Bubbleology is a word we coined at Zeal for the study of financial-market bubbles.  This section was originally launched back in 2000 when the notorious tech bubble had just started retreating off its mania top and stocks were still tremendously overvalued.  At that time everyone was caught up in the frenzy and no one cared or paid attention to stock-market valuations.  Since the valuation data so crucial to long-term investors was almost impossible to come by, we started collecting and collating our own valuation data.  These valuation metrics in this table help us understand where the stock markets happen to be in their great Long Valuation Wave cycles.



Bubbleology is found in Zeal Intelligence each month on Page 3.  The small page above as well as the real sample Bubbleology table below are both linked to a full-size page if you want to click and see Bubbleology in its original context.  Before delving into the data reported each month though, it is really important to have a rudimentary grasp of the underlying theory that makes this so valuable.


Long Valuation Wave Theory  The stock markets move in great cycles we call Long Valuation Waves.  One full wave tends to last a third of a century or so.  The first half of the waves when valuations are rising are the great bull markets of history.  The second half of the waves when valuations are falling are the great bears.  Knowing where we happen to be in our current Long Valuation Wave is utterly crucial to long-term investors.  If an investor buys in near a valuation-wave trough he is almost certain to earn a fortune over the coming decade almost regardless of his stocks.  But if he buys in near a peak, at best his stocks will languish flat for a decade.


Stock-market valuations are simply a way of expressing a stock price relative to the earnings and dividends the stock is producing for its owners.  If a particular stock has a high price-to-earnings ratio and a low dividend yield, it is expensive.  If an investor was to buy it, many decades would have to pass before the stock earned back for him what he paid for it.  Stocks get more expensive, or more overvalued, during the 17-year great-bull phases of the Long Valuation Waves.  They ultimately peak at bubble levels with very high price-to-earnings ratios and very low dividend yields.  At these times investors foolishly pay enormous premiums for future profits.


Eventually stock prices get so overvalued that there is no new capital left out of the markets to bid them higher.  Then they have no choice but to start the long 17-year great-bear phases of their Long Valuation Waves.  During this time valuations contract, price-to-earnings ratios fall and dividend yields rise.  At best stock prices trade sideways for over a decade and at worst they fall.  The reason stock prices have to be flat or down is to give underlying earnings time to catch up with high stock prices and reduce valuations.  Once a Long Valuation Wave starts contracting, nothing on earth can stave off this necessary process, not even monetary inflation.


For long-term stock investors there is nothing more important to understand than our current position in our Long Valuation Wave.  If you are not familiar with valuation waves, we strongly encourage you to click this link and carefully read and digest our essay Long Valuation Waves 2.  It will get you up to speed on why Long Valuation Waves are so important.  It would also be valuable to read Curse of the Trading Range 2.  It explains some of the great dangers to capital that arise by being trapped in a Long Valuation Wave reversion.  If you invest against a retracting Long Valuation Wave, you are almost certain to see your capital wither away over time.



Stock-Market Valuations  Most of the Bubbleology table is dedicated to stock-market valuations.  We track these key valuation metrics each month for the three most important stock indexes in the US and quite probably the entire world.  The S&P 500, of course, are the 500 biggest and best companies in the US and the most-widely-accepted proxy for the markets as a whole.  The Dow 30 are the 30 elite blue-chip giant American companies of the Dow Jones Industrial Average.  They are so large they utterly dominate the US stock markets.  And finally the tech-heavy NASDAQ 100 index, the 100 biggest and best NASDAQ companies, is analyzed.


Nine columns of data are tracked for stock-market valuation metrics.  Each column is split in half, with the first half containing the actual data and the second half containing the percentage change in the data from the previous data point of one month earlier.  In order to make these changes easier to assimilate at a glance, month-over-month percentage decreases are rendered in red.  Each of these nine columns is explained below.  Together they will help you understand where we are in today's Long Valuation Wave.


P/E Ratio  The price-to-earnings ratio is the most fundamental measure of stock valuation.  Just as it sounds, it is a company's stock price divided by the total of its latest four quarters of actual earnings results that are reported to the US Securities and Exchange Commission.  So if a stock is trading at $100 per share, and it earned $1.10 per share four quarters ago, $1.20 three quarters ago, $1.50 two quarters ago, and $1.20 in its latest completed quarter ($5.00 total), it has a P/E ratio of 20x.  20x is read aloud as "twenty times earnings".  A $100 stock price divided by $5 in most-recent annual earnings yields a valuation multiple of 20x earnings.


