Investment advice for a wild market

Your retirement nest egg might have lost 40% of its value since this summer and 10% the last 2 weeks. What should you do? Here’s the advice I’ve been giving to friends who ask, as well as what I’ve been doing with my own portfolio.

First, let me begin by stating that I make no claim whatever to be able to predict whether stock prices will go up or down over the near term or when the market bottom might be reached. In part that humility is inspired by a large academic literature demonstrating that it’s very hard to predict stock prices with formal statistical models.

The one element of predictability for which I do see some support in the academic literature is the claim that the price/dividend or price/earnings ratios do not wander too far from their long-run historical averages. The implication of that finding is that when prices are high relative to dividends and earnings, you can expect below-average stock returns. The graph below, which I’ve updated from Robert Shiller’s historical data base, conveys some sense of that relation and where we stand at the moment.

Ratio of value of S&P 500 to the average earnings of those companies over the previous 10 years, adapted and updated from
Shiller. Blue line: ratio of monthly average S&P 500 index (deflated by current CPI) to 10-year average of most recent monthly earnings (each deflated by CPI for that month). April-June 2008 earnings from straight-line monthly interpolation of 12-month as reported quarterly earnings from Standard & Poor’s. November 2008 value for S&P is the November 12 close. Red line: historical average (16.34).

We’re currently at a P/E around 14, a bit below the historical long-run average P/E of 16.3, meaning you could expect a slightly above-average return from buying stocks now. Specifically, if companies were to pay their shareholders all the income to which they’re entitled in the form of a dividend, that dividend would give you better than a 7% immediate return, and over the long run, the dividend would grow at least at the rate of inflation. That’s a return that proved more than sufficient compensation to investors for the extra risk they faced from stocks over the last century and a half, which included plenty of times tougher than those we’re going through at the moment. To me, a 7% real yield sounds like an attractive investment, despite the risk, and certainly dominates most other alternatives as a long-run vehicle for saving for retirement.

But isn’t it possible that the P/E will decline further, to much below the historical average, before the carnage is finished? Sure it is. But here’s another way to look at that. Companies in fact don’t turn over 100% of their profits to the shareholders as dividends, but re-invest some of those profits in the hope that future earnings will increase faster than inflation. The typical stock in the S&P 500 today is giving you a 3% dividend, which you could hope will grow 3% faster than inflation over the long run as a consequence of the reinvested profits. That again to me sounds like a very nice investment. You can buy and hold for the long term with the philosophy that it’s that stream of growing dividends that you really want and are going to get. Let the market price of the stock go up or down from here wherever the psychology of the market may take it– you’ve still received what you paid for, and it’s a reasonable deal.

But if stocks really weren’t such a good bargain a few years ago, why was the market valuing them as highly as it did? Shiller’s view is that investors simply miscalculated, misled by the fact that everybody else seemed to think they were worth that much. According to that philosophy, recessions and market busts are the time you should be buying. Here’s how Warren Buffett described how he put that into practice last month:

I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds….

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors.

John Cochrane instead attributes the big swings in the historical P/E to changes over time in the compensation that investors require for risk. According to Cochrane’s view, people understood that they’d be getting less than a 6% expected real yield on stocks if they bought a few years ago, and that stocks purchased today offer you better than 6%. John summarizes his investment advice this way:

If you’re less leveraged, less affected by recessions, and have a longer horizon than the average, it makes sense to buy [now]. If you’re more leveraged, more affected by recession or have a shorter horizon, it might be the time to sell, even though you might be cashing out at the bottom.

As for which stocks to hold, one unquestionably sound investing principle is the benefit of diversification. But if you pay a big fee to somebody to manage your portfolio, you’re out that fee before you start, and the evidence is to me unpersuasive that high-priced fund managers can systematically outperform the market. So my advice for most people is to use broad funds that mindlessly, mechanically, and cheaply do something simple like try to hold a portfolio mimicking the S&P 500. Broader diversification into smaller companies and internationally is also an extremely good idea. My 403(b) invests 1/4 each in the following funds:

Yes, they’ve all tanked this year, but here’s the bright side– those monthly payments I’m still putting in are now more likely to get me something for my money!

We’ve also been saving some money beyond the 403(b) limits, and we’ve always just had this in T-bills. I felt pretty silly describing this part of my portfolio as a professional economist, but I was fearful of putting any more into stocks, given the graph above. Now I’m feeling pretty proud of myself for being so silly.

But my wife and I also feel that now is the time to move that money out of Treasuries and into the stock market. Outside of a 401(k) or 403(b), one disadvantage of stock index funds is that you’re taxed on realized capital gains as they arrive, whereas if you buy and hold individual stocks, you can postpone the capital gains tax. Because of compound interest, this can make a big difference. For example, if you face a 50% tax rate assessed every year on the gains from your 6% return, after tax you’re re-investing 3% for a 20-year cumulative return of [(1.03)^20 -1] or an 81% total return. On the other hand, if you can hold that 6% as unrealized capital gains and only pay the 50% tax when you sell, you’ve got 0.5[(1.06)^20 – 1] = 110% total return.

So we’ve been buying stocks over the last month, and greeted yesterday’s carnage as good news for us in that the downturn allowed us to execute two more of our outstanding limit buy orders. I didn’t do nearly enough research on individual stocks, but know the kind of equities I wanted– a P/E of maybe 11, dividend of at least 3%, long record of strong growth, a solid balance sheet, and a company that I knew at least something about personally. Here’s what we’ve bought (some of which meet those criteria better than others) along with some brief annotations on each:

  • 3M COMPANY (MMM). Growth comes from continually developing new products– a lot more than Scotch tape.
  • Apache Corp (APA). Yes, I know spot oil is below $60, but once the world recovers from this downturn, there’s room for quite a few more cars in China, and Apache should actually have some oil to sell.
  • AT&T (T): I’m a sucker for the 6% dividend.
  • Delhaize Group (DEG): Owns a number of grocery store chains; the ones I’ve used I like.
  • Home Depot (HD): They should survive, and when growth resumes, they have a very successful strategy.
  • Eli Lilly (LLY): Downside is likely legislation targeting drug company profits. But I like the long record of profitable R&D and 5.5% dividend.
  • Walgreen (WAG): Drugstores too will survive.
  • Johnson Controls (JCI): Downside: U.S. auto industry will be absolutely hammered. Upside: I don’t think Congress will allow domestic manufacturing to be completely eliminated, and JCI will be one of the survivors. Also may benefit from Obama’s green investments.

We plan on buying more next month. One thing that’s clearly underweighted in the little portfolio above is stocks in the financial sector. But in the brief time I’ve spent looking at a dozen or so of these, I didn’t find one that didn’t have some bad smell to it. What I’d really like is a regional bank that’s been run with a paleolithic conservatism during the go-go years. Any such entity would be in a good position to profit mightily from the current mess.

