Prior to the current bear market, the worst bear market of modern times began in 1966 at an overvalue yield of 3.0 percent and was not completed until December, 1974 when the undervalue yield of 6.0 percent was reached. From 1975 to 1982 the market fluctuated between dividend yield extremes of 5.0 percent and 6.0 percent until a new bull market was launched.

The bull market that began at undervalue in 1982 rose to overvalue in 1992, remained there until 1995, and then a remarkable thing happened: For the first time in history the DJIA continued to ascend above its historically repetitive low yield and appeared to have formed a new profile of investment value. From the mid-1990s through September 2008, what formerly was the yield at overvalue (3.0 percent) became the new floor of undervalue and a dividend yield of 1.50 percent became the new selling area of overvalue.

In October 2008, however, the DJIA broke below 10,000 and eventually reached an intraday low price of 6440.08. Based on the composite dividend at that time, the dividend yield on the DJIA rose to 4.90 percent, a decisive violation of the undervalued dividend-yield floor of 3.0 percent.

In Figure 8.1 we display our Blue Chip Trend Verifier in bar-graph form to illustrate the incredible level of values during this period.

When the third and final leg down of the bear market began in 1973, the Undervalued category rose to dominance and remained there until the bull market began in 1982. As frustrated capital that had been pent up since the end of the bear in 1974 came rushing in, the Rising-Trends category eclipsed the Undervalued category as stock prices were pushed higher.

Now look at the bar graph in Figure 8.2 that illustrates the period from 1987 through July 2009 to see what happened to all of those historically good values.

On the far left edge of Figure 8.2 is the reading from July 1987. Note that the Rising and Declining Trend categories are about even. The dividend yield on the Dow had breached the 3.0 percent overvalue yield at this point. The next set of bars represents the reading of January 1988. Here we can see that the crash on October 19, 1987 had moved the majority of stocks into declining trends and the dividend yield on the Dow had declined back to 4.0 percent. The readings from July 1988 and January 1989 depict similar levels of value to January 1988. By the January 1990 reading, the rising trends had reasserted their dominance and the dividend yield on the Dow had declined once again to the 3.0 percent overvalue area.

From mid-year 1994 through January 1995 the Declining-Trends category took center stage. There is really only one explanation for this: The majorities of Select Blue Chips had declined below overvalue and were moving toward their respective areas of undervalue. You can almost sense that investors knew intuitively the market was overbought and needed to retrench.

Then the perfect storm, as described earlier, kicked into gear. From mid-year 1995 until mid-year 1997 the rising trends returned to the fore. At that point the dividend yield on the Dow was so low that well diggers would have had trouble finding it. From that point through early 2000, the Overvalue category reigned supreme as investors thoroughly trashed whatever could be trashed until the first leg down of the present bear market took hold.

In 2000, the luster and allure of quick profits in companies that were created on a cocktail napkin began to wear off. When earnings failed to materialize and the reality that, in many cases, these companies were simply speculations, the tech and dot-com illusion came to a screeching halt. By late 2000 and early 2001 it was clear the economy was in recession and the markets began to tumble in earnest. When America was attacked on September 11, 2001, the selling accelerated and the markets continued to decline through November 2002.

In response to recession and the market seizure as a result of 9/11, the Federal Reserve embarked on an unprecedented easing of Fed Fund rates. The only pool of capital readily available was tied up in home equity and the only way to unlock it was to drive interest rates down to Depression-era levels and to hold them there.

In the name of market reform, the Tax Reform Act of 2003 was passed and income tax rates on dividends and capital gains were lowered dramatically to stimulate investor interest. This Act, along with the tech and dot-com bust fresh in their minds, not to mention the Enron, World Com et al. scandals, encouraged investors to rediscover value stocks and dividends. As a result, high-quality dividend-paying blue chip stocks that had been virtually ignored during the decade of the 1990s were once again embraced, and shares appreciated dramatically.

Returning to the graph in Figure 8.2, we see that although investors had fallen in love with dividends again, in 2003 there was an obvious absence of anything that even remotely resembled historically good values. Also, when the first leg down bottomed in 2002 and retested in early 2003, the dividend yield on the Dow was still below its historically repetitive area of overvalue dividend yield!