While P/E ratios are usually calculated like this with per-share data, another macro method yields identical P/E ratio results.  If a company has a market capitalization (shares outstanding multiplied by share price) of $200m, and it earned a total of $10m over the last four quarters, its 20x P/E can also be derived this way.  At Zeal we use the micro method though, crunching per-share data.


Now over centuries of stock-market history, as explained in depth in our Long Valuation Waves 2 essay, stock markets have had an average P/E ratio of 14x earnings.  This 14x is considered fair value.  It makes logical sense too.  One divided by fourteen equals 7.1%.  7% is a fair rate of return for a saver providing capital to a company that needs it and 7% is also a fair rate for a debtor to pay to borrow the surplus capital of a saver.  With 7% being a fair rate for both the "buyer" and "seller" of capital, it is no wonder stock valuations have gravitated to this fair-value valuation over market history.  A stock or index trading at 14x is considered fairly valued.


When a stock gets over 14x earnings, it is considered overvalued.  And if it gets all the way up above 28x earnings, twice fair value, it is considered a stock-market bubble.  The US stock markets in 2000 were far above 28x earnings, actually up to their highest valuations in history, which is why we originally called this section Bubbleology.  If valuations get up above 28x and then start retreating over a year or more, then the odds are very high that a Long Valuation Wave reversion, or great bear market, is upon us.  Investors would do well not to invest in general stocks when they're in these great-bear phases where valuations retreat for 17 years.


In contrast when a stock falls under 14x earnings it is considered undervalued.  If it contracts all the way back down to 7x earnings, or half fair value, it is considered very cheap.  Stock markets trading at 7x earnings are only seen at Long Valuation Wave troughs at the beginning of great bull markets.  If you are prudent enough to buy stocks near 7x earnings and the Long Valuation Wave is rising again, you are going to earn a fortune during the great bull market over the next 17 years.  As such, long-term investors really want to back up the truck and buy with reckless abandon when stocks get so undervalued as a whole that they trade near 7x earnings.


So 14x is fair value, 28x is bubble levels, and 7x is very cheap levels.  There is another useful way to look at this.  If you are an investor and you buy a company at 14x earnings, assuming no growth it will take that company 14 years to earn back the price you paid for its stock.  At 28x it is a 28-year payback period but at 7x it is only a 7-year payback period.  Now as an investor wouldn't you prefer to buy stocks with prices so low relative to their earnings power that it only takes them 7 years to earn back your purchase price rather than 28 or more?  Remember the whole point of investing is to buy low and sell high, and buying near 7x is the way to do it.


Now figuring a valuation for a single stock is easy.  But determining the valuation for an entire stock index is a bit more complex.  With the S&P 500, for example, we obtain the individual valuations of all 500 of its component companies and then average them to get to the S&P 500 index P/E ratio we publish each month.  And rather than using a simple average, we weight the P/E ratios of the components by their market capitalizations.  This market-capitalization-weighted-average (MCWA) approach ensures that the index P/Es most accurately reflect their underlying fundamental realities with a minimal amount of distortion caused by extreme outliers.


For example, imagine an index composed of two companies.  ABC has a $100b market cap and trades at 17x earnings.  Meanwhile XYZ has a $5b market cap and trades at a much higher multiple of 63x earnings.  If we took a simple average of these valuations, we would have an index trading at 40x earnings.  40x is very expensive and deep into bubble territory, a screaming sell.  But in reality it is a little company skewing this valuation.  If we weight these valuations by market capitalization, the true valuation of the index is a far more reasonable 19x earnings.  19x is expensive but nowhere near bubble levels.  MCWA better reflects reality.


Watching these key stock-index P/E ratios over time, and charting them as we do in our charts section under "Stock-Market Valuation Charts" (logon and password can be found on Page 8 of the current issue of ZI), creates an outstanding visual representation of the Long Valuation Wave in progress.  Knowing where we are on the Long Valuation Wave can help investors earn fortunes by investing in general stocks at the right time as well as save them from losing fortunes by not investing in general stocks at the wrong time.


Fair Value  The fair-value column simply shows where each major index would be trading today if it had a fair-value P/E ratio of 14x earnings.  In this example above, the S&P 500 was actually at 1285 at the beginning of February 2006 but it was trading at 22.0x earnings.  In order to reach fair value at 14x earnings, the index would have had to fall to the 819 level listed in Bubbleology.  This fair-value number gives a quick idea of the valuation premium inherent in the stock markets at any particular time.


