You’ve probably heard: the stock market has been hitting new record highs lately.
It didn’t take long for the the boo birds to show up. “Just look! See how the market crashed each time it hit this level? It’s gonna happen again!”
Again, or Third Time’s the Charm?
It’s true: the peaks in 2001 and 2008 were roughly of equal height, and both were followed by devastating drops. It’s also true that the market has reached that level for a third time.
The glass half empty crowd hears the ominous music from Jaws, and says another crash is imminent. The glass half full crowd hears the music, too, and wonders: could history repeat itself?
Or dare they hope the third time’s the charm?
Can You Trust The Experts?
We like to say “no news is good news” (especially when our parents want to know why we don’t call or write). The media see it differently: they say good news is no news. No news —> no sales —> no pay. Bad news is what sells and pays the bills. You may disagree with their view, but you can’t really blame the media for loving bad news.
And that explains why the media love to quote experts, month after month, saying we’re about to fall into another recession. They said that all through 2012 but, as we know, the recession never came.
The doom prophets’ reasoning is simple: everyone knows another stock market crash is coming; it’s in the market’s DNA.
Nobody knows when, though.
You’re a smart investor, though, and you can see if they say every month, “Hey, it’s going to happen this month!” well, at some point there will have to come a month when they can’t help but be right.
As a smart investor you understand that of course, the media won’t ever mention their experts were wrong for 99 months, because who likes to tell others they carried predictions that didn’t come true? It doesn’t matter to them if the experts are right or wrong. All that matters to them is: are people reading those quotes? If readers are happy to read the same gloomy predictions month after month, who are they (the media) to deny us that pleasure?
Being a smart investor, therefore, you know we read and hear doom and gloom not because it’s truly imminent, but because human nature seems attracted to it, and it pays the media’s bills.
And so you’re not surprised to hear choruses of gloom every time the stock market reaches new heights.
Instead, you try to look at the numbers yourself and judge how imminent a crash really could be.
So, is a crash imminent?
I’m not a quotable expert (yet :)) but I say no, it doesn’t look like a crash is imminent, and here’s why not:
Which do you think is a better deal: a used Yugo for $5,000 or a brand new Mercedes S-Class for $6,000?
Both are imports, both are fairly rare, and both are expensive to maintain. But the Yugo costs $1,000 less than the Mercedes, so it’s clearly the better deal. Right?
Can you see how it’s possible to “spin” together arguments which, while true in isolation, misrepresent the big picture? We all know a new Mercedes for only six grand offers way more value, despite the 20% premium. Those other arguments miss the point.
What point? The point of value. The Dow Jones (or S&P 500) index is the “price” of the market. The fact that the index at its highest point ever doesn’t by itself mean the market is overpriced, because it overlooks the key question: what does that price buy?
The value of a stock, or the market in general, is measured by something called the PE ratio. Without going into theory and heavy math, the higher the PE, the more you pay for what you get. Put another way, PE tells you how expensive a stock (or the market as a whole) is.
(Note: the issue of valuation is covered more thoroughly in the free Investing Basics series, available here.)
Let’s compare two companies we know well, Apple and Whole Foods, to see how it works. As of today, Apple’s stock is around $450 per share and Whole Foods’ is around $85. Apple looks a lot more expensive, doesn’t it?
But is it really? Let’s see. $450 (Apple) buys you profits of $44 per year, while $85 buys you an annual profit of $2.65 at Whole Foods. To compare apples with apples (no pun intended) $10,000 would buy us:
- $970 in earnings per year with Apple
- $300 in earnings per year with Whole Foods
Which would you rather have? Apple ($450) might look more expensive than Whole Foods ($85), but the value you get from Apple is more than three times as much. Like the Mercedes/Yugo example, what looks to be a high price might actually be the better deal.
Using the PE ratio:
- Apple’s $450 buys you $44 in earnings, giving it a PE of just over 10.
- Whole Foods’ $85 buys you $2.65 in earnings, giving it a PE of over 30.
The higher the PE number, the more expensive a stock truly is.
Valuing The Market
If you add up the earnings and the prices of all the companies on the stock exchanges, you arrive at the PE for the whole market.
If that number is low, we can say the market offers good value. But if the number is high, we can say the market is becoming more expensive. And the more expensive it is, the more susceptible it becomes to a crash.
So, is the market’s PE in danger territory yet?
The three most recent stock market crashes occurred in 2008, 2002 and 1992.
You can clearly see how the PE ratio for the stock market spiked before each crash.
You can also see that, at roughly 18, the market’s PE today is nowhere near a spike.
Therefore, although the market is at is highest point ever, it’s not because the PE is spiking like the previous two times. This time round, the rise in the Dow (and S&P 500) seems to be mainly because the total earnings of all the companies listed are at their highest point ever, too.
There’s a good explanation for this: the recession forced companies to put the axe to their expenses (executives’ bonuses excepted, of course). As a result, the companies that make up the indexes are at their leanest ever, and any increase in sales yields a disproportionate gain in total profits, the E in PE. And the higher the earnings, the higher the price of individual stocks. Add up all the individual stocks and voila! The whole market rises, without an increase in the PE ratio.
Although the Mercedes is more expensive than the Yugo, it offers more value.
In the same way, it looks like the market today isn’t overpriced, even at its lofty level.
Back To The Future
So, is the stock market headed for a crash? It doesn’t seem likely, because there’s no spike in the PE ratio, the usual precursor to a crash. However, nothing is impossible, and there is always the chance that some extraneous event, like 9/11 or some civilized country reneging on its debt, can derail the market.
Many people have said the stock market’s high value is driven by the Fed’s Quantitative Easing program. If that were true, though, we would be seeing elevated PE levels. However, the chart shows us current PE levels are not that out of line with “ordinary times” in the past.
We could therefore expect that if corporate earnings keep going the way they’re going (up) the market should follow suit.
In fact, if there is a danger at this point, the danger might very well be that the soaring stock market will attract those investors who fled after getting burned by the crash of 2008. If that happens, it will push the market’s PE up, which in turn will attract more people into the market.
And, as we all know, that’s what people just love doing: buying high.
More about that sensitive topic next on Thursday.