Challenges in Stock Market Valuation and Forecasting

Key Insight

Accurately assessing the stock market's level, such as the DJIA at 900 and S&P composite at 100 in January 1972, is fraught with difficulty, as demonstrated by previous analyses. Historical judgments reveal the complexity of forecasting; for instance, in 1948, the DJIA at 180 was deemed 'not too high', and in 1953, at 275, it was considered 'favorable from the standpoint of value indications', despite concerns about its historically high absolute level and a longer bull market period than usual. This cautious stance in 1953 was not entirely brilliant, as the market advanced another 100% in the next five years. Similarly, a 1959 assessment declared the DJIA at 584 'a dangerous one' due to prices being 'far too high' and momentum inevitably carrying it to 'unjustifiable heights'.

Despite the 1959 caution, the DJIA advanced to 685 in 1961 before declining in near panic to 536 in May 1962, representing a 27% loss in six months. More dramatically, popular 'growth stocks' like IBM plummeted from 607 in December 1961 to 300 in June 1962. A complete debacle occurred in 'hot issues' of small enterprises, which were offered at ridiculously high prices and then driven to insane levels by speculation, often losing 90% or more of their value in months. Yet, the financial community was equally surprised by the market's unexpected recovery and new ascent later in 1962, leading to renewed bullish forecasts by 1964. By November 1964, with the DJIA at 892, a strong conclusion was that 'old standards (of valuation) appear inapplicable; new standards have not yet been tested by time', and that if the 1964 price level was not 'too high', then no price level could be.

The 1964 caution was somewhat vindicated, as the DJIA only advanced about 11% further to 995 before falling irregularly to 632 in 1970, closing that year lower than six years prior. This historical context informs the assessment of the early 1972 market. While the 3-year price-earnings ratio in October 1971 was lower than in 1963 and 1968, it was still much higher than in the early years of the long bull market. A critical factor is the interest yield on high-grade bonds; the ratio of stock earnings yield to bond returns had significantly worsened over the period, making January 1972 less favorable for stocks by this criterion. The dividend yield on the S&P index, which was over 7% in 1949, had fallen to 3.0% by 1961, while bond interest rates rose from 2.60% to 4.50%. This reversal meant bonds now yielded twice as much as stocks, a stark contrast to 1948. Consequently, the adverse change in the bond-yield/stock-yield ratio offsets any perceived improvement in the P/E ratio, rendering the early 1972 market level (DJIA 800-950) unattractive for conservative investment.