Dividend Yield  While P/E ratios are the primary valuation metric, dividend yields are a close second.  Indeed in some ways dividends are much more important than earnings since earnings can be manipulated with accounting games but cash dividends actually paid to shareholders each quarter cannot be faked.  Dividends paid out are set in stone while earnings are a sort of accounting fiction with all kinds of wiggle room depending on the accounting assumptions each company uses.  Thus it is very important to watch dividend yields too, which also gradually meander in great third-of-a-century Long Valuation Wave cycles right alongside the P/E ratios.


A dividend yield is simply the annual dividends paid per share divided by the current share price.  A stock trading at $100 per share that paid a total of $2 in dividends over the previous four quarters would have a dividend yield of 2%.  While dividend yields during history are not as well defined as P/E ratios, there is definitely a dividend-yield range of interest.  When dividend yields for the stock markets as a whole are over 6%, the markets are cheap.  When dividend yields are under 3%, the markets are expensive.  Fair value is near 4.5%.  We have a detailed essay on dividends within valuation waves, Dividend Valuation Waves, if you'd like more info.


While dividend trends during Long Valuation Waves aren't as well-defined as P/E-ratio trends, dividend yields act as a rock-solid confirmation for P/E ratios.  Since dividends paid are an acid test that is impossible to manipulate through creative accounting, it is a much less biased window into general stock-market valuations.  Of course long-term investors want to buy when dividend yields are high, which happens near valuation-wave troughs when P/Es are low.  And investors want to walk away when dividend yields are low, which happens during valuation-wave peaks when P/E ratios are high.  So dividend yields move inverse to P/E ratios over time.


As described above for P/E ratios, we determine our index dividend yields by obtaining the dividend yields for each individual component company of a stock index and then averaging all of these to get the index dividend yield.  And just as with P/E ratios, we use a market-capitalization-weighted-average (MCWA) approach to distill down all these individual dividend yields.  MCWA is a far superior methodology to simple averaging because it prevents small companies with extreme dividend yields from unduly influencing the final index dividend yield far beyond their appropriate proportions.  This most accurately reflects underlying fundamental realities.


On the percentage-change sub-column after dividend yields, the change is denominated in the same percentages as the dividend yields.  For example, if dividend yields went from 1% to 2% over one month, the change noted would be +1%, not +100% to denote a double of dividend yields.  While both methods are correct, percentage changes of percentages are confusing so they aren't used.


Overvalued  This column reflects how much each stock index is overvalued compared to where it would be trading if it was at 14x earnings.  In this example, the NASDAQ 100 stock index is 164% overvalued, or 164% higher than where it would be trading if it happened to be at the historical stock-market fair-value level of 14x earnings.  The more overvalued an index is, the more dangerous it becomes for long-term investors and the worse the deals they will be getting if they buy stocks at that particular time.


On the percentage-change sub-column after overvalued, the change is denominated in the same percentages as the overvalued levels.  For example, if an index went from 10% overvalued in one month to 20% overvalued in the next, the change noted would be +10% rather than +100% denoting a double.  Percentage changes of percentages are confusing so we do not generally use them.


Market Cap  This market-cap column is simply the entire market capitalization of each stock index as a whole.  For an individual company, market capitalization is computed by multiplying its total shares outstanding by its current share price.  To calculate the market capitalization of an entire index, the separate market capitalizations of all of its individual components are added up.  This column is included because it shows at a glance what the entire value of each major stock index is in the marketplace today as well as highlights changes in this key metric.  But this is not the only reason we calculate market capitalization each month.


A secondary subtler reason exists.  By comparing P/E ratio changes to market-capitalization changes we can infer key things about why valuations happened to rise or fall in that month.  For example, if a P/E ratio changes by the same percentage as the market cap then we can infer that earnings were largely unchanged for an index as a whole.  But if the P/E ratio rises slower than market cap if the latter is up or falls faster if the latter is down, then we can safely assume that earnings were growing for the stocks of an index.  Conversely if the P/E ratio rises faster than the market cap or falls slower, then this suggests that stock earnings are declining.


Co >28x, Co <7x, and No Profits  These next three columns delve into the composition of the valuations of the individual components that comprise each of the major stock indexes.  They record what percentage of the component companies of an index have a P/E ratio above 28x earnings, a P/E ratio under 7x earnings, or have no P/E ratio at all since they are losing money.  Companies trading at greater than 28x, of course, are trading at dangerously high bubble valuations.  Companies trading under 7x are probably fantastic buys if their low P/E ratios are the result of high recurring operating income rather than one-time special income boosts.


