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How the Market Works

The Stock Market Warnings: Part 2 of 3

Posted by kdadmin on July 1st, 2015.

The Stock Market Warnings: Part 2 of 3

There’s nothing like writing one of these pieces only to have market volatility oblige and prove my point. Before we get into that, let’s talk about the green line, as it has been a source of consternation among the ADD crowd. So …

The green line marks the top of the PE cycle over the past dozen years. A P/E (price to earnings ratio) of 27 means that you are paying $27 for every $1 of earnings in a particular stock. In other words, you are getting a 3.7% return for each dollar invested (1/27= 3.7%). Compare that with the 2.5% return of a mid term, mid quality bond, and you are only getting 1.2% more for taking SUBSTANTIALLY more risk in a stock.

Bonds have long been considered to be more stable investments because you are not betting on the growth of the bond to make money. You are betting on the ability of the issuer (corporation, government, municipality) to pay interest over the life of the bond, and pay back the principal at maturity. Whereas with a stock, you are betting on the ability of the company to both produce a profitable product AND grow the profit of the company over the near and far term. Stock growth is a MUCH harder thing to do than to simply paying interest and principal back on a debt (bond).

SO, there has to be a compelling reason to buy a stock instead of a bond. If you only get 1.2% more return for a stock than you do for a bond, there is no reason to buy the stock. The risk premium (the difference in return between stocks and bonds), in this case 1.2%, simply isn’t high enough to warrant the extra risk of loss that a stock poses. Aside from the brief insanity of the Dotcom bubble, notice that P/E ratios rarely exceed the green line.

Now, look at the circled spot on the graph. You’ll see that the P/E ratio (orange line) is roughly at 13 (second column). This means that in 2009 you only had to pay $13 for each $1 of earnings in a stock. For illustration’s sake, let’s assume that bonds in 2009 had the same return of 2.5%. So, in 2009, buying a stock gave you a 7.69% return (1/13=7.69%) against a bond that paid 2.5%. That means that the risk premium was 5.19% (7.69%-2.5%). This risk premium is certainly substantial enough to warrant the extra risk of loss in a stock.

Stocks were FAR cheaper per dollar of earnings when the P/E ratio was 13 than they are now when the P/E ratio is 27. In other words, stocks are underpriced at a P/E of 13 (2009), and overpriced at a P/E of 27 (now). It’s extremely unlikely that P/E ratios will exceed the green line.

Of course, it’s one thing for stocks to be overpriced. It simply means that you don’t buy stocks. Or, you sell your stocks now and wait for the stock market P/E ratios to get closer to the historical norm (16-18). But the sinister part of this is that red line above. Do you notice how both the blue line (SPY) and the orange line (P/E Ratio) pretty much follow the direction of the red line in lock step? The redline, of course, represents how much money the Federal Reserve has pumped into the economy since 2009. It’s a measure of quantitative easing. Or, in simpler terms, it’s stock market cocaine.

Guess what? It stopped. The red line has stopped. The Federal Reserve has stopped pumping money into the economy. They’ve cut off the market’s cocaine supply. Worse, for overvalued stocks, they are likely to take money out, in the form of higher interest rates, within three months. What do you think will happen to the eurphoric stock prices when they do that?

Considering what you’ve learned so far about how the market works, including this and previous warnings, what’s your guess?

Here’s a hint.

More importantly, how do you think your guess relates to the title of my final post in this series, “When the Music’s Over?” Stay Tuned.

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