The rate of slope of the trend channel is 6%. Not coincidentally, that is also both the long-term growth ratein S&P earnings and the S&P index, before dividends are added in determining the total return. To completethe picture for investors, the average dividend yield has been 4% which, along with the 6% annualappreciation in the index, is how the roughly 10% return from common stocks since 1926
is calculated.So, in the third graph, we’ve included a 10-year moving average of annual reportedearnings to smooth out the alwaystemporary aberrations, and to amelioratethe tendency to get overly excited whenreported annual earnings are getting aheadof themselves or depressed when they arefalling behind. As the graphics make clear,for the last 85 years reported earnings havealways “mean reverted”; i.e., like a jerky pendulum, they fluctuate around amidpoint. Without getting into the math,the eye alone will tell you that the market is more attractive when prices are closer to the bottom trendlinethan the top – both in terms of a lesser likelihood of falling still farther and its enticing corollary, the rising probability that it will rise at a rate faster than the trendline in the future. Think about that sentence carefully. Value investing throws the conventional high-risk/high-return paradigm on its ear. Value investors tilt therisk/return scales in their favor by disciplining themselves to buy only when the price-to-value favors themand not the seller. We call it the “margin of safety.” More importantly, the relationship between the index value and the 10-year moving average earnings – whether the index value is above or below, and by how much – is an indicator of how much valuation risk (or advantage) to which one is exposed at any point intime.In the final graph of the series, we’veadded the horizontal lines from Mr.Karletsky’s earlier chart and use them now to more closely examine his hypothesis. As for the line from 1929 through 1955, we are at a loss. Surely a rational valueinvestor would have not waited until 1955to invest, when the market finally “brokeout,” 23 years after the lows of 1932. That is unless, like millions of others, it wasn’t just his savings he lost, but his willto venture as well. On the other hand, thecase in the early 1980s is, from ourperspective and as is obvious from the graph, compelling. Being fastidious about detail, we think the lineshould be drawn somewhat lower, right on top of the 100 line found on the right margin. Doing so wouldonly strengthen Karletsky’s argument, but it would also be more consistent with our other writings about 17-year cycles, with the one in question beginning in 1966 and ending in 1982. As for looking forward fromtoday, Karletsky’s thesis that something has changed of which we are not yet aware must ultimately translateto two forces about which we have a low level of conviction: (1) corporate earnings will rise in the future at arate higher than the 6% average of the last 85 years and (2) interest rates will remain well below theirhistorical averages indefinitely. In fact, we would argue that the conditions necessary for (1) to occur for any extended period of time preclude the possibility of (2) coexisting simultaneously.
Ibbotson Stocks, Bonds, Bills, and Inflation Classic Yearbook
. Roger Ibbotson, Yale University. Published annually by Morningstar (Chicago). ISBN: 978-0-9849500-2-7