Since each index has a different number of components, the same percentage across these different indexes yields different numbers of companies in each category.  The S&P 500 has 500 component companies, so 20% of this flagship index would equal 100 companies.  Meanwhile the elite blue-chip Dow 30 only has 30 components, so 20% of it would equal 6 companies.  And of course 20% of the 100 NASDAQ 100 companies would equal 20 companies.  So please keep this in mind as you analyze these columns.


Watching these three categories over time can reveal much about the composition of a major stock index.  In the sample above, 53% of the NASDAQ 100 companies are trading above 28x earnings in bubble territory while another 9% are losing money.  Stats like these obviously can only arise in an extremely overvalued index trading at dangerously lofty valuation heights.  Meanwhile in the Dow 30 in this sample, only 3% of its companies are trading above 28x earnings and another 3% aren't earning any profits.  Thus the NASDAQ is way more overvalued than the Dow 30.  During a Long Valuation Wave trough this situation would reverse, with a large fraction of the component companies trading under 7x earnings.  Of course this is the ideal time for long-term investors to buy.


On the three percentage-change sub-columns here, the change is denominated in the same percentages as the data.  So, for example, if one month has a 10% reading in one of the columns and the following month has a 20%, the percentage increase listed is +10% rather than +100% to denote the double.  Percentage changes of percentages are confusing so we usually don't use them.


Lowest P/E  In every index each month the company with the lowest P/E ratio is listed.  We do this because buying the lowest P/E stocks at any given time tends to be an excellent long-term investment strategy.  One of its more common variants is known as "The Dogs of the Dow".  Basically very low P/E stocks are purchased to hold for a few years and then they are rotated out of an investment portfolio once their P/E ratios get high again.  But please realize that just because these companies happen to have low P/Es in a given month doesn't necessarily mean they will be good investments.  And we are looking no farther than their low P/Es here.


If you want to buy any of these, more research must be done.  A great low P/E stock to buy is one where its low P/E is a result of high operating earnings.  And not only must these high profits be from core operations, but they must be recurring with a high probability of being sustainable or ramping up in the future.  Fairly often in the markets low P/Es are not this favorable result of great margins on operations but due to one-time events.  For example a company could sell a division for a profit, something it can't repeat in the coming years, and temporarily have high earnings and hence a low P/E.  So low P/Es only matter for recurring core operating earnings.


Inflation  The last line in Bubbleology is loosely related to stock-market valuations as it tracks various inflation measures.  Inflation is not merely a rise in prices as most people falsely assume today, but it is the rise in general prices driven specifically by an increasing supply of money.  This is very distinctive from a solitary price rising due to its own supply-and-demand dynamics.  For example, if oil supplies are growing slower than demand on a global basis so the oil price is bid higher, this rising oil price is not inflation but just its own supply and demand.  But if oil prices rise along with general prices due to more money created, it is inflation.


When a money supply grows faster than the underlying pool of goods, services, and investments on which to spend it, inflation is the inevitable result.  Relatively more money competes for relatively fewer goods, services, and investments and hence bids up the prices on all of them.  Inflation is dangerous and pernicious but it can be harnessed for you too.  You can invest with it rather than fight it.


If the citizens of nations around the world are going to allow fiat-paper currencies with no intrinsic value, and central banks are going to continue creating these paper currencies out of thin air at reckless rates, then the best thing a prudent investor can do is try to invest in market sectors that are likely to be bid up by some of the fresh money created.  Historically general stocks have done poorly in inflationary environments since they are also just paper, hence new stocks can be created at will.  Instead commodities stocks tend to thrive during these times because the supply of physical commodities is finite and cannot be expanded magically with a keystroke.


M1 and MZM Growth Rates  Since the US dollar remains the world's reserve currency for now, it is dollar growth (or inflation) rates that are most important to monitor worldwide.  There used to be four main money-supply measures reported in the US.  In order from the smallest to largest they were M1, M2, MZM, and M3.  In the sample above we used M3 and MZM money supplies as our primary measures of monetary inflation.  Unfortunately in March 2006 the US Fed ceased reporting on broad M3 money-supply growth rates, igniting fury within conspiracy theorists everywhere.  Deprived of M3, we were forced to change Bubbleology to M1 and MZM.


