by Peter Brimelow and Edwin S. Rubenstein
Commentary: Stocks have more potential upside than downside risk
Stocks rebounded strongly in 2009. But they're still fairly low by historic standards.
We base this conclusion on the work of Prof. Jeremy Siegel of the University of Pennsylvania's Wharton School, author of the classic book, "Stocks For the Long-Run." (Note: Siegel should not be blamed for the conclusions we draw from his data.)
Siegel's most famous finding: Counting capital gains and dividends together, and adjusting for inflation, stocks have accumulated on average in real terms at a remarkably consistent 7% or so over the past 200 years. Shown on a log scale, this consistent trend appears as an impressive upward-slanting straight line.
For several years, we've been writing columns that look at stocks relative to that upward-slanting trend line.
Since the Crash of 2008, we've twice pointed out that stocks had reached levels below trend that in the past marked historic lows.
Our conclusion: A stock market bottom was in sight.
This was a very unpopular conclusion at the time. But the world did not come to an end, and stocks are now considerably higher.
Stocks have not, however, gotten very far out of the range that marks historic lows.
As of the market's close on Wednesday, Feb. 24, stocks were 27.9% below trend.
In contrast, October 2008, they were 38% below trend. Last January, they were 43.1% below trend.
That was very comparable to the levels seen at historic bear market bottoms in 1981 (40% below trend), 1974 (41% below trend) and 1932 (42% below trend).
Of course, the stock market did rebound strongly in 2009. But not enough to move stocks out of historic low ranges, because the trendline itself is slanting up so sharply.
Our (cautious) conclusion now: Stocks have more upside potential than downside risk.
Note carefully: we are not saying that stocks can't go down, maybe by a lot, or move sideways for a long time. These relationships are very approximate.
Over the longer term, however, they prevail.
Thus, when we first started following Siegel's work, in the 1990s, stocks were far above trend, approaching levels associated with market tops.
We concluded, therefore, that the market was overvalued. And apparently it was, but it took years to break. (Stocks reached 86.39% above trend in 1999).
In our early MarketWatch columns, we pointed out that, despite the 2000-2002 Crash, stocks had never gotten anywhere close to the levels associated with historic lows.
We concluded that stocks had more downside risk than upside potential. But they stooged along sideways for years and even managed a blow-off before finally tanking.
But, eventually, they did tank. Remember?
Our conclusion now is the mirror-image of our conclusion in 2007: Stocks are not high by historic standards. They can go down, but they can't go down all that far before getting to unsustainable levels. And, someday, they have to go up.
Edwin S. Rubenstein is president of ESR Research in Indianapolis.
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