The Upside to a Market Crash

Judging by the indifferent or incredulous response to my recent report, I can tell that many Australian investors are now profoundly lazy and complacent about the idea that there are riskier, tougher times ahead. In fact, it’s one of the weaknesses (psychological) I cited in my report. But don’t take my word for it. Look at the chart below.

Fourth time’s the Crash?

click to enlarge


Yale economist Robert Shiller’s cyclically adjusted price-earnings ratio (CAPE) sits at 26 right now. It was higher than that in 1929, 2000, and 2007. And then it was lower after that each time. In last week’s Port Phillip Insider (a thrice-weekly publication that goes to you if you’re a subscriber to any of Port Phillip’s services), I explained why it matters to Aussie investors:

‘Companies that pay regular dividends — assuming they aren’t borrowing to pay them — generate regular cash flows. In other words, they’re as safe and as predictable as any business gets. Those are the companies you want to own over the long term, given the importance of dividends to the total return of stocks as an asset class.

Those companies are not hard to find. But you have to look at more than just the most recent year’s earnings. In Securities Analysis, Ben Graham and David Dodd suggested taking a moving average of the last ten years’ worth of earnings and dividing it by the current share price. That would give you a ‘cyclically-adjusted price earnings’ ratio, or CAPE.

Obviously, it has no application for growth stocks. You apply it to companies that have an operating history long enough to calculate the average of ten years’ worth of earnings. Finding them isn’t hard if you know what to look for….But knowing when to buy them so you don’t over-pay matters a lot, too. Right now probably isn’t the best time.

But hang on! Researcher and strategist Ed Yardeni says we may be in the fourth and final stage of a market cycle in which stocks ‘melt up’. Somewhere in America, Kris Sayce is smiling. Sir John Templeton said there are four stages of a market cycle: pessimism, scepticism, optimism, and euphoria. Yardeni’s colleague Laszlo Birinyi also has a four-stage cycle: reluctance, digestion, acceptance, exuberance.

Yardeni reckons we’re not yet in the ‘exuberance’ or ‘euphoria’ phase for markets. That means there’s still upside. The speculators of the world have the green light from Janet Yellen, Mario Draghi, Mark Carney, and Haruhiko Kuroda to party on. As long as interest rates stay low, the argument goes, stocks will head higher.



Dan Denning
for Markets and Money


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Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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