Don’t Be Another Wall Street Chump

Securities and Exchange Commission Rule 156 requires financial institutions to advise investors to not be idiots.  Hence, the disclosure pages of nearly every financial instrument in the U.S. are embedded with the following admission or variant thereof:

“Past Performance Is Not Indicative of Future Results”

The instruction is futile.  Most investors are idiots, including many of the pros.  What’s more, suspiciously absent from all disclosures is “how” to not be an idiot.  Perhaps this is because such guidance would discourage many unwitting investors from getting mixed up with the stock market in the first place.

Without question, if you don’t know what you’re looking at, the past can be an abysmal predictor of future investment returns.  One year the S&P 500’s up 10 percent.  Another year it’s up 20 percent.  Then, to the surprise of practically every Wall Street analyst, the S&P 500 crashes 50 percent.

Still, practically everyone projects future returns based on past performance.  For example, your retirement advisor at Edward Jones will be quick to point out that the average annual return of the S&P 500 over the last 60 years is about 8 percent.  He’ll then show you a colorful chart that calculates precisely how much you must save and invest each month to retire a millionaire.

The phony precision, however, is double flush drivel.  Eight percent may be the long term average annual return of the S&P 500.  But averages are deceiving.  And 8 percent is hardly a factor you should blindly count on.

Attaining or exceeding the average takes luck and/or critical contemplation of the past.  Without either of these you’ll end up as another one of Wall Street’s chumps.  We’ll offer some guidance on how not to be another Wall Street chump in just a moment, but first several words on how to not be an idiot…

Price Matters

The return on an investment is a function of three factors: The price you pay for it.  The price you ultimately sell it at.  The cash flows it generates – or costs you – in between.

Of these, you have most control of when you buy and when you sell.  You want to buy low and sell high.  Most investors buy high and sell low.

When considering the stock market as a whole, as measured by the S&P 500, the critical distinction to make is the difference between its overall price and the corporate earnings or sales that underlie it.  Price, without the context of corporate earnings or sales, has little meaning.  But price in relation to earnings or sales identifies whether the stock market is expensive or cheap or somewhere in between.

Obviously, when the stock market is cheap you want to buy and when it is expensive you want to sell.  Yet at these times your emotions will be telling you to do the exact opposite.  When stocks are cheap, the emotion of fear will be compelling you to sell, or at least remain on the sidelines.  When stocks are expensive, the emotion of greed will be compelling you to buy, often at a time of peak mania.

Right now, the stock market, as measured by the S&P 500, is extremely expensive.  This is a time to be cautious.  A time to take some of your capital – not all – out of the stock market and put it in cash and gold.

Here’s why…

Don’t Be Another Wall Street Chump

The Shiller’s Cyclically Adjusted Price Earnings (CAPE) ratio looks at the price of stocks relative to their average earnings, adjusted for inflation, over the past 10 years.  This provides a big-picture view, which smooths out the year-to-year swings in earnings.

Currently, as of market close September 12, the CAPE ratio for the S&P 500 is 30.17.  That’s over 81 percent higher than the CAPE’s long-term historical average going back to 1881.  Moreover, the CAPE ratio has rarely been higher.

For example, on May 3 the CAPE ratio was 31.05, which was higher than its extreme valuation in the late 1920s, right before the October 1929 stock market crash.  The only time CAPE ratio valuations were higher was the late 1990s, just prior to the popping of the dot com bubble and subsequent collapse.

Indeed, according to the CAPE ratio the S&P 500 is extremely overvalued.  But if you really want to drill into valuations, you should look at the MAPE ratio…

John Hussman, Ph.D. and President of Hussman Investment Trust, is ‘smarter than the average bear.’  He’s researched stock market valuations and cycles at a deeper level than just about anyone and everyone.  As part of his research, he’s developed several metrics for valuing the stock market and for identifying subsequent 10 year returns.

One of Hussman’s key valuation metrics is the Hussman Margin Adjusted Price Earning (MAPE) ratio.  The difference between the CAPE and the MAPE is that, for the MAPE, Hussman cyclically adjusts the profit margin.  Hussman has found the MAPE correlates better with subsequent 10 year returns than the CAPE.

The Hussman Market Comment for September shows a MAPE of approximately 45.  At this level, the current market valuation exceeds the extremes reached in 1929, 2000, and 2007.  We recommend reading the entire article.  But for our purposes, here’s one of Hussman’s deductions:

“The steep losses of the S&P 500 in 2000-2002 and again in 2007-2009 were consistent with a century of historical experience.  Given current market valuations, the prospect of yet another 10-12 year period of zero or negative returns for the S&P 500 would also be wholly consistent with a century of evidence.”

In other words, portfolios of S&P 500 index investors could be at or below today’s current price come 2030.  Absolutely, the price you buy at matters.

And only Wall Street chumps buy the S&P 500 at these valuations.  Don’t be one of them.

Sincerely,

MN Gordon
for Economic Prism

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