within a downtrend
• Feb 5: Weekly update of the downtrend
• Feb 12: Weekly close near the down-cycle resistance
• Feb 19: Weekly close near the down-cycle resistance

The S&P 500 closed the week fractionally lower (down 0.4%) from last Friday and remains stalled at the 10-week moving average. Serge's latest chart speculates on the need for the ROC momentum indicator to break above downtrend resistance for the longer-term market recovery to resume.

Click the chart for Serge's full commentary.

• ROC (Price Rate of Change)
• RSI (Relative Strength Index)

The S&P 500 closed the month of January 3.7% below the December close. However, all three of the S&P 500 monthly moving averages we've been tracking continue to favor equities.

Since 1950 the S&P 500 10-month SMA has had 41 buy signals; 26 of them (63.4%) led to a gain before the next sell signal, 15 of them (36.6%) led to a loss. The 12-month SMA has had 31 buy signals, 21 (67.7%) led to a gain before the next sell signal, 10 (32.3%) led to a loss. These moving-average signals have a good track record for long-term gains while avoiding major losses. But they're not fool-proof.

The Ivy Portfolio

Here is a table with the current signal for the 10-month SMA for the five ETFs featured in The Ivy Portfolio. I've also included a table of of 12-month SMAs for the same ETFs for this popular alternative strategy.

Background on Moving Averages

Buying and selling based on a moving average of monthly closes can be an effective strategy for managing the risk of severe loss from major bear markets. In essence, when the monthly close of the index is above the moving average value, you hold the index. When the index closes below, you move to cash. The disadvantage is that it never gets you out at the precise top or back in at the very bottom. Also, it can produce the occasional whipsaw (short-term buy or sell signal).

Nevertheless, a chart of the S&P 500 monthly closes since 1995 shows that a 10- or 12-month simple moving average (SMA) strategy would have insured participation in most of the upside price movement while dramatically reducing losses.

The 10-month exponential moving average (EMA) is a slight variant on the simple moving average. This version mathematically increases the weighting of newer data in the 10-month sequence. Since 1995 it has produced fewer whipsaws than the equivalent simple moving average, although it was a month slower to signal a sell after these two market tops.

A look back at the 10- and 12-month moving averages in the Dow during the Crash of 1929 and Great Depression shows the effectiveness of these strategies during those dangerous times.

For an interesting article on trend signals using a crossover of two moving averages, see this article on Quantitative Chart Screening for Trends by Richard Shaw of the QVM Group. The 52-week/26-week crossover looks especially interesting for long-term investors willing to check their holdings weekly.

For anyone who would like to see the 10- and 12-month simple moving averages and the equity-versus-cash positions since 1950, here's an Excel file (xls format) of the data. My source for the monthly closes (Column B) is Yahoo! Finance. Columns D and F shows the positions signaled by the month-end close for the two SMA strategies.

The Psychology of Momentum Signals

Timing works because of a basic human trait. People imitate successful behavior. When they hear of others making money in the market, they buy in. Eventually the trend reverses. It may be merely the normal expansions and contractions of the business cycle. Sometimes the cause is more dramatic — an asset bubble, a major war, a pandemic, or an unexpected financial shock. When the trend reverses, successful investors sell early. The imitation of success gradually turns the previous buying momentum into selling momentum.

Implementing the Strategy

Our illustrations from the S&P 500 are just that — illustrations. In actual practice, you should have a separate signal for each asset class that you plan to use for this strategy. For example, you wouldn't buy and sell a small cap index mutual fund or ETF based on an S&P 500 signal. The strategy is most effective in a tax-advantaged account with a low-cost brokerage service. You want the gains for youself, not your broker or your Uncle Sam.

Recommended Reading

In the past we've recommended Mebane Faber's thoughtful article A Quantitative Approach to Tactical Asset Allocation. The article has now been updated and expanded as Part Three: Active Management his book The Ivy Portfolio, coauthored with Eric Richardson. This is a "must read" for anyone contemplating the use of a timing signal for investment decisions.

The book analyzes the application of moving averages the S&P 500 and four additional asset classes: the Morgan Stanley Capital International EAFE Index (MSCI EAFE), Goldman Sachs Commodity Index (GSCI), National Association of Real Estate Investment Trusts Index (NAREIT), and United States government 10-year Treasury bonds.

As a regular feature of this website, I try to update the signals at the end of each month. However, my retirement flexibility and life's unpredictability preclude a firm commitment.

