Reality Bites Bears And Bulls
Investors are motivated by two basic human emotions: fear and greed. Whether you choose to believe that's true... or would rather base your decisions on other assumptions about the human condition is up to you. But at the end of the day, you still have to do something with your money.
You have to decide, for example, whether to buy stocks or bonds... whether to be long or short....whether to be in the dollar or to hedge against it. And the outcome of those decisions can make or break you. Maybe you will have enough money to enjoy the kind of retirement you want - and maybe you won't. Maybe your finances will be a source of worry to you...or maybe they'll be a source of confidence and security.
Very often other people depend on you to make the right decisions. The most important decision you can make right now is whether or not you believe the stock market has found its "Big Bottom," or if there are worse things to come.
A crucial but little-followed barometer of stock market wealth indicates that the total market value of all U.S. stocks as a percentage of the entire Gross Daily Product (GDP) of the United States. If you're not an economist, let's try a simpler explanation.
Market cap tells you what the public thinks stocks are worth. That number has skyrocketed in the last 10 years to $16.5 trillion. GDP tells you the dollar value of all the goods and services produced in the economy each year. GDP reflects reality - what people are actually paying for things each day. Market cap reflects what people think things will be worth someday. The more optimistic people are, or insane, the more they're willing to pay for what they think things will be worth in the future.
Take 1929. Until recently, that was the highest ratio of market cap to GDP ever. Stocks were worth 81% of all the goods and services traded in the economy. And remember, there were fewer publicly traded stocks back then. So investors were placing a huge value on a much smaller number of companies. But then again, stocks had reached "a permanently high plateau," as Yale Professor Irving Fisher said just days before the famous crash.
It couldn't last. The average value of all publicly traded stocks is around 50% of the value of the entire economy. After all, the future is unknowable. Investors who assume that things will only get better usually end up paying too much for stocks. Stocks aren't always priced for perfection. Usually they're priced for reality. And that means sooner or later stocks fall. Hard.
The Pain of Average Results
So what would happen today if stocks fell back to just their average share of GDP - 52.2%? Current GDP is just over $10 trillion. So for stocks to fall just to their average percentage of GDP, they'd have to fall by over $10 trillion. To put that in perspective, that would mean a 66% decline in stock indexes. You'd have Dow 3,640 and Nasdaq 961.
Sounds a little extreme. Again though, we're just talking about stocks reverting to their average percentage of the economy. But let's say it's not that bad. Let's say stocks were valued at equal to the rest of the economy. A one to one ratio. Even then, you'd have to see another $6.5 trillion lopped off the market cap, or 40%. You'd have Dow 6,400 and Nasdaq 1,129.
You may have a hard time believing it. Most investors will, until it's too late. But all you're seeing here are the facts of history.
Is the Third Time a Charm?
There have been only three times in history when the ratio between stock prices and earnings has been as high as it is now. And each time, it hasn't been earnings that have gone up. It's been stock prices that have come down...a long long way. When things get out of balance, something has to give.
After the huge bull market of the 1920s, the P/E ratio reached 32.6. But by June, 1932 after stocks had finished their death march, the S&P Composite Index had fallen 80.6%. It wasn't until 1958 - 29 YEARS LATER - that the S&P reached its 1929 value.
The second example of a high P/E ratio was 1966, when the average P/E reached 24.1. According to Robert Shiller's book Irrational Exuberance, by 1968 stocks were down 56% from their earlier high. It wasn't until December 1974 they reached their '66 high again.
It's worse in real terms. Shiller says, "Real stock prices would not be back up to the January 1966 level until May 1992. The average real return in the stock market (including dividends) was -2.6 % a year for the five years following January 1966, -1.8% a year for the next ten years, -0.5 a year for the next fifteen years, and 1.9% a year for the next twenty years.
And the third time stocks have been priced so high? Even after last year's bloodbath, stocks are still way too high. The P/E on the S&P is still over 24. If history is any guide, this market is in for a terrible day of reckoning. Much worse, by far, than most investors are expecting.
Could you afford to retire if all you made on your stocks over the next 20 years was a lousy 1.9% a year? Probably not. But that may very well be what most investors will get from the market - if stocks do as we expect and return to their normal values. It's simple third grade math, addition and subtraction.
One way or another, trillions of dollars are going to be washed out and written off. This market is still $5 trillion to $8 trillion too high.
It can happen slowly. Or it can happen quickly. But one way or another, it is going to happen. Because, no matter how much money you throw down a money pit...it's still gone. You can pretend that it's still there. You can write pieces of paper that say it's still there. You can even convince yourself that you still have it. But - it's gone forever! There is no way to bring it back. |