I look forward to hearing other suggestions or investment philosophy from our readers in the comment section below.

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90 thoughts on “Investment advice for a wild market

  1. Chris E

    Except that as earnings sink, the P/E ratio stay constant and prices could go lower simultaneously.
    Buying when the P/E is ‘on average’ lower wouldn’t really get you past Great Depression style troughs. And the notion of what is average gradually rises over the course of the 20th century, without much coherent explanation.

  2. Rich Berger

    I started the year 60% equities and 40% FI and I am down 26% YTD as of yesterday – to be down 40% you have to have invested rather agressively.
    I think forward earnings are a better indicator than backward, even if they are estimated.

  3. jm

    I too believe earnings are going to decline very substantially. I also believe that a direct effect of that will be to further destroy bullish sentiment and force the P/E down.
    Stocks aren’t going to bottom until we see another “Death of Equities?” cover on Business Week, with no waiting cheerleaders on the sidelines shouting that we’ve finally seen the capitulation and, “It’s time to buy!” The real capitulation will consist of all the cheerleaders going home and leaving the playing field in a deathly silence.

  4. JDH

    On the earnings decline, note that the denominator in the graph above is a 10-year average. It takes a lot to whack that 10-year average down.

  5. jg

    Professor, we are going into a depression. Some seasoned hands are now seeing the light:
    Earnings will be getting killed through 2012.
    There are two ways to make money in this Greater Depression: short sell the market and hold gold for when the dollar fails.
    I have been 2.0-3.5X short the S&P 500 since Mar. ’07. As of yesterday, my portfolio was up 90% in the last six weeks.
    After the forthcoming crash (within weeks), I will switch to holding gold and gold mining stocks (UNWPX).
    So far, so good.

  6. Keith S

    I wouldn’t take investment advice from Buffett. He has so much money that he has no risk aversion. If he loses 50% of his money, not a single thing in his life would change.

  7. Jug

    Taking an earnings estimate of 77 the fwd P/E on S&P500 is at 11. The recent fiscal year earning is at 46. That implies an impressive earnings growth (>~85%). Just plot estimated eps on the index against its actual eps. So either we are going to see impressive growth in earnings going fwd or the earnings estimates are going to be significantly cut. Make your pick!

  8. Ironman

    I apologize in advance – I’m going to bombard you with links!
    P/E ratios really aren’t a particularly good way to measure the proper valuation of stocks in the stock market, especially with Shiller’s ten-year average for earnings. Here’s why, along with an introduction to a better method for gauging proper valuations for the market.
    Building on that, here’s a way you can use stock market data to measure the level of distress in the market. Speaking of which, here’s a look at the correlation between distress in the stock market (such as we’re seeing today) and recessions.
    Going beyond that, here’s how you can recognize disorder in the stock market, as well as how to recognize when order re-emerges. The latter post gets to the meat of describing how the market acts during disruptive events, such as we have going on now.
    Now, since I keep discussing using normal distributions to define stock market performance in those posts, yes, I’m well aware that’s wrong and that stock prices do not follow a normal distribution. As it happens, it’s wrong, but useful. Here’s a practical example of that in action!…
    Finally, I’m going to leave you with two key data references. Here’s a tool you can use to extract stock market metrics for the S&P 500 for any two calendar dates between January 1871 and September 2008, and use to find the rate of return, both with and without dividend reinvestment and with and without the effect of inflation between the two dates you select (I’ll be updating that tool later this month to go through October 2008.)
    The second is a brand new tool, which allows you to see how a series of investments in the S&P 500 would have fared through the worst of the Great Depression.

  9. DickF

    Your analysis would be great if these were normal times but the $2trillion bailout screams that these are not normal times. The stock market crash was caused by concerted bad economic policy from the President and congress.
    Our President-elect has already signaled that he will follow a Keynesian take-from-the-producers give-to-the-indolent economic policy.
    Realize that the Democrats have been bought and paid for by the unions and so unions will get special privilege and the result will be higher than market wage rates. This will drive down earnings and as others have noted PE ratios will become basically useless.
    Also realize that the $2trillion plus bailout will have to be paid somehow. If AIG is any example the government will not make any money off of their brilliant investments in nearly bankrupt companies.
    We are in for a long season of despair.
    If you want to make money play the short side until real supply side policies begin to come out of congress.

  10. Mike G

    As far as paleo-conservative banks: Canada’s are doing quite well, and are cross-listed on the American exchanges. I quite like TD: P/E 10.57, Div 4.48%, $45.20/share. They are confident enough in their position that they are talking about making purchases of US assets through the downtown – and besides that, I quite like their Chief Economist and some of the members of their board, which is novel to me. It’s a great bank. It was also up 5% today.
    The other big ones in Canada: BMO, RY, CM, BNS.

  11. Avo

    I’m curious as to why you chose the actively-managed, high expense Fidelity Emerging Markets rather than the much lower expense, passively managed DFA Emerging Markets that is available in the UC plan.
    Also why you chose to put tax-efficient stock funds in your 403(b) and tax inefficient T-bills in your taxable accounts.
    Finally why you believe your stock picks will outperform the broad market. (The academic literature also calls into question the stock-picking ability even of professional money managers.)

  12. Hitchhiker

    I think you are on target. Peter Lynch always believed downturns were the time to buy. His philosophy was to buy good companies and buy more when they went on sale like Oct 1987 or now.
    Of course, the triumvirate of Obama, Reid, and Pelosi makes things considerably more risky. The doomsayers might turn out to be correct this time. The proper policies could make a recession into a depression and these clowns are just the folks to do it. On the upside, those of you with beachfront property and no knowledge of science can relax.

  13. jm

    I too believe earnings are going to decline very substantially. I also believe that a direct effect of that will be to further destroy bullish sentiment and force the P/E down.
    Stocks aren’t going to bottom until we see another “Death of Equities?” cover on Business Week, with no waiting cheerleaders on the sidelines shouting that we’ve finally seen the capitulation and, “It’s time to buy!” The real capitulation will consist of all the cheerleaders going home and leaving the playing field in a deathly silence.

  14. Jim

    Policy rebalancing is the way to go. A fixed percent in bonds and a fixed percent in stocks – implemented using a mix of good index funds. The ones from DFA are the best. Stocks smash and bonds don’t. Therefore, rebalance back to policy weights – which means selling bonds and buying stocks. Do it in reverse when the market soars. It saves a person from thinking – and from following emotions, or silly advice from the TV.

  15. jg

    I read Prof. Shiller’s book four years ago, and it convinced me to stop blindly, monthly, buying index funds (I took Prof. Fama’s two-quarter finance class at Chicago, and was a firm believer in the EMH, until I read Prof. Shiller’s book).
    I use trailing twelve months earnings to look at P/Es. This site updates such weekly (S&P 500 is 20.1 as of last Friday):
    The historic S&P 500 TTM P/E since ’36 is average 15.8/median 15.5:
    And, corporate earnings continue to come in horrible (down 38% year over year for the 60% of publicly held reporting companies that have reported Q3 results):
    Don’t go long yet, Professor! Unless you are going to play trading games, wait until the market troughs in three years or so.
    Just my read of the data.