At the risk of being redundant, I need to drive this point home. Since 1966, when the Undervalue category represented 17 percent or less of our select blue-chip universe, it has been coincident with major market tops. When the Undervalue category is between 70 percent and 80 percent of our universe, it has been coincident with major market bottoms. At the market top in 2000, our Undervalue category was 12 percent of our universe. When the first leg down bottomed in late 2002 our Undervalue category still represented only 16 percent of our universe! So after dropping 5,000 points, the Dow was still dramatically overvalued! By mid-year 2005, our undervalued stocks had fallen further to only 4 percent of our universe. Now consider this: With the previous as a backdrop, the market continued to move higher for two more years. At this point the terms overvalue and irrational exuberance have no meaning; we are talking sheer insanity. Isn’t it amazing what massive amounts of liquidity created by rock-bottom interest rates and the illusion of derivatives can create?

Obviously some segment of investors had recognized that the massive leverage and speculation that had been compounding since the end of World War II had finally reached a tipping point. How can I write this? The majority of stocks in the Undervalue category were banks and other financials.

For a point of reference, let’s look at the chart in Figure 8.3, which illustrates the pattern described earlier in the 1966-1974 bear market.

The bear market began in 1966 when the dividend-yield on the Dow declined to its historically repetitive area of overvalue at 3.0 percent. The first leg down was completed later that year and reversed course when the dividend yield on the Dow reached 4.0 percent. The first counter-trend rally topped out in 1969 just below the 1966 high.

The second leg down commenced shortly thereafter and did not halt and reverse until the dividend yield reached 5.0 percent. The second counter-trend rally topped out in early 1973. Note that this counter-trend rally exceeded the 1966 and 1969 high-price areas. Coincidentally, the dividend yield on the Dow at the 1973 top was 3.0 percent. Many investors believed a new bull market was underway at this point due to the Dow eclipsing the 1966 high price. As you can see, however, the market rolled over into a third leg down, which was completed when the dividend yield on the Dow registered 6.0 percent in December, 1974.

Now let’s compare the this with the current bear market as depicted in Figure 8.4.

If my analysis is accurate, the first leg down began in early 2000 and ended in October 2002. If you refer back to the Investment Quality Trends chart for the Dow in Figure 6.2 in Chapter 6, note that at the bottom of the first leg down the dividend yield was below the 3.0 percent yield area. The counter-trend rally began in earnest in 2003 as the Greenspan Fed and the Bush administration unleashed the one-two punch of extremely low interest rates and relaxed federal tax rates on capital gains and dividends.

In late 2003 through the fall of 2007, we see what happens when massive amounts of home equity, never-before-seen degrees of leverage by speculators, and institutions using lethal doses of derivatives can do to the stock market. When the Dow eclipsed its 2000 high in 2006, investors believed, just as they did in 1973, that a new bull market was underway. And, just like 1973, the market rolled over into another leg down.

The second leg down bottomed intra-day on March 9, 2009, with the dividend yield on the Dow reaching 4.90 percent, 10 basis points (10 one-hundredths of 1 percent) within 5.0 percent. Simultaneously our Blue Chip Trend Verifier recorded that 72 percent of our select blue chips were in the Undervalue category, indicating that the potential for a counter-trend rally was high.

As we know, a very powerful counter-trend rally has developed. If the pattern of this bear market mirrors that of bear markets in the past, the counter-trend rally should retrace at minimum 50 percent of the previous down leg, which would approximate 10,300 on the Dow. As you know now, counter-trend rallies can also return to the old high as in 1969, or can even breach that level as in 1973 and 2006.

Knowledge of these patterns allows investors to initiate new undervalued positions at important reversal points such as the March, 2009 lows and to recoup some lost ground on older positions that may have been held through the previous decline. If and when the counter-trend peaks and begins to decline again, it is time to take profits on overvalued stocks, place stop losses on below-rising trend stocks that have advanced significantly, and raise cash in anticipation of the next halt and reversal.