"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.