  16. Zephyr

    I think PE is a good piece of info, but it will lead you way off target if you use it as a primary tool. Investing based on PE would have you sell early in all rallies, and then buy well before the bottom in all declines. However, it is probably better than a blind dollar cost averaging plan.
    If you use to mildly color your outlook I think it is helpful.
    I think it is better to follow monetary policy and the yield curve – in an effort to anticipate cycle turning points.
    Based on this during 2006 I became very nervous about a coming recession. So during 2007 I sold into rallies reducing my stock holdings by about 75%. I am so glad that I did that.

  17. Mike Laird

    A very good source of both data and its investing implications is John Hussman, who is a former economics professor. His current weekly article is at I have no funds invested with Hussman, and am not an owner. I simply find his weekly articles to be useful. JDH, he has a similar perspective as you, but qualifies by saying the market could well go significantly lower before it goes higher, in the long term.

  18. Fred

    S&P500 at 900 is indeed a good price, though not a great price. Corporate profits have taken an above-average percentage of GDP for the past 15 years, due to the low savings rate. As the savings rate declines, profits will decline as well. I expect earnings to revert to mean, as a proportion of GDP, which means the trailing 10 years of earnings is not a good guide to the future. Nevertheless, I bought heavily into the market back on Oct 10, because I don’t see any better alternative to stocks (other than junk bonds and other distress situations, but that is a market for professionals only), provided you can buy the S&P500 at under 900. I’m hoping to get the S&P500 at under 700 for the remaining 50% of my money (which is currently in short-term corporate bonds), but that is a gamble on Mr Market’s manic-depressive antics, since there is no guarantee that the market will fall that low.

  19. GK

    I think we can agree that 900 is a good, but not great price. At the same time, brief swings to 700 or less could happen.
    By 2020, there is a good chance that the S&P500 could be above 3000 (with dividends on top of that). But what happens in between, no one knows.

  20. calmo

    Using your consummate interpersonal skill set, (in part honed by your attentions demanded by your blogging audience), find an insider…I don’t see one yet here.
    Failing that, dig over the boulevard –despite the immediate reaction of your neighbors…who will see the light soon enough,
    and plant potatoes, onions, cabbages –whatever will grow.

  21. Fred

    Ooops! I meant that corporate profits will likely decline as a percent of GDP as the savings rate increases back to the normal 10% or so, versus the very low or even zero savings rates of the past 10 years. Low savings rates don’t directly cause high corporate profits, of course, nor vice-versa. However, the phenomena which gave rise to low savings rates, once reversed, will likely also give rise to increased wages as a percent of GDP but lowered profits as a percent of GDP.

  22. anon

    The key is to dollar cost average through the remainder of the expected life of the recession (1 year is a conservative estimate). This is basically Hussman’s approach as well.

  23. anon

    Canadian banks are also an excellent value now; unlike the Americans, and notwithstanding choppy times ahead, they will almost certainly maintain their dividends.

  24. Moopheus

    My investment strategy is not to have one. I’ve always kept the bulk of my money in the bank. During the Internet bubble, the justifications I heard people giving me for what was happening really reinforced my feeling that the stock market is where the stupid go to get fleeced. Yeah, the interest rates’ not much, but over the long run, it’s done as well as any investment fund, all of which lose money eventually. The markets go up and down and it doesn’t affect me very much one way or the other.

  25. TedK

    Naseem Nicholas Taleeb, the author of Black Swan, advises people to keep 90% of their portfolio in safe fixed investments and keep only 10% in the stock market, mainly in technology companies. Of course he made a lot of his money by buying put options just before the 1987 crash.
    Gold has also been volatile and could fall suddenly. You may be successful for a time in market timing, but or you could lose a lot in one bad step.

  26. Andrew B.

    Why use P/E ratios rather than EV/EBIT (or EBITDA)? Also why focus on dividends? Think about it…if dividends were really the only determinant of value, and news is widely available on them, wouldn’t there be easy arbitrages?

  27. Charles

    James, what the graph you present shows is that PE ratios can get very low– as low as 5–and stay low for a very long time. Your strategy may work well because you have a stable outside source of income and reasonably deep savings. But it’s a risky strategy for people who may have emergencies or less deep savings.
    Furthermore, as you know, past behavior is not necessarily predictive of future behavior. If the US changes from being primarily a consumer economy toward one based more on export, one could see some PEs remain low for a very, very long time, even as the average PE rises toward the historical norm.

  28. njh

    Wow. You are (mostly) such smart people but are incredibly uninformed on reality. Taking historical returns and performing analysis on them is the hallmark mistake of economics. Growth this past century has been based on energy gain, which we no longer have, or have much less of. There is no natural law that says stocks will go up 10% over time, or even go up over time period. In fact, I suspect the alltime highs for all stock market indices are now in the past. Depletion eventually trumps technology and human ingenuity-second law guarantees there is always a heat ‘loss’ – so ‘renewable’ energy will not be able to replace fossil fuels on any reasonable time scale (unless we dramatically lower consumption, which will kill growth faster).
    Since 2004 I have been between 150-200% invested, always net short, and all of my longs have been energy companies (except for BCST which makes internet compression tech). I’m up 112% ytd (after a 35% retracement since July) and 60% annualized since 2000. I have taken 25% of assets out of market entirely in last month and am investing in real capital (land, etc.)
    I suspect that in the next 18 months, 401ks will become the next HELOCs, even with the penalty. I think the current currency malaise highlights how financial capital is only a marker for real capital (natural, built, social and human). Any long term future of public financial markets functioning will have to reconcile this. Otherwise currencies will drop one by one.
    Buffet was a black swan. I used to talk with him in the early 90s at Salomon. Brilliant man. Spinning the dopamine circuitry to increase his pile – but the rules by which he learned the game, and the rules that economists and business students learned about CAPM, etc. (I have MBA), are bogus. They don’t take into account ecology and don’t recognize that economic predictions are based on correlation not causation.
    Depending on what feds do, we COULD see nominal highs in stocks again, but those earnings will buy far less than 2008 dollars would. This is the beginning of end of financial markets – I suspect they won’t exist by 2020, possibly much sooner. 2009 will be the year of deflationary panic.
    My advice is to not assume patterns of monthly allocation to equities will continue to work. Look at your fundamental assumptions on that one…

  29. Michael Krause

    I’m surprised no gold or heavy commodity asset plays.
    njh makes some interesting assertions, but ‘end of financial markets’ sounds a little bit silly. What are you proposing? The power plants stop powering the computers and we all stop trading things? The markets will run as long as we are alive.
    I’m absolutely convinced personally that there will always be pockets of opportunity, and winners will appear random due to this. Place your bets and hope for the best.
    Near term deflation is baked in. But past that … Either the meltdown accelerates and economy goes bust, triggering a government debt default and currency implosion, which makes internationally traded commodities do very well in relation to US dollars.
    Or the fed is successful and gets enough money in the system to resume our inflationary ways. Wonder if monetary velocity will ever return to previous levels. If it does, there will be a lot of mopping to do.

