Foundations: U.S. Market Structure & Value

Powerful Trends, Increasing Fragility & Coiled Tension

As you know, many on CNBC and across the social media spectrum are very excited about AI and the potential for very high stock valuations continuing and even expanding.

$6 trillion. I see $6 trillion! Can we have a $7 trillion? $7 trillion! Can we have a $10 trillion? $10 trillion oh my!

I have a different view rooted in the fundamental arguments I have made, so far, including Cardinal Sign of A Bubble: Supply Side Gluttony, Unicorns & Cockroaches: Blessed Fraud, as well as The Supply Side Gluttony Recurrence and the Blessed Fraud Recurrence.

I have also penned my bearish take on Palantir with Palantir’s New Clothes: Foundry, AIP & the Failure of Reason, and Palantir, An Accounting.

I have been attacking the narrative, warning of failed expectations.

I have yet to tackle directly the overvaluation of the market itself, which is generally a good thing - for a very specific reason. Along these lines, however, I do track something that I want to share with you.

Most of us are familiar with the long-term logarithmic chart of the U.S. stock market. It is a glorious thing, and looks like a remarkably steady march over the last century.

A baby born today, put $1,000 in an index fund and be done with it, right? That’s the idea behind 530A accounts, a.k.a. Trump Accounts, delivered by the One Beautiful Bill, perhaps at an auspicious time.

Nevertheless, a long chart like that glosses over some extremely painful periods that would require almost inhuman fortitude of an individual investor or portfolio manager. Few can hold through a decade or more of significant losses – that is fighting against human nature in a dozen different ways.

Below, a chart of the Dow Jones Industrial Average from 1900 to the present day.

I added some perspective. The blue line is the Dow Jones prices arranged logarithmically. The red line is a more sobering view, which is the Dow Jones adjusted for inflation.

Additionally, I used the average Shiller cyclically adjusted PE ratio (CAPE) from 1900 (purple dotted line) and from 1990 (orange dotted line) to chart the Dow Jones as if it were at one average constant PE ratio the entire time. This takes out variance in PE multiple over time. Those two dotted lines look less violent, less dramatic.

Multiple compression and expansion comprise a large portion of the volatility in stocks over the years.

Also, note the vertical light red shaded areas are secular inflation-adjusted bear markets. That is a 100-year chart, so right off the bat you notice, those last a long time and are as common as inflation-adjusted bull markets.

For the Dow Jones, the inflation-adjusted drawdowns were, from past to present, 65%, 74%, 65%, and 39%.

The pattern in the first three bears is devastatingly consistent. The real trough didn’t stop at fair value — it overshot dramatically below either PE-adjusted line before reversing. In 1921, in 1932, and at the 1974 + 1982 bottom, the market was trading at Shiller PEs of 5–8x — roughly half the century average, let alone the modern era average.

The 2000–2013 bear is the outlier – its trough in 2008–2009 landed roughly at the 1990+ average PE line and modestly above the century average — meaning the market found support at “fair value” rather than overshooting into deep undervaluation, on this metric.

I gave the S&P 500 Index the same exact treatment, starting at 1928, instead of 1900, as you can see in the chart below.

For the S&P 500, the inflation-adjusted drawdowns were 58%, 55% and 43%. The S&P 500 Index does not capture the 1906-1921 drawdown.

Those are significant, painfully deep and painfully long drawdowns. Stocks protect investors from inflation, but not without serious patience, a good diet and regular exercise.

Here too, with the S&P 500, we see the 2000-2013 bear is, not surprisingly, an outlier. Of course, never had there been such scale of policy intervention: zero interest rates, quantitative easing, interest on excess reserves held at the Fed, TARP, nationalizations of three large financial concerns. The government’s backstop was powerful and effective in its delivery of moral hazard for future generations.

I have maintained for some time that there was no natural conclusion to the bear market of 2007-2009. Zero interest rates, IOER, and other crisis-era policies remained in place for a decade or more. AIG’s rescue saved Goldman Sachs, and the whole narrative shifted, ushering in our current era of populist politics and nihilistic youth.

But I digress.

Interest Rates, Who Needs Them?

Truth is, avoiding those drawdowns is hard. In fact, people lose a lot of money trying to do just that. Many still try, and interest rates and inflation are big foci for investors. For this very reason, few government events are more highly anticipated or analyzed by markets than ones involving the Federal Reserve Chairman.

Recent rate and inflation history put the interest rates/stocks theory to a serious test, however.