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By Norman P. Poiré

" Where the holding period is infinity, the value of a stock is the discounted present value of its prospective dividend stream…" This well-established financial principle, stated in Graham & Dodd’s classic publication Security Analysis, simply means that in the long run investors own stocks to collect cash dividends. After all, unless companies part with some of their accrued wealth, shareholders are playing a zero sum game where they can increase their net worth only at the expense of other shareholders.

The chart below illustrates the principle. In it is presented a capitalization-weighted index of U.S. stocks that is adjusted for inflation using the consumer price index and divided by U.S. population. Cash dividends issued by companies are not included.

The index which is set to a value of 100 for the year 1835 represents what the inflation-adjusted price of stocks would be had they been distributed to every man, woman, and child in the United States over time. It might help to think of the index as a single company stock that continually splits to keep pace with population growth.

What we find is that the resulting real per capita stock index has for the most part been trading sideways for two centuries, leaving shareholders with no net capital gains. Since we know that investors as a group have pocketed handsome profits over this period, all their rewards must have come by way of dividend distributions.

In recent years, however, investors’ appetite for cash dividends has fallen to unprecedented lows. By letting companies retain a larger share of their earnings, shareholders have helped propel the index to never before seen levels.

Whenever dividend yields are low, investors are expressing optimism over future earnings prospects. The level of optimism exhibited at the present time suggests that the public believes that today’s market is substantively different than all that have come before. Is this New Era optimism justified or could we be witnessing the Mother of all stock manias? To answer this question, let us begin by examining the chart more closely.

Prior to 1998, the 200-year index was contained within a parallel channel that changes slope every 83 years but on balance doesn’t alter its value over time. This 83-year pattern is of particular interest because it aligns with two cycles, one social and one technological, that can be traced back a number of centuries.

In their 1990 book, Generations, authors William Strauss and Neil Howe present a four-part social cycle that has averaged 83.5 years since 1648. They show that the changing constellation of generations is responsible for an alternating pattern of spiritual awakenings and secular crises in the United States over the last four centuries.

The technology cycle, a product of my own research, is characterized by alternating periods of technological innovation and intellectual achievement. The two most important innovations of the last 200 years appear near the beginning of eras of technological innovation. The steam engine is credited with igniting the Industrial Revolution in 1769 while the invention of the computer in 1939 launched today’s Information Revolution.

The most influential scientific discovery during this timeframe was introduced to the world in Charles Darwin’s 1859 publication On the Origin of Species by Means of Natural Selection. It appeared shortly after the commencement of an era of intellectual achievement.

The steam engine, the discovery of natural selection, and the electronic digital computer are all landmark technologies that dominated their respective eras. Landmark technologies have appeared on average every 83.2 years for over five centuries, as illustrated in the table below.

If the cycle repeats, we find ourselves on the brink of a turning point where society moves from one era to the next and the trading channel changes slope. This would be the third such event since 1800 and on all three occasions stocks challenged the upper band of the channel in the proximity of the turning point. These unsuccessful bids ended in 1835, 1929, and (perhaps) 2000. The letters A, B, and C in the chart highlight these market extremes.

In the first two instances, stocks beat a hasty retreat from their respective historic highs. Indeed, the worst three-year period for stocks since 1800 occurred from 1929 to 1932 while the second worst period was from 1835 to 1838. From beginning to end the two declines averaged 70 percent (based on annual averages), taking just three years to reach bottom after the 1929 top and an agonizing seven years from the 1835 peak.

Should the third and most ambitious market extreme follow suit, the index will simply fall back into the long established channel, erasing much of the gains of recent years. A move from current levels to just the top of the channel would take the S&P 500 Composite index below 1000. A decline consistent with the two preceding turning points would drive the index into the 450 neighborhood — a fine neighborhood back in 1994 but one investors would not wish to visit again.

Many market analysts insist that historical comparisons are irrelevant because the economy is different today. A number of arguments have been presented to support the case that we have entered a New Era — one that justifies much higher stock market valuations.

The most oft-cited are (1) the development of important new technologies that promise a dramatic increase in productivity, (2) a long-standing monetary stability ostensibly engineered by skillful authorities, (3) fiscally responsible government action that has produced a favorable interest rate environment, and (4) the defeat of a destabilizing military threat. The particulars in each category are microcomputers and the Internet, the Volker/Greenspan Fed since 1979, a declining federal deficit, and the 1989 collapse of the Soviet Union.

While these are worthy reasons for investing in equities, they are not unique to today’s market. At the 1835 market peak the very same ingredients existed in the form of canals and railroads, the establishment of the 2^nd Bank of the United States in 1816, the lowest federal debt since the creation of the republic, and the 1815 defeat of Napoleon’s army at Waterloo. In 1929 it was automobiles and radio, the creation of the Federal Reserve System in 1913, a steady reduction in the federal debt since 1919, and the triumph over the Kaiser’s Second Reich in 1918.

Since the weight of argument favors mania over New Era, then, what catalyst might reverse the upward trend of recent years and what force could drive the market into a tailspin? The answers in order are liquidity and leverage — not enough of the first and too much of the second.

Falling liquidity will prick the speculative bubble and indications are that the penetration has begun. Liquidity as measured by the change in M2 money supply adjusted for inflation and population growth (RPCM2) reached a trigger point last summer that in past instances has coincided with important downturns in the stock market.

Once the tide turns, a highly leveraged economy that has increasingly placed its bets on continued expansion and a rising stock market has little choice but to react in dramatic fashion. Leverage is a two-edged sword that compounds gains on the way up and just as effectively compounds losses on the way down. Consumer and corporate debt near record levels may be all the force that is needed to bring about the gloomy projection presented above.

Just as I opened with a quote from Graham & Dodd, so shall I close with more of their wisdom. "It is reasonable to conclude that in the future (as in the past) there will be secular growth in the prices of…common stocks. However, the typical investor should not take much comfort from the highly probable expectation as to future growth, because the secular increase in stock prices is exceedingly erratic…Even genuinely long-term investors can hardly disregard the price paid for common stocks by following the logic that they will be ‘bailed out’ by the secular growth in stock prices."