  30. Michael Krause

    Also on ETF’s:
    KRE and RKH are decent regional bank ETFs if you don’t feel like name picking. For you, is it even worth name picking in this sector for a small portfolio when you can get high beta and amplified returns more easily in other sectors (refiners, commodities, emerging market ETFs)?
    Another idea… RSX (Russia) looks like a fun high beta ride, offering plenty of upside if the ruble doesn’t take too much a haircut and oil supply creation keeps falling back.

  31. Anonymous

    Great post, professor! Your advice is sound and it’s always nice to be able to observe a mind like yours put his money where his mouth / mind is.

    Two comments:

    1) Re: “the evidence is to me unpersuasive that high-priced fund managers can systematically outperform the market.”

    Please also take into account that many, perhaps most of the best performing active funds are not in the samples of academic performance studies! Klarman’s Baupost, for an example at one end of the spectrum of investment philosophies, or Renaissance Tech’s flagship fund at the other end. and many, many others I could actually name from the top of my head.

    2) Re: “It takes a lot to whack that 10-year average down.”

    Hm, maybe. But it seems to me these are extraordinary times. How much more do you think it needs before a change in 10-year average gets nontrivial probability assigned from you? Also, I agree with Soros’s notion, last laid out in his testimony, of a “superbubble” coming to an end. So the latest 10-year average of earnings may well be special, also taking the changes in tax and accounting legislation in the period into account, if you take “as reported” values!

  32. toddleem

    Since I make a living doing this, let me give you a quick run-down on some stocks that you might want to buy: Note that since the sell down has been across the board, quality is on sale. I think it is hard to argue that the following stocks are overvalued.
    SCI. Funeral Home 13% Free Cash Flow yield. Some downside eps due to slowdown in pre-pay cemetery, but people will die.
    JWN. John Wiley. Academic publisher with a huge accretive deal with Blackstone. 12% Free Cash Flow yield. Highly unlikely that earnings or cash trade go down more than 10%.
    All property casualty reinsurance stocks with good balance sheets. ACGL, AXS, RNR, PRE, VR, AHL.
    All sell

  33. me

    Thank you JDH,
    It is important that intelligent people like yourself post important views like this post. It reinforces for many of us that agree with these views, that there is reasoning behind what we believe.
    It is easy to get caught up in ignorant reporter headlines or anonymous blogger postings, but what you do is important and appreciated by many of us.

  34. jg

    Ted, my bet on gold is this: I think we are going back to the gold standard, after the failure of the dollar and the Federal Reserve system.
    I will be a long-term holder of gold, i.e., until it reaches $3,600-5,500 per ounce, which will be its price if every dollar in M2 requires gold backing.
    People thought I was nuts when I passed on buying La Jolla real estate in ’04 (median price has fallen 25% from peak). People thought I was nuts when I double/triple shorted the S&P 500 in ’07.
    If you think that we are headed right into a Greater Depression, with real risk of failure of government taxation –> inability to sell/rollover Treasuries, gold makes great sense.
    Yesterday’s Treasury auction was a harbinger of things to come:

  35. Anon

    Great post James. I am 100% on board. Keep nibbling away at these low and fair stock prices but keep some cash in case even better deals are to be had. Pretty much anything is a good buy right now provided, as you say, it can survive and you are thinking long term (three years or more out).
    Of course, the world might end in a total catestophic financial meltdown but then who cares – whatever you do you will be sunk.
    Those who keep waiting for “bargains” generally miss them …it is best to keep buying a little on the way down.
    I agree Canadian banks are a good choice – you can buy the index through Barclay’s ishares XFN-T. Will they be hurtin’ for a while – sure – but like you said about Wallgreen’s – everybody needs banks so they ain’t going to disappear. You get about 3% yield too on XFN.

  36. Dan Weber

    to be down 40% you have to have invested rather agressively.
    I have to back this up. Last I checked, my bond index fund was up year-to-date. Not a lot, but still up, which is saying something in an environment like this.
    I think some people — okay, a lot of people — are finding out that they misoverestimated their risk tolerance.

  37. MarkS

    JG offers sage advice. Financial markets will remain in chaos until the bulk of Alt-A and Adjustable Rate mortgages reset (by early 2012), and the losses are recognized via forclosure and security devaluation (bond and CDO losses). Earnings will deteriorate precisely because $13 Trillion in credit has thus far been vaporized in the U.S. equitiy and real estate markets spawning a world-wide recession.

    Opportunities are available (for less sophisticated investors), in shorting the market via ETFs…
    The same will go for US Treasury debt when rates rise in response to massive deficit spending…

    We are in the throes of a full-bore banking crisis which inevitably comes at the end of the business cycle. Credit expands until it can no longer be serviced… losses are taken, demand slackens, prices moderate and presto – We again have conditions for capitalization, growth, and profitability.

  38. SvN

    I’m impressed by the average performance of inflation-indexed bonds (TIPS in the US.) While riskier than t-bills since they are longer maturity, they have a much lower beta than conventional bond funds. I think of them as a close substitute for zero-beta assets, and one with better returns than t-bills.

  39. guest

    the 7% ‘real yield’ you talk about is not a real yield. it fails to take into account the current level of inflation. if for instance inflation is 2%, our real yield is 5%. it is this real yield that will be preserved if dividends grow at the rate of inflation.

  40. Roberto Rosenfeld

    Thank you for sharing your investing plan, Professor. I’d like to know as follows since your issue is economics. Could you say what the size of the economy is today compared to 11 years ago, period in which stock indexes remained nominally flat?
    The reason I ask it’s because I once read that in a rare public speech Warren Buffet asked the public what was the difference between 1964 and 1982, period in which stocks remained flat (same nominal value after 18 years). The difference was that the economy had grown 10 fold (I may not remember the exact multiple), thus -he informed his audience- stocks were now cheap!

  41. BAJ

    Irving Fisher, Sep. 5, 1929
    There may be a recession in stock prices, but not anything in the nature of a crash. Dividend returns on stocks are moving higher. This is not due to receding prices for stocks, and will not be hastened by any anticipated crash, the possibility of which I fail to see…
    J.D. Rockefeller, Sr. Oct. 30, 1929
    Believing that the fundamental conditions of the country are sound and that there is nothing in the business situation to warrant the destruction of values that has taken place on the exchanges during the past week, my son and I have for some days been purchasing sound common stocks. We are continuing and will continue our purchases in substantial amounts at levels which we believe represent sound investment values.

