The DOW dipped below 11,000 this morning for the first time in two years. Worse, the stock market has now been flat for the better part of a decade. Normally, long-term investors would be happy about such events: weakness creates an opportunity to buy cheap. Unfortunately, since stocks were so expensive to begin with, they’re still not cheap.
Given the sharpness of the recent plunge and consensus that the US economy and financial system are headed for disaster, the market is due for a bounce. (It’s always darkest before dawn.) But stocks are also, unfortunately, still priced to perform no better than cash over the next 10 years.
In recent months (as ever), you have no doubt been bombarded with research and opinions that stocks are now cheap. Most of these opinions are probably based on standard P/E ratios or relative valuations (“low interest rates”). Most of these measures, unfortunately, are bogus. Stocks are cheaper than they were a few months ago, but they’re not cheap. This chart from Andrew Smithers, a London-based strategist, tells the real story:
There are only two valuation methods that have been shown to have predictive value over long periods of market history: cylically adjusted price earnings ratios (CAPE) and “Tobin’s Q.” Cyclically adusted earnings ratios adjust for the business cycle by “normalizing” corporate earnings to average profit margins (as opposed to the record-high margins of recent years). Tobin’s Q, meanwhile, is an estimate of business “replacement value.” In the past, stocks have gravitated around these measures, often with multi-decade swings above or below the long-term average.
As Smithers’ chart shows, stocks have been “expensive” on CAPE and Q measures since about 1990. Now, thanks to the market’s recent collapse, they’re getting back toward average levels.
If you believe these long-term averages–or corporate profit margins–have shifted permanently upwards (because of new technologies, investor intelligence, or whatever), then you might view today’s stock levels as “cheap.” If you don’t think it’s different this time, however, you will likely conclude that:
- the market has a lot further to fall,
- or stocks will be treading water for another decade or so.
So what should you do? If you’re a long-term investor, nothing different. Despite the current hysteria, the world is not coming to an end. This doesn’t mean the DOW won’t go to 7,000 over the next year–or 15,000. It might. It does mean that, over the long term, the market will probably be fine. (If it isn’t, it will be because we’ve gone through a communist revolution or Armageddon or something, in which case, you’ll have bigger things to worry about.)
So just continue to invest your savings regularly in a diversified portfolio of low-cost index funds (stocks, bonds, cash, real estate, across as many geographies as possible). The good news is, thanks to the market’s recent drop, your expected returns on the equity portion of the portfolio are higher then they were a few months ago. (And if the market falls further, they will get even better).
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