There is a science to market movements and various
trends because human nature is consistent over time. Bear markets follow a
pattern as do bull markets. In recent weeks we’ve noted the
similarities between the past four equity bull markets. They start off strong
for six or seven years before slowing down over the next five years. Then
they break to new highs and eventually accelerate into a bubble. As we show
in this update, change in valuation explains how bull markets evolve into
The following chart shows the Nikkei (black) and its
price to earnings ratio (blue). The chart comes from DailyWealth
but the annotations are mine. In our opinion, the Japanese bull market began
in the late 1960s. Note, from 1977-1983 the PE ratio trended down slightly,
yet the market continued to rise. In other words, profits increased faster
than the market (share prices). In 1983 the PE ratio broke to a new high and
would move from 20 to over 70 in about five years.
Next is a chart of the Nasdaq’s
price to earnings ratio, courtesy of InvestTech
Research. The ratio declined from 1991-1995. It wasn’t until the end of
1996 that the ratio began to move to new highs. We cut off part of the chart
as it was too tall due to the fact that the PE ratio eventually reached 260!
Where do the gold equities stand? This chart from
the Erste Group, shows the
PE ratio for the HUI Gold Bugs Index. This chart was produced in July 2011.
Since then the HUI has declined slightly. The estimated PE for 2011 (less
than 15) is close to reality. We do expect 2011 to be the bottom for the PE
ratio. According to Yahoo Finance, the trailing PE ratio for GDX (large cap
gold stocks ETF) is 10. After hitting a low, it took less than three years
for the PE ratio for the Nasdaq and Nikkei to move
to new highs.
Bull markets follow three stages. These are the
initial stealth phase, the wall of worry phase and then the bubble or public
participation phase. By now you should know we are in the wall of worry
phase. The current valuation of gold stocks confirms that. Sentiment confirms
that. After all, gold stocks have made little net progress in the last four
years while Gold has nearly doubled in the same period. The mainstream
continues to ignore the gold equities while most of the true supporters are doubting the future.
Yet this wall of worry phase is what sets the stage
for the bubble phase. In this period, earnings increase faster than stock
prices and it results in lower valuations and improved fundamentals. At the
same time, sentiment from a contrary perspective becomes more compelling.
Many investors bail out of the bull market in this period leaving the strong
hands in control of a bull market that remains intact.
Remember, stock prices are a function of earnings
and valuations. In the first phase of a bubble we see earnings rise and
valuations move from a low to a high. In the second phase of a bubble,
skyrocketing valuations are the primary driver of share price appreciation.
Bubbles develop from a one-two punch of rising profits and rising valuations.
Over the next several years, the PE for the gold stocks (currently 10) could
easily move back to 2004-2005 levels. Combined with continued increases in
profits, share prices would explode. If you’d like help in stock
selection and navigating this bull market then we invite you to learn more
about our premium service.
Jordan Roy-Byrne, CMT