  42. TedK

    If your claim of having got 60% annualized returns since 2000 is true, that should put you ahead of famed investors and many top-rated hedge funds. I am skeptical, but if you did in fact get those returns, you can share more details with us.
    And how do you justify buying land at the moment, when the possibility of a depression is upon us, and land values are likely to decline even further?
    Thanks for your explanation.
    It is good that you didn’t buy real estate; many of us shared your view. But the problem I have with gold (and currencies) is that its price is based on complex, global factors that are harder to analyze compared to the factors that affect local real estate and domestic stocks.
    Going back to the gold standard is something I cannot rule out, but I wouldn’t put a high probability on that. Anyway, even if we assume gold will soar, how do you plan to have physical gold? With an agent or at your home? How about the probability of theft, need to purchase insurance, etc.? I don’t like to lose sleep over such things.
    I moved to 70% cash and 30% equities( mainly the mutual funds in my 401K) early in 2008, but even that 30% got whacked starting in September. One fund that I had, Neuberger Berman Genesis Trust, actually held up pretty well until this September/October. I am content to do a little playing in options to partially make up for the loss in my 401K, but am otherwise staying in cash for now.
    Oil and natural gas prices have fallen, but the few companies that own the pipeline assets like Kinder Morgan (KMP), appear to be not as sensitive to gas/oil prices, and also have a high dividend yield, something like 11%, when I last checked. Even the put/call option ratio is very small–so options traders are bullish on this stock. I am not sure if that should be taken as a contrarian indicator, but I believe such companies should be included on any list for long term plays.

  43. GK

    “JG offers sage advice. Financial markets will remain in chaos until the bulk of Alt-A and Adjustable Rate mortgages reset (by early 2012), ”
    I think the biggest chunk is in 2009. 2010-12 has relatively less. Confidence is another matter, however. Home prices won’t rise strongly before 2015. People will just be too burned.

  44. MarkS

    2009 is scheduled to have LOWER mortgage resets than any year in the 2007 through 2011 period.
    See the Goldman Sachs reset chart in..

    or the Credit Suisse chart…

    There is some speculation (Russ Winter and others) that the optional low mortgage payments paid by most OAR borrowers may push them into an earlier than scheduled reset when their outstanding balance exceeds 110 or 115 percent of the initial mortgage amount… If the lenders enforce the contracts, the reset spikes for 2010 and 2011 may occur a year earlier.

  45. GK

    So is it your belief that this recession will last 4 years?
    I can believe that the bear market will last 4 years, but not the recession.

  46. Rory

    A few comments. From each peak in PE ratios in 1900 1929 1964 and 2000 (reading off the graph might have the years slightly wrong), in each case PE ratio fell to 6 or 7 thereabout. At present level of 14 that would presuppose a 50% drop from here still to go.
    As some other commentators noted future earnings are likely to fall further. That could be another 50% drop on average.
    That would indicate a 50% drop on 50% = 25% of current level.
    One other comment, in the crash of 29 there was an initial drop an up and then a final fall over those years. It was said that the dumb money lost on the first drop but the smart money lost on the second fall. I think professor you are the smart money. Be careful.
    If I was to advise you I would say average in over a 4 year period.
    Good luck but I won’t be buying for next 3 years.

  47. jg

    I agree, Ted, that safe storage of gold — safe from theft and out of the reach of the Feds, who confiscated gold at FDR’s order in ’33 — is of paramount importance.
    Three weeks ago, I opened an account at a private Swiss bank in Zurich, and may open an account at another in Basel.
    If you meet the minimums, the folks at make introductions to these two banks.

  48. Raghuveer

    When you use long-term P/E as a reference you need to also look at two other factors which currently operate in favor of sound investment in equities
    1. Interest Rates – Which are now well below historical averages, in early 80s when stocks were selling P/E of 8, 10-Y US treasury was yielding 17% compared to today’s 3.5%.
    2. Corporate Profitability – American companies have a much better RoE and return on invested capital in the last 25-30 years. So companies warrant a better earnings multiple.
    Anybody using the historical P/E should factor in these two factors or else they are likely to sit out a very good opportunity.
    I think the S&P 500 (Currently @850) should yield close to 10% return (if you reinvest dividends) for the next 7-10 years.

  49. Chris

    You can buy the same stocks Buffett has recently bought for much less than he paid. I doubt he invested in companies headed for bankruptcy, so your getting his smarts about which companies to buy and a big discount too. In general I like to pick companies I am pretty sure won’t go belly up and put in an absurdly low bid, good until cancelled, and wait for some guy in a panic to sell it to me: GE, AXP, IR, UNH and some infrastructure plays. Then you might note that Russian stocks are so cheap one can’t believe.

  50. MarkS

    GK- I can’t say with certainty that a technical recession will continue until some time in 2012. For instance, we may have severe consumption erosion during 2009 followed by banking re-regulation and massive stimulus to “jump start” the economy, leading to a small GDP increase in 2010. What I will say with certainty, is that the real economic activity we saw in 2005 and 2006 will not be recovered until after QTR 1 2012… There simply is not enough credit (assets) available in the US economy to service economic expansion…

    There are gargantuan losses to be reconciled, ranging from mortgages, to credit cards, to LBO and privatization debt and the big cahoona- credit and interest rate derivatives. As can be seen with the first bout of sub-prime mortgage failure, it can take a very long time for the financial system to recognize and write down bad debt… Like Japan, I think its most likely that America will sweep the losses under the rug and obscure insolvency. The sure way to reduce the severity of the pain, but extend its duration.

    Don’t forget the biggest elephant in the room- the U.S. Current Account Deficit. This has to be resolved by decreased imports, and increased industrial production. We have seen the erosion of industrial production in America over the last 35 years, with another large bout to occur with the bankruptcy (or nationalization) of the auto industry…It will take a long time for industry to recapitalize and secure greater market share in increasingly competitive international markets. Want to take a guess at how long that will take?

    Longer term (the next 20-30 years), profound issues have to be addressed and resolved in order for a long term economic expansion to occur:
    1. Securing an economical energy supply that does not result in massive carbon-related pollution.
    2. Establishing a competent and international banking and financial regulator with enough power to trump individual sovereignty assertions by nation states, and resist cooption by industrial lobbyists.
    3. Resolving how to tax multinational corporations to support governmental expenses.

  51. Lance

    What the chart shows to me is that there were three bear markets in the 20th century.
    The first lasted from about 1900 to 1920. The second from 1929 to about 1949. The third from about 1963 to about 1983. Each time the P/E ratio fell to 5 before eventually rebounding, and each time it took about 20 years.
    If the chart predicts anything, what it seems to predict to me is that we should expect this bear market to last another 11-12 years, and for prices to fall by another 67%. That’s if earnings stay the same. If they go down, losses would be steeper than that.