Before the market opens on the last trading day of the month, we can safely assume there will be no monthly-close surprises in our S&P 500 market timing signals. All three monthly moving averages we've been watching continue to signal an equities position. The 10-month SMA gave a buy signal at the end of June, and the 12-SMA and 10-EMA signaled buys at the end of July.

The Ivy Portfolio

The top table table previews the 10-month SMA timing signals for the five asset classes highlighted in The Ivy Portfolio. See the Timing Updates for interim updates.

This month I've also included the 12-month SMA timing signals for the Ivy ETFs in response to the many requests I've received to include this slightly longer timeframe.

As you can see, two of the ETFs (IEF and DBC) in the Ivy Portfolio are within less than 2% of a signal, hence the yellow highlight. And IEF is very close to a signal in the 12-month variant of the standard Ivy Portfolio system.

The bottom line, as we've pointed out earlier, is that these moving-average signals have a good track record for long-term gains while avoiding major losses. They're not fool-proof, but they essentially dodged the 2007-2009 bear and thus far have captured significant gains since the buy signals after the March 2009 low.

Here's a fascinating chart from Chris Kimble, a 30-year+ market technician and student of Sir John Templeton, who hails from outside of Kansas City, Kansas.

Chris has applied his technical skills to the ongoing debate over the wisdom of buying bonds at the current yields. His chart shows that the yield on the 30-year bond has exhibited a repeating pattern for the past 15 years. Yields are now up against a downtrend resistance line that has generally signaled a good time to buy bonds. But will this time be different? Chris highlights a classic inverse head and shoulders pattern since mid 2007. This pattern often signals a reversal of the previous trend.

Will yields fall? Or will they break through the neckline and head higher? Given the uncertainty about a worldwide economic recovery, the direction of the dollar, the risk of sovereign defaults, and the inflation-deflation dispute, this pattern of potential trend reversal will be especially interesting to watch over the next several months.

The cover story in the latest issue of CentrePiece, a publication of the Centre for Economic Performance (CEP) of the London School of Economics, has the eye-opening title The Doomsday Cycle. Co-authored by Peter Boone of the CEP and Simon Johnson, a professor Sloan School of Management, MIT, the article examines the stunning record of regulatory failure since 1980.

I was immediately struck by their chart showing private sector credit/GDP ratio and the Fed Funds Target rate since 1980. The chart is annotated with four financial fiascos: the S&L Crisis, the LTCM Bailout, the Tech Bubble, and the Subprime Bubble. Regular visitors to this website know me well enough to know — I couldn't resist the urge to add an overlay the S&P 500.

● Doomsday Chart
● with S&P 500 overlay

The immediate question on everyone's mind is "Where do we go from here?" The authors believe that "The real danger is that as this cycle continues, the scale of the problem is getting bigger. If each cycle requires greater and greater public intervention, we will surely eventually collapse." They conclude with this unpleasant observation: "Last year, we came remarkably close to collapse. Next time, it may be worse. The threat of the doomsday cycle remains strong and growing."

Boone and Johnson offers suggestions for reform, but, given our track record and the officials in charge, they see little hope for sustained, effective financial regulation.

The article is reprinted here at the voxeu.org website, or you can download a PDF of the CEP published version here. I used the chart in the Vox reprint for the overlay.

My recent post on federal debt was based on data in the 2011 budget introduced by President Obama on February 1. The main focus was the six-year forecast by the Office of Management and Budget for 2010-2015.

Today's chart examines the pattern of the seven rolling forecasts since the 2005 Bush budget was presented in February 2004. As you can see, 2008 was a pivotal year. In fact, the federal debt from 2000-2008 and the five Bush budget forecasts shown on this chart (2005-2009) deviate only slightly from a linear regression drawn through the debt data and extended to 2015, illustrated here. Despite the war or terror and the cost of wars in Iraq and Afghanistan, federal debt was a relatively simple extrapolation.

The financial crisis that began in 2008 changed everything. Government policies to deal with the crisis have significantly altered the OMB estimates, as the two Obama budgets (2010 and 2011) dramatically illustrate. The 2010 budget (presented February 26, 2009, 11 days before the market low) included a forecast for the fiscal-year-end debt that proved to be 8.3% higher than the 2009 final number, a fact that illustrates the magnitude of uncertainty introduced by the financial crisis. The 2011 six-year forecast has scaled back the numbers for 2010 and 2011, but it closely tracks the later trend of the previous budget.

These federal debt forecasts confirm we what already know — 2008 was a major economic turning point, a metaphoric fork in the road. However, the chart helps us quantify the magnitude of the new direction. The current 2015 forecast of a 19.68 Trillion debt is about 46% higher than the equivalent point (about 13.5 Trillion) on the road not taken.