Both Peter Brimlow and Mark Hulbert commented this week on the surprising change of view from Richard Russell, the editor of the oldest stock market newsletter in existence: Dow Theory Letters. Russell has been an unabashed gold bull for a number of years and he has been absolutely correct. As well, he has been mostly negative on the equity markets.
So it is rather surprising to hear that he has now told his clients that he believes that the stock market is the better place to be for inflation-adjusted returns going forward. As Peter Brimlow reports, Russell wrote this recently to his subscribers:
I’m changing my position on the stock market. I’m now recommending buying the Dow in the form of the diamonds SPDR Dow Jones Industrial Average ETF Trust. I believe the Dow (but not all stocks) is being seen as a hedge against the dollar and as a safe-haven for those who perceive that the dollar is steadily losing purchasing power.
In the very big picture, I believe Americans are facing one huge and daunting problem – the steady loss of their purchasing power via a declining dollar. What we’ve been seeing is the Dow rising as it adjusts to the diminishing purchasing power of the dollar. To put it simply, the Dow alone (but not most stocks) has been acting like a currency hedge.
To be fair, his call is a much nuanced shift than it might appear at first glance. Russell is not abandoning gold nor is he telling his clients to sell their gold holdings. What he is saying is that because he believes that we are going to see inflation in the near future, corporate earnings will enjoy an equal or greater gain.
I don’t disagree with Russell’s assertion, especially since there is ample evidence to show that earnings track or exceed inflation. After all, when all prices are rising across the board, companies have few incentives to not raise prices. When they do, they enjoy higher revenues and earnings. Mark Hulbert also agrees, citing similar historical evidence.
Where I part company with Russell is in the assumption that earnings have a direct link to future stock market returns. They do not. The vast majority of stock market returns are accounted for – not by earnings – but by earnings multiple contraction or expansion. In other words, the value (P) that the market puts on each incremental dollar of earnings is key, not the earnings (E) themselves. Unfortunately I don’t have any quantifiable evidence for this assertion but I do recall reading about it a few years ago. If anyone knows of any relevant data or research, please let me know.
As well, I’m a bit nervous because I do remember the last time that Russell changed his stripes and went bullish after making lengthy and adamant bearish noises. It was back in May 2007 when Russell issued a Dow Theory buy signal. That didn’t go over so well. The stock market topped out at a high plateau in a matter of weeks. What followed is still seared into every trader’s memory.
Russell usually abides by two important rules before going long equities: value and the Dow Theory. Right now the stock market is not providing an especially appetizing value proposition. Neither is it providing a Dow Theory buy signal – especially not when you consider the weakness in the Dow Transportation index.
It seems that Russell is siding with Jeremy Grantham who has been a proponent of “high quality” stocks – large caps that pay solid dividends. But Grantham is an astute market timer and judge of value. Grantham, mentioned most recently in his quarterly letter that he sees the fair value of the S&P 500 index closer to 900 than 1300.
Far be it from me to question the great Sage of the Dow. Richard Russell, after all, has lived through many more market cycles than I have and his previous successful calls are legendary. But I can’t shake the feeling that right now is not the time to be going long equities. And even more strangely, I find myself rooting for gold – something that I don’t usually feel comfortable doing most of the time.