  52. Mister Snitch

    Here’s the deal:
    1) We’re awfully close to a bottom.
    2) If you wait until the market feels ‘secure’, it will rise before you can get in. Then, the market will factor in some risk (with higher price levels) for YOU.
    So what do you prefer? Take a risk now, as a discount, or later, at a steeper price?

  53. GK

    Note that the P/E correction from 1965 to 1982 happened with a flat market. So money was not lost in nominal terms. Dividend yields were also high, so a lot of reinvestment happened at the lower prices.
    The best times to buy in the last 60 years were 1974 and 1982. We are approaching a similar opportunity here (which would be S&P500 at 700 or so).
    I think buying big at the 700 level is not too risky. Note that the dividend yield would be about 4% at that point as well. So being scared away from 700 out of fear of it going to 500 is probably unwise.

  54. Michael A. Cuttler

    Historically, bear markets don’t end until there is some visibility about future earnings. There’s no way to quantify the shape of this economic event at this point in time. To buy now is to guess at the depth of the recession and its shape. The most optimistic predictions are for a V shape recession which will turn positive in about nine months. A study by the international monetary fund believe that economic downturns that are based on banking system problems versus inventory corrections last twice as long and are four times is deep. There is plenty of time to buy. One does not need to catch the bottom to make an excellent return on one’s money.

  55. br

    “Outside of a 401(k) or 403(b), one disadvantage of stock index funds is that you’re taxed on realized capital gains as they arrive, whereas if you buy and hold individual stocks, you can postpone the capital gains tax.”

    Sorry, this doesn’t really make sense. I’m guessing you wanted to compare tax-deferred and taxable accounts, not stocks vs index funds, and probably with respect to dividends, not capital gains.

  56. mmckinl

    Whether or not to invest will depend on how the current credit crisis is handled … another 9 months of pain is already baked in the cake but if the new administration takes the right steps in supporting the economy it could turn up from there.
    Getting a floor under the housing market is mandatory. Getting banks to realize losses through a FDR style Bank Holiday is mandatory. Huge amounts of debt will have to be either written off , inflated out of or a combination of both.
    Those hoping for the Japanese scenario would be wise to consider that Japan had a high savings rate and trade surplus at the time they started down their 15 year bust.The US has no such capital advantages, in fact, quite the opposite.
    Much will depend on what the new administration does.Dipping a toe in here wouldn’t hurt especially in solid companies with excellent dividends. Even Intel pays over 4% now. If you think Intel is going out of business you are probably reading this in your redoubt and not interested in anything made of paper.

  57. beezer

    Has anyone done some reading about how the gov geared up for WWII? I’d take that model and implement it now, if I were Obama.
    I’d also send out a huge rebate (tax cut) check. Having a hundred million taxpayers reduce credit exposure, with a little spending to boot, would make a huge positive for cash flow increases at the individual level–which allows for some freedom of action on Main Street.
    Common stockholders in many manufacturing companies would get zeroed out. But at current prices, on auto cos for example, only speculators are involved. The average stockholder is probably completely out.
    As for investing right now. Conservative with 80% of whatever you have that’s fungible. The rest in high risk endeavors. I wouldn’t play the “trend is your friend” game, unless you want to park your butt in front of the computer 24/7. Everyone playing that trend game is being beat senseless right now.
    We’re in a long term commodity bull market. If you know those industries, medium term leveraged positions will probably pay off extremely well.

  58. observa

    You forgot demographics chaps. Investing is all about the old lending to the young to finance their retirement and the relative returns reflect their respective cut of the pie. Never before has a new generation failed to appear on such a scale and so the rules have fundamentally changed.
    It’s why central banks got away with monetary expansion for so long. If you threw that sort of money at a youth generation in the late 60s early 70s the inflationary response was swift and obvious. Fast forward and an aging demographic took that monetary expansion and started to plan for retirement, bidding up asset prices rather than goods and services inflation in the process. Asian savers who had institutional barriers to safe lending in their own backyards, quickly piled on and fuelled the greatest ponzi scheme in memory. The length and breadth of that is the nature of the problem now. Demography is THE issue now. There simply are not the Gen X,Y,Zedders around for baby boomers to liquidate assets to to fund their retirements. More willing sellers than saved up buyers equals sustained low prices in my Eco101 textbook.

  59. observa

    You’ll also note that when the players fianlly worked out the nature of the ponzi scheme, all that monopoly money quickly went looking for real value in commodities with the inevitable boom and bust. The market now wants to deleverage all that funny money back to some real intrinsic value ie basically crash the baby boomers’ expectations. However they are trying to resist that by creating more funny money and tax liability for their offspring. It can’t work of course but that won’t stop them and their political emissaries from trying, more’s the pity.

  60. Richard

    TD Bank is worth a look for your well-run regional bank. It’s one of the largest banks in Canada, conservative, well capitalized, the CEO is intelligent, and they took a policy decision a long time ago to stay away from sub-prime mortgages and related securities when everyone else was doing the opposite.

  61. GK

    Note that the lowest P/E ratios were not always the lowest market prices. They may have been the safest time to buy, but are not the lowest price.
    If one goes off P/E ratios, then it is a perfectly logical strategy to not buy until a low P/E is reached. Even if this means staying in fixed-income for 20 years, you still would come out ahead by waiting.
    Anyone who held cash for the 15 years prior to 1982, and bought only then, came out ahead.
    We are bound to see stock underperform FI from 2000 to 2012 or later. Perhaps much later.

  62. GK

    Amidst all the doom-and-gloom claims of another 10 years of flatness (or worse), one thing I see almost no one talking about are the major opportunities for profit in a) shorting, and b) covered-call writing.
    A 10-year flat market is a dream come true for covered-call writers. Shorting is tricky, but those who are moderately good at it have profited immensely in recent weeks.

  63. GK

    “There simply are not the Gen X,Y,Zedders around for baby boomers to liquidate assets to to fund their retirements. More willing sellers than saved up buyers equals sustained low prices in my Eco101 textbook.”
    A decent point, but remember that the number of young people in emerging markets is much higher than the surplus amount of baby boomers.
    Also, while the Baby Boom (1946-64) was followed by a low-birth bust (1964-80), from 1980 onwards, the aggregate number of births has picked up a bit. There might be 77 million Baby boomers, but another 100 million were born between 1980 and 2000. They are currently between the ages of 8 and 28.

  64. JDH

    Thanks all for many interesting comments and helpful suggestions.

    br: The difference between the 81% and 110% return in the example provided reflects the difference between being forced to realize your capital gains as they come (as you often are with an index fund) and postponing your capital gains (as you can if you own individual stocks outright) when the two are contemplated as alternative holdings for a taxable account.

    BAJ: If Fisher and Rockefeller had performed the calculation I’m recommending, they would have found the long-term P/E in September 1929 to have been 32.56, by which metric it was most assuredly a dreadful time to be buying stocks. Even after a year of carnage, the P/E in October 1930 was still at 18– not cheap enough for me. The “buy” signal I’m using here, of a P/E of 14, wouldn’t have been reached until September 1931.

