how to properly value the stock market LOL
For decades, retirement investors have been taught that they should invest most of their savings in broadly diversified stock portfolios, because for decades (1982-2022) broadly diversified stock portfolios have gone up 6%/year on average, plus dividends of 2-4%.
It seems like financial magic, simply put 10% of your salary into a stock portfolio each month, whether stocks are going up or down right now, and eventually you'll be able to retire as a millionaire. Easy peasy!
Retirement investors are taught not to worry about "timing" the market, because over time it will simply keep going up and up.
In reality, there have been long periods of stock market declines. The peak US stock prices of 1929 were not reached again until 1959. In Japan, stock prices peaked in 1990 and still have not fully recovered. So, it is possible to lose money in stocks over the entire course of your working career. It has happened before. It is possible that the S&P 500 peak in January 2022 will not be reached again until 2052, and that young adults who start saving for retirement today will witness a flat stock market for decades to come. Again, this has happened before, in different times and places. Stocks do not always go up.
But how is a person to know whether today is like 1982, or today is like 1929? Are we about to have a magical upward trend, or a dreary flat trend?
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It's impossible to know for sure, of course. But the people who study the entire history of all the stock markets have learned some things about how to value stocks.
First, understand what stocks are --> stocks are shares in an underlying business that aims to make a profit. Not all businesses are profitable. Some businesses are only profitable for a period of time, and then they become obsolete. A few businesses become fantastically profitable for a long period of time. Stocks represent a stream of future profits, and stocks go up either because current profits go up, or because future profits are expected to go up. If a company is not expected to ever make a profit, why would people buy its stock?
Second, profits fluctuate along with the natural business cycle. For example, profits fell by half from 2006 to 2008, during the Great Recession. Then profits doubled from 2008 to 2009 as the economy recovered. So you shouldn't judge the profitability of a corporation based on only one year, instead you should look to the stream of profits over the course of at least one full business cycle.
After you've estimated the long-term profitability of a business, how much should you pay for that stream of profits? Well, stocks are not your only investment alternative. You can also invest in bonds, or real estate, or precious metals, or art/collectibles, or foreign currencies, or (eek) crypto. To properly value stocks you should understand the proper value of these competing investments. What is your opportunity cost when you invest in stocks instead of bonds or real estate?
Perhaps at this point, you're beginning to see how complex this problem is.
-----
Each class of investments suffers from its own momentum cycles, as they come into or fall out of fashion. To figure out whether an investment class is cheap or expensive, you need to analyze its historical values and historical ratios as compared to other investment indicators.
Want to know whether gold is a good investment right now? You need to look at the history of gold prices as compared to the consumer price index, because over time gold has fluctated with respect to the general inflation level. Sometimes this ratio is high, sometimes it is low.
Want to know whether bonds are a good investment right now? What is the history of interest rates? Where do current interest rates stand as compared to the historical highs and lows?
With real estate, how do current housing prices compare to the median family income, is the current ratio high or low compared to historical norms?
Similarly with stocks, you need to look at the history of stock prices as compared to their long-term profits, is this "price to long-term earnings" ratio currently high or low compared to historical norms?
And then you should compare all of these investment classes to each other. Is one class cheap according to its history, while another class is expensive compared to its history?
Smart and careful investing requires a lot of work, which is why most people don't bother, they just follow the crowd. If everybody else is investing in Bitcoin right now and Bitcoin is going up, they jump on that bandwagon and buy some Bitcoin also. If you're lucky, you can make a lot of money by following the crowd. But you need to get in early and then get out before the crowd moves on. Can you predict which investments will be popular next year? That's one way to make money. Consult an astrologer.
-----
When I value stocks, I use the Shiller Cyclically Adjusted Price Earnings Ratio, also known as CAPE, also known as the Shiller ratio. As I suggested doing above, this ratio doesn't look to current earnings, it looks to a 10-year stream of earnings. Even the CAPE isn't perfect, because different times in history have different numbers and types of business cycles within a 10-year period. The past 10 years have not had a significant profits recession -- the last profits recession was from 2006-2008. So right now even the CAPE overestimates the long-term profit potential of a stock index.
As a further distortion of CAPE, the federal government threw so much aid at businesses during the Pandemic Recession, that the already cyclically high profits of 2019 increased an additional 50% by 2022! These unusually high current profits have fueled enormous speculation in stocks that pushed the CAPE well above 30 during 2021 and 2022, much higher than the CAPE was back in 1929 before the great stock market crash that accompanied the Great Depression -- a stock market crash that took 30 years to recover from.
