Stock Markets Extremely Undervalued Under the IBES Valuation Model

By: Clif_Droke

Two tectonic plates and “The Big One” - We've all heard it before: The next major depression is expected to begin sometime around 2011-2012 and continue its ravaging impact until about 2014-2016. This belief has become so accepted among cycle theorists as to be almost a type of gospel.

And based on a purely deterministic interpretation of the K-wave and long-term Kress cycles, this outcome would make sense. Some persuasive arguments of this theory have even been advanced from a demographic perspective (see “The Next Great Bubble Boom” by Harry Dent and “Baby Boomers, Generation X and Social Cycles” by Edward Cheung, for example).

Yet this overlooks a salient fact that has been an important part of the recovery of the U.S. stock market since 2002, namely, the extraordinarily attractive valuations of stocks compared to bonds. I'm referring of course to the super-bullish long-term readings in the IBES Valuation Model.

Recently I received a correspondence that addressed a topic I think is of paramount importance to us as investors and we'll be exploring it more in depth in the coming weeks:

"I first introduced myself to you as your Kress Cycle enthusiast after reading your posted articles. I had never seen any commentator discuss these cycles, much less place any reliance on them for forecasts. The second thing I've seen you uniquely refer to (starting with your 'Clowns' article, and lately in your MSRs) is the IBES Valuation model. I am wondering if they are the markets' version of two tectonic plates building up stress ahead of 'The Big One'.

"Your Kress Cycle articles suggest that the party will last till the end of the decade, at which time the hard down phase of the longer term cycles will exert tremendous downward pressure on markets and economies. However, it's hard to ignore the long term IBES charts you have been referring to, as they have tremendous predictive value. They seem to suggest that stocks have a huge remaining upside.

"If the Kress Cycles (and K-wave bottom) are as hard to defeat as Kress suggests, then how will IBES go from being extremely undervalued to extremely overvalued in less than two years. Since it comprises stock prices, earnings, and yields, could it be that stock prices might not go up much, but earnings might fall and yields rise (perhaps starting at the change in decade). Or could there be a meteoric rise in stock prices in less than 2 years? Without knowing the weighting of each in the formula, I'm curious how you see this playing out."

Here's my answer to this question:

This thought has also occurred to me and I wonder if maybe the fateful 2010-2014 time frame when the cycles all converge (and which everyone seems to be worried about) might not be so bad after all.

All of this is not to say we're in some kind of perpetual bull market/economic boom. I still think the cycles will hold true and we'll see a bear market in stocks and a slowdown or recession by 2012. But it might not be nearly as bad as many seem to think.

I've heard more than one expert who I respect suggest that the bear market we had in 2000-2002 was a once-in-a-generation phenomenon. We might not see anything like that again for a long time. It's also possible that the carry-over fear that has persisted since the last bear market could get us through for another 10-15 or so years before we see another bear market quite like the last one.

The answer to your question is just a guess. You suggested that it might take longer than two years for that record IBES undervaluation to morph into overvaluation and you could be right. However, looking back you can see that when the public becomes decisively bullish on stocks and sheds their fear and jumps in, it doesn't take as long for undervaluation to disappear as you might think.

In the past the market has gone from undervalued to overvalued in an average time of 2-3 years. So it's possible we could hit fair-to-slightly overvalued by 2009-2010.

Will we hit those massively overvalued levels that were seen in the late 1990s? I doubt it. That's one reason for suspecting the upcoming 120-year cycle and K-wave bottom could be milder than anticipated.

As for the possibility that Treasury yields could rise and stock earnings fall, I don't see this happening. The K-wave/Kress Cycles should keep the bond yields from rising too much in the coming years. In fact, demographics alone argues against persistently rising bond yields.

As for a drop in earnings, I read a study not long ago which concluded that for the market to lose its undervaluation based on earnings, earnings would have to undergo the equivalent of a super-crash for this to happen. I can't remember what percentage earnings would have to drop, but it was some ridiculously high number. And even if this did happen, IBES would only rise to fair value -- it still wouldn't hit overvalued!

Bottom line: the next time we see IBES go up toward overvalued I think it has to come from a rising stock market, which implies widespread public participation.

Here is another question we almost never hear cycle theorists discussing: What impact might the merging of the world's major economies have on the cycle outlook for the U.S.? When the global economy has been fully integrated and central bank policies have been super coordinated, will the long-term economic rhythms of foreign countries create a muting effect on our own domestic cycles?

I'm not sure anyone, let alone the world's central bankers, know the answer to this question. We're truly entering into the unknown here and there are so many X-factors as to make prediction virtually impossible. The old economic models will almost certainly have to be discarded in favor of new ones that address issues such as global liquidity, global money velocity and a host of related monetary concerns.

Then there's the issue of new technologies. The last major bull market in the U.S. rode off the back of the Internet wave. Is there a new technological boom waiting in the wings that will propel the next super boom? Nanotech perhaps? The old-fashioned and extremely deterministic cycle approach doesn't take this into account, either, rendering it obsolete as a standalone model for economic forecasting.

The bigger question confronting the cyclical approach to forecasting the future is whether the combination of technological development, global liquidity and super-undervaluation of stocks will combine to completely override the coming Kress 120-year Cycle and K-wave bottoming process between 2011-2014.

To get an answer to this question it helps to go back to the previous 120-year cycle bottom around 1894. If you look at the old Axe-Houghton industrial average of stocks from that time period you'll be amazed to discover that in spite of the bottoming cycles and a major industrial depression, the stock market held at or near its all-time high up until the end of 1892.

Cycle theory says that the final 8-12% of a cycle is the “hard down” phase. It also assumes that the years between 1890-1894 should have been bearish for stocks. Yet the bear market in stocks as measured by Axe-Houghton didn't begin until early 1893 (Panic of 1893). Was there an economic force or combination of monetary factors that kept stocks afloat through this troublesome period of 1890-1892? Is it a stretch to assume that whatever force(s) kept the “hard down” phase of the cycles at bay until 1893 can manifest in our time with a different set of rules and circumstances to keep super deflation from rearing its ugly head? The monetary authorities of our day certainly have more tools at their disposal than did their counterparts of 120 years ago. Can you imagine what might transpire in the coming years with the many “seismic” forces on a global scale, all them converging like so many tectonic plates? The possibilities are staggering!

None of the foregoing should be construed as a vilification of cycle theory. It is merely an attempt at looking at an old problem with a modern perspective, a perspective that is often lacking in cycle theory debates of today.

By Clif Droke
www.clifdroke.com

Clif Droke is the editor of the three times weekly Momentum Strategies Report newsletter, published since 1997, which covers U.S. equity markets and various stock sectors, natural resources, money supply and bank credit trends, the dollar and the U.S. economy. The forecasts are made using a unique proprietary blend of analytical methods involving internal momentum and moving average systems, as well as securities lending trends. He is also the author of numerous books, including "How to Read Chart Patterns for Greater Profits." For more information visit www.clifdroke.com

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