    Roberto Rosenfeld: Economic growth is incorporated into the denominator of Shiller’s P/E calculation. Specifically, real earnings are up 33% (logarithmically) over the last decade whereas real stock prices are down 48%, which two factors together make stocks a decidedly more attractive investment today than they were 10 years ago.

    guest: You are mistaken. The numbers I relate already are real yields. You’re evidently thinking that you wouldn’t receive your first dividend payment until one year from now. Instead, you start collecting with the current quarter and those payments can start to grow from the current quarter. Note that in fact the calculation is based on average earnings over the previous 10 years, so that, in normal times, the approach here would seriously understate the real yield. As I noted above, you could absorb quite a hit to current earnings and still come out ahead of the 10-year average. If you thought the next several year’s earnings and dividends will be below that 10-year average, then granted there may be some overstatement. But this has nothing to do with your point. The earnings/price ratio should always be interpreted as a real, not a nominal yield.

    Avo: I don’t claim to be able to outperform the market with the above portfolio. My goal is to get some of the diversification of a simple index fund without the fees or realized capital gains.

  65. GK

    A few more thoughts :
    1) Massive job losses mean that corporations are cutting costs aggressively. So earnings could rebound 6-9 months after the unemployment rate spikes higher.
    2) If productivity rates also spike in this period, that also points to earnings improvements.
    3) On a personal level, the chart shows clearly that one should not buy stocks until the P/E is below 10. Sometimes it goes lower than this, but this is a good general rule. This could mean staying away from stocks even for 20 years, if necessary. Also, one should start selling when the P/E is above 20. The P/E has stayed about 20 for only brief periods, so that should be a clue.
    Yes, this means that one should have got out of stocks in 1996. There would have been tremendous pressure during the 1997-2000 run-up, but the person who got out in 1996, is still ahead as of 2009.
    4) If the S&P500 stays at 1000 for another 5 years, the earnings by 2013 could be $110 or more, enabling a P/E of about 9.
    5) There is a tendency of markets to cling to round numbers for decades, while P/Es catch up.
    S&P @ 100 lasted for 16 years. The Dow at 1000 was over a similar period. We are already about 9 years into the Dow 10,000/S&P @ 1000 rangebound action. This could easily last 7 more years until 2016, by which time the P/E could be down to 6-7 again for Dow 10000/S&P @ 1000. Only by then will these round numbers be left behind permanently.

  66. GK

    One question to other readers :
    Value stocks almost always have P/E ratios less than growth stocks, correct? This is the very definition of ‘value’, no?
    So Value stocks already have a P/E around 10, do they not?

  67. bailout

    We are seeing a couple of things that haven’t been seen before. Specifically, unprecedented volatility and speculative leverage, particularly on the short side.
    To address the second, the “ultra” short eft’s and credit default swaps have provided unprecedented ways to go short — which seem to be effectively reducing cycle times. In other words, any reliance on historical cycle timing is less likely to be predictive then it ever was.
    Intra day swings of 10% now seem unsurprising. The “so what” of this is that I think that markets have an ability to “melt up” as well as crash, which puts everyone that is trying to time things on a hair trigger.
    I have also never really liked the use of aggregate PE’s in down periods, since we have recently witnessed a rout in financial stocks over the last year, with a lot of real economy stocks holding up very well until October. The financials include huge losses that cant be sustained — either because they have written everything off, or they will run out of capital. One can be as skeptical as one wants, but certain entities will never have another writedown, because they are out of the indices. AIG, WB, Wamu, MER, LEH, BSC, etc. They were a trillion plus of market cap a couple of years ago. Although they lost their capital, a lot of their assets, like deposits, fee income, etc. has been transferred to surviving institutions.
    Commodity prices have just collapsed, especially energy, which will have a stimulating impact on the economy. Maybe more so then last year’s tax rebate checks which mostly went into gas tanks.
    Comparisons to the great depression of the 1930’s don’t take into account the fact that we have economic policies that draw on that scenario and are not anxious to make the same mistakes.
    The real story of 2008 was the commodity bubble, which finally took down the real economy. That negated all the fiscal and monetary policy intervention. I suppose that one could consider the whipsaw effects of it as overall harmful, the fact is that real costs have been taken out of the system and the benefits will show up as an increase in real spending capacity.

  68. GK

    “The real story of 2008 was the commodity bubble, which finally took down the real economy. ”
    How so? Don’t falling commodity prices help the economy?
    The wheels really came off in October, by which time oil was already cheap.

  69. bailout

    Perhaps I wasn’t clear, but high commodity prices in the first 1/2 negated the tax rebate and reduced real spending much more then cpi figures.
    So it was the inflation part of the commodity that was the final blow for the real (excl FIRE) economy. Part of the damage was the extent to which it blew up the auto industry that had the wrong product for $4 gas, airlines, etc.
    I agree that the falling prices will be a stimulus and good.
    In addition, the unusual volatility and unprecedented ability to short via derivatives is favorable. Two things that should mitigate the constantly recited economic headwinds.

  70. GK

    “In addition, the unusual volatility and unprecedented ability to short via derivatives is favorable. Two things that should mitigate the constantly recited economic headwinds.”
    The ability to use these ‘ultrashort’ ETFs is interesting. The whole market may have a much higher percentage of shares short than normal.
    But how would a ‘melt-up’ happen? How is it any different from an old-fashioned short squeeze?

  71. AlmostChosen

    Ah, even the best of us sometimes fall for “past performance is no guarantee of future results”. 🙂

  72. ronin

    Why more stocke? I know, they’re “cheap”, but an asset allocation of 15% bonds reduces volatility and has little or no effect on long-term returns.
    Shouldn’t we expect fixed income rates (outside of Treasuries) to go up? There are likely to be values to be had outside of stocks.

  73. Fred

    There’s massive values in junk bonds. It is much, much easier to predict which B rated corp can pay their bills over the next 5 years than to project out to infinity the future stream of income for a AAA rated corp, which is what it takes to perform fundamental analysis on stocks.

  74. GK

    “There’s massive values in junk bonds. It is much, much easier to predict which B rated corp can pay their bills over the next 5 years than to project out to infinity the future stream of income for a AAA rated corp, which is what it takes to perform fundamental analysis on stocks.”
    Buying a mutual fund of junk bonds is the way to go.
    Regarding equities, I almost never buy any individual stocks. ETFs are the way to go, and now there are so many that every strategy is possible.

