‘Stay the distance…’
‘Markets are looking for a floor and in time will rebound…’
‘This is the correction we needed…’
Then there’s the investment industry’s (one of many) chestnut…
‘Remember, it is time in the market — not timing the market — that matters.’
These have been the standard responses to the recent bouts of nervousness on Wall Street.
Have you heard ‘get out now, there’s worse to come’ from anyone?
Nope. Me neither.
At what point do you panic?
After the stock market has lost half its value or before your capital is cut off at the knees?
The events of last week are certain to have more investors asking themselves (and possibly their advisers) that question.
Do we reduce our weightings and retreat to a place of safety?
The industry has a readymade answer for that one…buy the dip.
You know how it goes…the market has fallen to a level where you can buy quality shares at a slight discount. But what if it’s a case of quality shares merely going from being extremely overvalued to just being overvalued? Are they really trading at a discount, or are they just less expensive?
And just to back it up, they’ll reassure you with the old ‘rising earnings’ chestnut.
This is up there with the dumbest things the industry says.
Australian corporate profits rose strongly during 2008/09 — as a result of pre-GFC business activity. But that didn’t stop the Australian share market falling over 50% in value in 2008/09.
Source: Trading Economics
[Click to enlarge]
Because ‘earnings’ are only one part of the ‘price’ equation.
The PE ratio — the multiple applied to earnings to determine ‘price’ — expands and contracts.
Look at what happened to the All Ordinaries Index PE Ratio in 2008…it fell in half.
Investors — spooked by the global debt crisis and possibility of bank failures — were no longer prepared to apply the average multiple to earnings.
The same thing happened in 1987. Investor mood changed overnight…plunging the PE ratio from 22x to 12x.
Source: Market Index
[Click to enlarge]
Rising earnings are only one part of the price equation.
Ignoring the elasticity in the multiple applied to those earnings is truly dumb.
In my book — How Much Bull Can Investors Bear? — I dealt extensively with the investment industry’s ‘smoke and mirrors’.
The ‘rising earnings’ myth was covered in a chapter on secular markets.
Here’s an edited extract…
‘The P/E ratio is the multiple applied to earnings to determine the value of a company.
‘For example, if a company earns $10 million and the P/E ratio is 15, the value of the company is $150 million.
‘Over the long term, the average P/E is around 15.
‘However, averages mean very little in periods where greed and fear is rampant. Extremities in social moods create the high and low data points that contribute to the average.
‘There is a distinct pattern of P/E contraction in Secular Bear markets and P/E expansion during Secular Bull markets.
‘The movement of the P/E line is really an indicator of the prevailing social mood…optimism followed by pessimism.
‘During the good times, investors are more optimistic about the future, and are therefore prepared to pay a higher earnings multiple. In the late 1990s, when the “tech boom” was in full flight, investors — giddy with greed — lost all touch with reality. The US market’s P/E ratio blew out to over 40-times earnings…nearly three times the market’s long-term average.
‘Since the “tech wreck” in 2000, the Shiller P/E 10 ratio has been on a path of mean reversion…but it remains well above the long-term average of 15.
‘The P/E 10 ratio is based on the work of Benjamin Graham (Warren Buffett’s mentor) and David Dodd in their book Security Analysis, published in 1934.
‘The P/E 10 is the price-earnings multiple based on average earnings over the past 10 years. This method smooths out the peaks and troughs in the earnings cycle.
‘The P/E 10 ratio was made popular by Nobel Prize winning economist, Professor Robert Shiller of Yale University. Which is why you’ll often hear it referred to as Shiller P/E 10 or CAPE (cyclically adjusted P/E).
‘The reason markets can trade sideways is a simple case of mathematics.
‘For example, earnings can double, and P/E ratios can halve.
‘Based on a P/E ratio of 40, a company earning $10 million is worth $400 million.
‘Based on a P/E ratio of 20, a company earning $20 million is worth $400 million.
‘Earnings may double, but if investors are less optimistic about the future, a lower multiple is applied to those earnings. The potential for P/E ratios to contract explains why a company’s share price could stagnate even if profits are rising.
‘When surrounded by economic upheaval, investors naturally tend to adopt a more cautious approach. This is human nature…retreat to safety in times of uncertainty.
‘Years of markets going nowhere fast tend to gradually dampen investor animal spirits.
‘The boom time (Secular Bull) optimism slowly but surely becomes a distant memory. Doubt and lingering concern alters the investor psyche. Investors retreat, opting to apply a more conservative multiple to earnings.
‘Towards the end of previous Secular Bear markets, P/E ratios have fallen to the five to eight-times level…a far cry from the boom time high of 40-times.
‘Over a very long span of time, market values are ruled by the head…by mathematics. However, there are periods when the heart overrules the head…on the upside and downside.
‘Understanding the role emotions play in the pricing of assets can provide a valuable insight into whether you are a buyer, seller or holder.
‘Using the above example of a company with current earnings of $20 million being valued at $400 million (on a multiple of 20 times), look what happens to its value if earnings double over the next decade and — due to a serious market downturn (panic) — the P/E ratio falls to five.
‘$40 million x 5 = $200 million.
‘Even though earnings double, the share price falls 50%.
‘But what happens if the economic conditions are tough, and the company’s earnings remain stable? $20 million x 5 = $100 million. In this scenario the share price falls 75%.
‘Finally, what happens when earnings fall by, say, 20%, to $16 million?
‘$16 million x 5 = $80 million. Now the share price falls 80%.
‘Just because a company has achieved a higher profit, you must remember this is only half of the price equation. The other half is what multiple investors are prepared to apply to those increased earnings in order to determine the company’s value.’
Mathematics may or may not be your thing…but if you’re going to invest in markets, you had better make it your ‘thing’.
Unlike the investment industry, maths does not lie.
Smart people — those with vested interests — are the ones who have created the long list of dumb reasons to stay in the market.
They know if the herd hears something for long and often enough, they’ll believe it without question.
It is only after the event that investors gain a little wisdom.
But the industry even has a dumb answer for when that happens. It goes like this: ‘No one saw this coming, it was the perfect storm.’
If you would like to seek alternative advice on how to manage your money and be wise before the event, please go here.
Editor, The Gowdie Letter