Why it's good time to stay out of the stock market

Sep 9, 2014

Paris, France

Dear Diary,

Yesterday, we turned 66 years old.

When did we get so old? We can't remember.

But '66 is still young'; everybody says so. Especially our mother, who is 93...and our uncle, who is 96.

For our birthday, we went with Elizabeth to the Dome du Marais, a nice restaurant in the center of Paris, housed in a handsome round building which was once a pawn shop. The pawn shop had been set up, explained the menu, by Louis 14th in order to combat usury. In the days before credit cards, people could come to the pawn shop, rather than to loan sharks, for their financing needs.

The Marais is a charming part of the city. Narrow streets. Ancient buildings. Chic shops. It is much more fashionable and cosmopolitan than our neighborhood. At one table was a group of young professionals - perhaps in finance - some from England, some Americans, an Asian...and others. It looked very much like a group you'd see in London or New York. At another table was a couple we took to be Scandinavian...or Russian. An American couple sat at yet another table, but left early.

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"That didn't seem like Paris," said Elizabeth afterward. "It could have been anywhere."

Now, the small talk out of the way, let us return to our subject.

The Dow has traded at more than 20 times earnings 6 times in the last 114 years. At the very beginning of the 20th century, in the late 20s, in the mid-30s [because earnings were so low], in the '60s, in the '90s, and twice in the '00s. Each time (save the last...so far) was followed by a bear market, which brought shares back to more reasonable levels.

Likewise, the Dow has traded below 10 times earnings only 3 times during that period. Between about 1915 and 1925...again, after the crash of '29 off and on until 1945...and then between about 1977 and 1984. (The dates are approximate, because P/E ratios are slippery.). Each time was a buying opportunity; stocks rose substantially afterwards.

STS couldn't be simpler. P/E > 20 = sell. P/E < 10 = buy. When stocks are above 20 times earnings, you are out. When they fall below 10 times earnings, you buy again. Otherwise, you do nothing.

Had you come to adulthood 1900...and somehow lived to today...following STS, you would have saved yourself the worst drawdowns...and still taken advantage of the big bull markets of the '20s, the '60s, the '80s and '90s...and even the bull markets of the '00s,depending on how you calculated your P/E ratio (note that using Shiller's P/E measure, you would have been out of stocks since the late '90s...his CAPE never fell below the 10 times entry mark).

Easy, peasy, right? Your rate of return would have been far in excess of buy and hold, again depending on the specific numbers you used for deciding exactly went to get in and out. But the beauty of the system is that you didn't have to be too exact about it. The system is meant to help you get the big moves right; the details almost don't matter.

Our old friend Stephen Jones has been studying the essential question for decades. He has come up with an even better way to determine the real value of the stock market and its likely direction - better than Shiller's CAPE and better than Tobin's "q". Earnings, he points out (the denominator in the P/E ratio) are misleading. They can be goosed up by unsustainable trends. That is exactly what has happened now; earnings are greatly flattered by the Fed's easy credit. It is better to look at total output - GDP, he says, and then to adjust the figure by the macro trends that are sure to affect it going forward. The two main ones are debt and demographics. It has been shown that both influence growth. As debt increases and a population ages growth declines. Stephen put those figures into his model...and found the resulting indicator was more accurate than any other other market-forecasting tool.

What does his model tell us now? First, stock prices are well over 20 times earnings, when earnings have been properly normalized...or smoothed, as Shiller would do it. [P/E > 20]. Second, the model forecasts annual returns of MINUS 10.5% for the next 10 years. Simple and obvious advice; it's a good time to stay out of the stock market.

But wait. If this were so simple, surely the smart money must have seen it. Surely, it noticed that stocks were sometimes cheap and sometimes dear. Surely it realized that investors were moved by greed and fear...and that they frequently mispriced stocks.

And what about all those guys with Ph.Ds on Wall Street? Don't they know about the anomalies Porter mentioned yesterday? Don't they see all those dollars, lying on the ground, just waiting to be picked up? Don't they know they can time the stock market - at the extremes - as our STS does? Of course they do!

Tomorrow: what's wrong with the 'smart money?' How come it leaves so much money available for investors like us? Are they not-so-smart after all?

Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.

Disclaimer: The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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2 Responses to "Why it's good time to stay out of the stock market"


Sep 11, 2014

Bill Bonner is a pessimist. I stopped reading his column more than a year ago as I found that he only predicts doom. While equitymaster talked of SENSEX touching 27000 Bill talked off the impending meltdown. If someone goes through archives of his letters it will be obvious that he is a negatively charged particle. I often wonder why is he allowed to publish his perpetually negative views by Equitymaster as going by his logic all investors should move out of stock to fulfill his prophecy of doom. Looking only at PE is the most foolish advice anyone can give.

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Sep 10, 2014

Interesting .Is this SELL call for PE over 20 or buy call for PE less than 10 applies to overall stock market level or individual stocks also? Is this true in India also? If not ,what are the relative figures for Indian market? May be they can be one of the filtering point for entry/exit.

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