Some researchers have used more sophisticated statistics to determine better cyclically-adjusted PE ratios than Shiller's 10-year standard, and their results show that US stocks have never been as highly valued, compared to long-term earnings potential, as they were during the past couple years.
It is more plausible than usual, that we're currently at the beginning of another 30-year drought for stocks.
-----
"How should I invest my retirement savings" is one of those nice-to-have problems. Only about half of US adults have any significant savings at all, and we're one of the richest countries on the planet.
But until recently, every investment class was trading at peak bubble levels. And recent declines, while in some cases sizeable, still haven't returned investments to a more normal historical range. Interest rates have gone up compared to recent times, but are still at the low range when you look at the full history. Housing prices are high, gold prices are high, and crypto shouldn't be worth anything at all LOL.
The ultimate truth for investing right now is that there's just too many people trying to invest their savings for the future instead of spending their income right now. It's a supply and demand problem that cannot be easily fixed. When you don't spend your money now, but instead want to save it for spending in the future, there's only a finite amount of stuff in the future. If too many people are avoiding spending now, because they want to spend in the future, they're effectively bidding up the price of future stuff. When we pay too much for stocks, real estate, bonds, gold, or Bitcoin, we're effectively paying higher prices for future stuff.
We're exporting inflation into the future. That's what all these investment bubbles have done. When we all try to cash in our retirement savings, we'll all be competing with each other for future stuff, bidding up the prices of that future stuff.
This may be happening already, as we flip from an era of low inflation to an era of high inflation. There's too much savings around the world, and as all these savers try to spend their savings, prices must go up. It's a phenomenon of the global Baby Boom that followed WW2 from 1946 to 1964. The last of the Boomers are approaching retirement age, they've all been piling up retirement savings -- which fueled this Everything Bubble in all categories of investment. And as they flip from saving to spending in retirement, the Everything Bubble will crash, while prices for goods and services will skyrocket.
There's probably no easy way to invest around this overriding trend, although lucky people might be able to ride short-term momentum up and down if they can guess which investment fad is coming next. As somebody who has studied all this stuff to the point of exhaustion, I have no good answers for you. I'm just trying to downsize my own spending so that I'll fit more easily into retirement with whatever pension and savings I end up with.
But I find it entirely plausible that we've now entered the next 30-year drought for stocks. The S&P 500 may not revisit its recent highs until 2052.
As I wrote the other day, you have been warned LOL.
It seems like financial magic, simply put 10% of your salary into a stock portfolio each month, whether stocks are going up or down right now, and eventually you'll be able to retire as a millionaire. Easy peasy!
Retirement investors are taught not to worry about "timing" the market, because over time it will simply keep going up and up.
In reality, there have been long periods of stock market declines. The peak US stock prices of 1929 were not reached again until 1959. In Japan, stock prices peaked in 1990 and still have not fully recovered. So, it is possible to lose money in stocks over the entire course of your working career. It has happened before. It is possible that the S&P 500 peak in January 2022 will not be reached again until 2052, and that young adults who start saving for retirement today will witness a flat stock market for decades to come. Again, this has happened before, in different times and places. Stocks do not always go up.
But how is a person to know whether today is like 1982, or today is like 1929? Are we about to have a magical upward trend, or a dreary flat trend?
-----
It's impossible to know for sure, of course. But the people who study the entire history of all the stock markets have learned some things about how to value stocks.
First, understand what stocks are --> stocks are shares in an underlying business that aims to make a profit. Not all businesses are profitable. Some businesses are only profitable for a period of time, and then they become obsolete. A few businesses become fantastically profitable for a long period of time. Stocks represent a stream of future profits, and stocks go up either because current profits go up, or because future profits are expected to go up. If a company is not expected to ever make a profit, why would people buy its stock?
Second, profits fluctuate along with the natural business cycle. For example, profits fell by half from 2006 to 2008, during the Great Recession. Then profits doubled from 2008 to 2009 as the economy recovered. So you shouldn't judge the profitability of a corporation based on only one year, instead you should look to the stream of profits over the course of at least one full business cycle.
After you've estimated the long-term profitability of a business, how much should you pay for that stream of profits? Well, stocks are not your only investment alternative. You can also invest in bonds, or real estate, or precious metals, or art/collectibles, or foreign currencies, or (eek) crypto. To properly value stocks you should understand the proper value of these competing investments. What is your opportunity cost when you invest in stocks instead of bonds or real estate?
Perhaps at this point, you're beginning to see how complex this problem is.
