Dow Theory Update for May 7: More about the unreliability of trying to gauge the secular trend

Primary and secondary trends for stocks, gold, silver and their miners unchanged.

The lull continues. So, once again, I’ll focus on issues pertaining to investing with a Dow Theory focus. Today I will delve into secular trends, valuations and what to do about them.

This blogger truly yours has been skeptical as to trying to determine the existence of a secular bull/bear market based on valuations. You can read my most recent post on this matter here.

Well, Matt O’Brien has recently written on the Washington Post that the valuation issue is highly elusive and that there might be good reasons for the seeming overvaluation of stocks (which has been with us for at least the last 25 years). O’Brien quotes a couple of pearls of Eddy Elfenbein, of "Crossing Wall Street" which should prompt us to forget valuations (as there is no proper yardstick to define “valuation” to begin with, or, if you prefer, your yardstick changes with time, so any measure or comparison you make is meaningless) as a good indicator to time our investments in the stock market.

Here you have the quotes:

"The only problem is they’ve been getting expensive for awhile low. “According to CAPE,” Crossing Wall Street’s Eddy Elfenbein told me, “stocks have been valued above average for most of the last 25 years.” Part of that is accounting standards are different than they used to be, so valuations are too—they’re higher. Another part is that interest rates having been falling the last three decades, and, all else equal, lower rates should mean higher stock valuations. And the last part is that CAPE overweights what happened before to what’s happening now. Think about it like this. Today’s 27.2 CAPE ratio is so high, in part, because earnings were so bad during the financial crisis. But it’s a little funny to say that a historically crummy economy seven years ago means stocks are overvalued now.

Another way to look at this is to just consider last year’s earnings. Now this has the opposite problem of only weighting what’s happening now. So if earnings are negligible or negative, like they were in 2008, this will say that stocks are super expensive when they’re actually super cheap. But as long as we keep that in mind, this still helps us look at stocks from a slightly different angle. And it tells us that, with a PE ratio of 19.7, the S&P 500 isn’t a bargain, but it isn’t exorbitant either. In other words, it’s a little high, but compared to the last 25 years, not crazily so. (That’d be the tech bubble). Besides, it’s a “misperception that the market falls due to valuation,” Elfenbeing says, when “more often stocks fall with lower fundamentals instead of prices soaring beyond fundamentals.”

          (emphasis in original)

My Dow Theorist comment: So, forget about valuations if you want to catch the next downturn of the market, you better look for clues elsewhere and here comes the Dow Theory in handy. The best time frame not to be deluded by valuations is the cyclical bull/bear markets (average duration 1-2 years) which is long term enough not to be a day trader and to avoid noise, and short term enough not to be in the secular timeframe which requires valuation and fundamental considerations (which are subjective and inaccurate per se) in order to decide whether to be “in” or “out” of the market. Hone your Dow Theory skills, become proficient at it, and relax. You’ll be able to know when to be “in” and “out” without resorting to fancy valuation methods, which are close to useless (as they are inherently flawed to begin with) to most of us mere mortals.

Sincerely,

The Dow Theorist.