  75. Fred

    No, no, no. A mutual fund of junk bonds is the WRONG way to go because you get too much diversity, which guarantees average performance. Average performance is fine for stocks, which is why I use index funds or index ETFs there, since the stock market is pretty efficient and fundamental analysis doesn’t really work. The only thing investors like me can do to boost stock returns is to time the market over the very long term (like 20 years or so), “buying when others are fearful and selling when others are greedy”, because the market is NOT efficient with respect to herd mentality. I use the market cap to GDP ratio rather than P/E’s to time my movements into and out of the market. At 838 for the S&P500, market cap to GDP is good value, though it will probably get cheaper. Given that drops below 838 are not guaranteed and given the risk of sustained 3% inflation down the road, it would be foolish not to get a good chunk of money into the market at 838, unless you have some other equity investment that is better than stocks (like your own business or real-estate).
    Don’t underestimate the difficulty of going against the herd, especially when you will be doing the opposite of everyone else for perhaps 10 years at a time. Lots of people like to think they are contrarians but then aren’t. If you’ve been in stocks rather than bonds or cash since 1999 (other than perhaps dipping your toe in during late 2002), then you are most definitely NOT a contrarian, because stocks have been overpriced all this time.
    Junk bonds is different from stocks. While the market for junk bonds is usually fairly efficient, so that there aren’t that many screaming bargains, occasionally some values pop up and fundamental analysis will find them. Remember, all you have to determine is whether the company can pay its bills. It doesn’t have to grow, it doesn’t have to make big profits, it doesn’t even have to stay in business forever. All it has to do is stay in business until the bond matures. Once you find a good deal via fundamental analysis, then pile on and concentrate your bets. Diversity is the enemy of outstanding performance.
    If you don’t have the financial background to do fundamental analysis of junk bonds, then ignore all the above and just buy the Vanguard Total Stock Market index fund or ETF.

  76. snow

    Can’t you pull your money from your cash account, short sell your stocks you’re losing XX on, and wait it out without losing anything more instead of pulling out?

  77. GK

    Yes, being a contrarian is hard. I was successfully a contrarian in not buying a home all these years (despite the horrendous cultish social pressure to do so), but I messed up with stocks. I waited until 1150 on the S&P500, thinking that was the bottom. I was wrong.
    Do you have more data on your market cap to GDP ratio? Where is it relative to historical medians, right now? Where is it, relative to 1974 and 1982 (and 1932) bottoms right now?

  78. Fred

    GK: you can get the GDP from a variety of places, either BEA or table F.6 in the Federal Reserve Z.1 report.
    The Z.1 report also shows market cap of corporate equites in table L.5. But the Z.1 report is only published quarterly. To get current info on market cap, you’ll need to go to standard and poors ( I am not sure if the Fed and S&P are using the same definitions for what constitutes market cap, because there are some tricky issues with this concept. So be careful about mixing these two sources of data.
    Anyway, here is some info I just pulled from the Z.1 report. These numbers are millions (gdp is from table F.6, mcp is market cap from L.5, rat is the ratio, values are for end of year or end of quarter for 2008):
    2002 2003 2004 2005 2006 2007 2008-q2
    gdp 10469 10960 11685 12421 13178 13807 14312
    mcp 11900 15618 17389 18516 21004 21861 19363
    rat 114% 143% 148% 149% 159% 158% 135%
    1974 1982
    gdp 1500 3255
    mcp 632 1562
    rat 42% 48%
    S&P says market cap is 8848 as of Nov 18. Now assuming S&P and Z.1 are using the same definition of market cap, this means the market cap to gdp ratio is now about 60%. I recall making a spreadsheet of historical market cap to GDP ratio long ago (using just the Z.1 data), and the trend line is slightly up because of the increasing percentage of corporations that are publicly traded versus privately held, so when comparing 2008 to 1982 and 1974 you have to take this into account. Then again, there have been a lot of privatizations via leveraged buyouts since 1982, so you also have to take that into account. You can probably quantify these factors using the Z.1 report and/or S&P data.
    But anyway, 60% is definitely near the trend line, which means stocks are no longer overpriced as of Nov 18 and so it is safe to buy, though it is quite possible that stock will drop further in the months ahead.

  79. Fred

    Okay, I did some more investigating and the S&P and Fed Z.1 data are definitely different using different definitions of market cap. I don’t want to explain why, because I’ll just get it wrong and confuse everyone. However, it is possible to extrapolate using these two data sources together to get an apples to apple comparison, and the conclusion is that stocks are now more or less on the trendline, and about as cheap as they were back in 1995, but not nearly as cheap as they were back between 1974 and 1982. The entire period from 1995 up until Oct 10, 2008 was a stock market bubble and we are only now returning to normality.

  80. GK

    Wait, 60% is just the trendline? As in, half of the time in the last 60+ years, it has been below that?
    It appears that another 20-30% drop would get us to 1974 or 1982 levels. But market cap tends to drop faster than price. Note how the 2007 market cap was over twice what it is today, but the index level has not dropped by half.
    If this is the case, then to get to 45% of GDP, the index merely has to drop about 10-15% from current levels.

  81. Fred

    Here’s a quick and dirty way to estimate the current market cap to gdp ratio, based on the Z.1 definition, is as follows: divide the S&P value for market cap on Nov 18 (8848) by the S&P value no June 30 (13615) and then multiply by the ratio for end of 2nd quarter 2008 (135%). (June 30 is the end of the 2nd quarter, right?) Result is 88%, which is more than double the ratio back in 1974. I found my old Z.1 spreadsheet and the ratios are shown below, which shows that stocks are about where they were back in the early 90’s and also the period from about 1958 to 1973.
    1946 49%
    1947 44%
    1948 40%
    1949 44%
    1950 49%
    1951 49%
    1952 47%
    1953 43%
    1954 59%
    1955 68%
    1956 70%
    1957 61%
    1958 79%
    1959 82%
    1960 80%
    1961 96%
    1962 86%
    1963 90%
    1964 98%
    1965 102%
    1966 84%
    1967 100%
    1968 109%
    1969 85%
    1970 80%
    1971 86%
    1972 97%
    1973 68%
    1974 42%
    1975 51%
    1976 57%
    1977 45%
    1978 42%
    1979 45%
    1980 54%
    1981 44%
    1982 48%
    1983 52%
    1984 45%
    1985 54%
    1986 60%
    1987 57%
    1988 60%
    1989 70%
    1990 61%
    1991 81%
    1992 86%
    1993 95%
    1994 89%
    1995 115%
    1996 132%
    1997 160%
    1998 178%
    1999 211%
    2000 180%
    2001 151%
    2002 114%
    2003 142%
    2004 149%
    2005 149%
    2006 159%
    2007 158%
    One other thing to note, is that assuming that stocks stay at the same market cap to gdp ratio, and disregarding birth and deaths of companies (which reduce returns for holding of existing stock slightly), then the return on stocks will be (by definition) equal to the rate of growth of GDP plus the dividend rate. So if you expect the market cap to GDP ratio to stay stable, AND you expect real GDP growth of about 2.5%, AND you expect the current dividend rate of about 2.5% to be maintained, then the real return on stocks should be about 5%. All three of the assumptions can be questioned, in which case returns might be higher or lower.

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