We’ve been reading Richard Russell, one of the greatest stock market observers in the country, for at least 10 years. Now in his mid-80s, Russell has seen it all. And he thinks we’re in a bull market.
Though we’ve been reading for a long time, we have never figured out how Dow Theory (his system) works. There are a lot of indicators and technical enhancements involved, but it appears to us to come down to this:
When prices are moving up, we are in a bull market. When prices are going down, we are in a bear market. When we are in a bull market – as Russell believes we are now – how long will it continue? Until prices go down!
After the epic high of 2000, Russell maintained that the Dow would probably remain in a bear market until an epic low was reached. This made sense to us. At least in broad outline. We buy when prices are low. So, we’ll wait for another epic low. What the heck…we know it is coming sooner or later. In the meantime, taking the long view, everything is going downhill.
But now, Russell says stocks are in a bull market…with another big burst of gains coming. How long will it last? Until it comes to an end, says Russell. How high will it go? Until it reaches its peak, he explains.
The Dow only went down only about 20%, after January 2000, so it never got to an epic low; it never even reverted to the mean. Instead, stocks have been expensive since the mid-’90s. From here, maybe they’ll go higher. Maybe they won’t.
We don’t know what to make of Russell’s system, but we have a deep respect for the man’s experience and intuition. When he says stocks are headed higher…we pay attention.
Why would stocks go up from here? Could it be just the final stage of a credit bubble…could it be the bailout cash will float them up…or, could it be that stocks’ earnings will rise?
Colleague Chris Mayer ruminates:
“You know the big debate about profit margins. They are near all-time highs. The mean-reversion guys (Granthan, et al) say they will come back to trend. Others (GaveKal) believe the economy is fundamentally different now.
“But what if the high profit margins (and high return on assets) are due to understated book values (because of the cost accounting assumptions) and that the actual cost to replace these assets – because of inflation – is actually much much higher?
“Then, what happens is that as companies replace plant and equipment or expand, capex expenses should rise. This won’t show up in earnings right away, because of the delay between capex and when they start hitting the P&L in the form of depreciation charges.
“But it becomes a stiff headwind against earnings after a while. Earnings fall as they reflect more truly the cost of the assets used, and profit margins fall, book values rise, returns on equity fall…stuff starts to move back to trend…
“Obviously, this doesn’t affect all industries equally…but it could be a contributing factor to a potential decline in earnings…
“And, of course, it would mean the market price has to come down some. Bad for stocks generally.”
We suspect Chris is right. American companies have borrowed heavily. But much of the money has gone into bonuses, fees, buybacks and other non-capital investments. When they actually have to replace plant and equipment, to keep up with foreign competitors, they’re going to find themselves a little short.
Markets and Money