To track these monetary inflation rates, two measures are used for both M1, narrow money supply, and MZM, a much broader money supply that includes money-market funds.  First, the actual monthly growth rate of each money supply as reported by the US Federal Reserve is noted.  This measure of true monetary inflation is provocative as it almost always exceeds reported inflation per the CPI and PPI.  In addition for each money supply, it is compared to the current officially reported US government gold reserves.  This gives an idea of how many dollars in circulation that each ounce of official US gold reserves "backs".  The numbers are staggering.


"Backs" has to be in quotes here because the US government severed the last remaining vestiges of the gold standard back in 1971.  Today the US dollar is backed by nothing but future promises to pay.  The US government can grow dollars into infinity and never be legally called upon to surrender physical gold in exchange for paper dollars.  Nevertheless, in a philosophical sense at least the US's remaining gold reserves sort of "support" the dollar as they help maintain faith that the US has actual hard assets and not just paper.


For many decades now the US government has reported unchanging gold reserves of 8139 metric tonnes, or 261.7m troy ounces.  In the sample above, the US MZM money supply was running $6,902b, or just under $7 trillion dollars.  Dividing MZM by the ounces of gold in the official US reserves, each ounce "backs" an unbelievable $26,374 of currency in circulation!  While we report on this each month as a commentary on the staggering rates of monetary inflation in the US, it also has a secondary role.  These numbers show just how chronically undervalued gold is today relative to paper dollars.  Even at $5,000 per ounce gold would still be relatively cheap!


CPI and PPI  The CPI and PPI, of course, are the popular and widely-followed official US government measures of inflation, the US Consumer Price Index and the US Producer Price Index.  The former is supposed to measure consumer inflation, the inflation that average American citizens face.  The latter is supposed to measure producer inflation, increases in the prices of raw materials that manufacturing operations use to produce finished products.  While the CPI and PPI are terribly flawed and do not do what they are supposed to do, they remain the most-widely-accepted inflation measures by Wall Street and the stock markets so we watch too.


The CPI and PPI are designed and manipulated to chronically understate actual inflation in the US.  This is accomplished via a careful selection bias for index inclusion as well as mathematical wizardry including hedonic adjustments.  When a price is rising too fast, the custodians of these indexes either remove it or weight it lower to reduce its impact on headline index growth rates.  When they weight it lower, they often justify it using hedonic math.  Hedonics is a silly theory that tries to quantify benefit rather than cost, looking at the perceived pleasure and perceived utility derived from a good or service rather than the actual hard costs out of our wallets.


For example, if you bought a 1ghz computer five years ago and a 3ghz one today, the CPI custodians would claim that the actual cost of the computer was irrelevant.  It would be cut by two-thirds for index-calculation purposes since presumably a 3ghz machine does three times as much as your old 1ghz machine.  Obviously this is madness, as most of the computer tasks we do depend on us (like how fast can we read and respond to our e-mails) rather than our machines.  This ridiculous hedonic math is used to claim prices are dropping for consumers and businesses in the US in key areas when in reality absolute prices are rising.  It is incredibly misleading.


Why would the US government intentionally understate inflation?  A couple major reasons exist, and a myriad of lesser ones.  First, higher reported inflation rates make the stock markets very wary.  If true inflation was reported, odds are the stock markets would sell off sharply.  Politicians in power never want to rile the stock markets since these markets tend to heavily color the voters' perceptions of the politicians' economic performance.  Higher reported inflation, even though true, would lead to lower stock markets and a widespread perception of a weakening economy which would make it harder for politicians to secure votes in the next election.


On a parallel securing-votes front, higher reported inflation rates would lead to higher interest rates.  Not only would these higher rates hurt the stock markets, but they would hurt debt-based markets near and dear to voters' hearts such as the US housing market.  Higher rates make Americans feel poorer as more of their disposable incomes must go into servicing their big debt loads.  As such, if politicians want to remain in office and win future elections, they have enormous incentives to lowball inflation.


Second, most entitlement and welfare spending programs are tied to official inflation rates.  Politicians love to spend the taxpayers' money on their own pet projects, but they can only spend money after welfare payments are made.  These welfare payments are indexed to the CPI.  So the slower the growth in the CPI, the slower the growth in non-discretionary government transfer payments.  This leaves more money to bribe future voters with largesse, go fight a foreign war, or any other adventures that politicians tend to gravitate to like moths to a flame.  Since the politicians pay the statisticians' salaries, the latter are under big pressure to understate.