Worries about the Market

A couple of days ago I read a warning about the prices of stocks based on the high value of a couple of macro-technical indicators – the CAPE, a ratio of present stock price to average earnings over the last ten years,  and the q ratio, a ratio of present stock price to an estimated cost of replacing all of a firm’s assets.  Such warnings are commonplace, and may be justified in our present situation. All the two indicators really are are measures which go up when stock prices increase a lot and go down when stock prices decline a lot. As such they can offer suggestions as to when stocks are expensive or cheap. The problems and the silliness begin when people try to go beyond their probabilistic and suggestive utility and treat  them as having almost mystical predictive powers.

It is interesting to look at two periods when the CAPE and the q ratio were low that did turn out to be good times to buy stocks. (It is also worth remembering the ratios have also been low at times when stocks turned out to be bad buys and high when stocks turned out to be good buys.) The first was the decade immediately after World War II. Stocks were a  great buy at that time. However the reason they were is that the economic condition of the country changed  - from depression to a quarter century of the greatest prosperity it had yet experienced. If that had not happened, and if the predictions of the leading economists of the day that the ending of wartime government spending would lead to massive unemployment and a continuing depression had come true, stocks would have been a bad buy irrespective of what the metrics suggested. The second time was in the late 1970’s and the early 1980’s. Once again stocks were a great buy, but once again,  the reason was a change in the conditions of the country. The nation went from the malaise of the inflationary depression of the 1970’s to another  quarter century of  the greatest prosperity it had ever experienced.  If it hadn’t, and if economic, political, and geopolitical events had  continued on the trajectory of the 1970’s,  stocks would have been a bad buy irrespective of the metrics. It was not the indicators, but the impending macro-economic improvements that made stocks a good buy at both of those times.  

Stocks prices tend to be low when people are dubious about the economic state and future of the country. Times when such pessimism is unwarranted are often good  times to buy. Stock prices tend to be high when people are expecting   growth and prosperity. Times when such optimism is wrong are often  bad times to buy. Whether stocks are too expensive now will be answered by how the nation’s economy does in the next few years, and that is a hard question to consider. The anti-growth policies and plans of the present administration are a serious threat. The ability of firms to lower costs of debt and the continuing effects of new technologies are good signs. The fact is that we don’t know for sure what will happen, and no chart, wave theory, or horoscope will tell us. That is why investors should be careful and diversified in their investments.