-----
Each class of investments suffers from its own momentum cycles, as they come into or fall out of fashion. To figure out whether an investment class is cheap or expensive, you need to analyze its historical values and historical ratios as compared to other investment indicators.
Want to know whether gold is a good investment right now? You need to look at the history of gold prices as compared to the consumer price index, because over time gold has fluctated with respect to the general inflation level. Sometimes this ratio is high, sometimes it is low.
Want to know whether bonds are a good investment right now? What is the history of interest rates? Where do current interest rates stand as compared to the historical highs and lows?
With real estate, how do current housing prices compare to the median family income, is the current ratio high or low compared to historical norms?
Similarly with stocks, you need to look at the history of stock prices as compared to their long-term profits, is this "price to long-term earnings" ratio currently high or low compared to historical norms?
And then you should compare all of these investment classes to each other. Is one class cheap according to its history, while another class is expensive compared to its history?
Smart and careful investing requires a lot of work, which is why most people don't bother, they just follow the crowd. If everybody else is investing in Bitcoin right now and Bitcoin is going up, they jump on that bandwagon and buy some Bitcoin also. If you're lucky, you can make a lot of money by following the crowd. But you need to get in early and then get out before the crowd moves on. Can you predict which investments will be popular next year? That's one way to make money. Consult an astrologer.
-----
When I value stocks, I use the Shiller Cyclically Adjusted Price Earnings Ratio, also known as CAPE, also known as the Shiller ratio. As I suggested doing above, this ratio doesn't look to current earnings, it looks to a 10-year stream of earnings. Even the CAPE isn't perfect, because different times in history have different numbers and types of business cycles within a 10-year period. The past 10 years have not had a significant profits recession -- the last profits recession was from 2006-2008. So right now even the CAPE overestimates the long-term profit potential of a stock index.
As a further distortion of CAPE, the federal government threw so much aid at businesses during the Pandemic Recession, that the already cyclically high profits of 2019 increased an additional 50% by 2022! These unusually high current profits have fueled enormous speculation in stocks that pushed the CAPE well above 30 during 2021 and 2022, much higher than the CAPE was back in 1929 before the great stock market crash that accompanied the Great Depression -- a stock market crash that took 30 years to recover from.
Some researchers have used more sophisticated statistics to determine better cyclically-adjusted PE ratios than Shiller's 10-year standard, and their results show that US stocks have never been as highly valued, compared to long-term earnings potential, as they were during the past couple years.
It is more plausible than usual, that we're currently at the beginning of another 30-year drought for stocks.
-----
"How should I invest my retirement savings" is one of those nice-to-have problems. Only about half of US adults have any significant savings at all, and we're one of the richest countries on the planet.
But until recently, every investment class was trading at peak bubble levels. And recent declines, while in some cases sizeable, still haven't returned investments to a more normal historical range. Interest rates have gone up compared to recent times, but are still at the low range when you look at the full history. Housing prices are high, gold prices are high, and crypto shouldn't be worth anything at all LOL.
The ultimate truth for investing right now is that there's just too many people trying to invest their savings for the future instead of spending their income right now. It's a supply and demand problem that cannot be easily fixed. When you don't spend your money now, but instead want to save it for spending in the future, there's only a finite amount of stuff in the future. If too many people are avoiding spending now, because they want to spend in the future, they're effectively bidding up the price of future stuff. When we pay too much for stocks, real estate, bonds, gold, or Bitcoin, we're effectively paying higher prices for future stuff.
We're exporting inflation into the future. That's what all these investment bubbles have done. When we all try to cash in our retirement savings, we'll all be competing with each other for future stuff, bidding up the prices of that future stuff.
This may be happening already, as we flip from an era of low inflation to an era of high inflation. There's too much savings around the world, and as all these savers try to spend their savings, prices must go up. It's a phenomenon of the global Baby Boom that followed WW2 from 1946 to 1964. The last of the Boomers are approaching retirement age, they've all been piling up retirement savings -- which fueled this Everything Bubble in all categories of investment. And as they flip from saving to spending in retirement, the Everything Bubble will crash, while prices for goods and services will skyrocket.
There's probably no easy way to invest around this overriding trend, although lucky people might be able to ride short-term momentum up and down if they can guess which investment fad is coming next. As somebody who has studied all this stuff to the point of exhaustion, I have no good answers for you. I'm just trying to downsize my own spending so that I'll fit more easily into retirement with whatever pension and savings I end up with.
But I find it entirely plausible that we've now entered the next 30-year drought for stocks. The S&P 500 may not revisit its recent highs until 2052.
As I wrote the other day, you have been warned LOL.