Emma’s Note: Our colleague Tom Dyson is back in the guest editor chair this week. As regular Diary readers know, Tom has invested nearly all his savings in gold and silver while he waits for better value in the stock market. Below, he tells us the simple charts he uses to guide his decision… and they’re both screaming a warning right now.
What do a field, a tree, property, and the stock market have in common?
They all yield something.
A field yields crops, a tree yields fruit, a property yields rent, and the stock market yields profits.
But what if we told you that now is one of those rare occasions when the market will not yield profits… and instead, it will yield massive losses over the next few years?
Take a look at the chart below. It shows the cyclically adjusted price-to-earnings (CAPE) ratio of the S&P 500 – also called the Shiller P/E, named after Nobel Laureate Robert Shiller – going back 120 years…
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When the line on the chart is high, it means the stock market is very expensive relative to the earnings it generates. When the line is low, it means the stock market is cheap relative to its earnings.
The Shiller P/E comes out once a month. The latest reading is almost 39 (more than double the long-term average of 17). And as you can see from the chart above, the ratio has only been higher once in history…
That is, the 25 extraordinary months between July 1998 and November 2000 – otherwise known as the dot-com boom.
That was a terrible time to buy the S&P 500. When the dot-com bubble burst and the ratio started falling, stocks lost 78%.
Q Ratio
Another valuation metric we look at is the Q ratio – also called Tobin’s Q, after American economist James Tobin. It compares the stock market’s valuation of companies in the S&P 500 with their actual net worth, measured at replacement cost.
The orange line on the chart below shows the Q ratio going back 120 years. (The blue line shows the S&P 500 adjusted for inflation, which I’ll come back to shortly.)
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When the orange line on the chart is high, it shows that the S&P 500 has a high price relative to its net worth. It’s expensive.
When the line is low, the stock market is undervaluing the S&P 500’s actual net worth.
The long-term Q ratio average is about 0.77. Right now, the ratio is at 1.91. The S&P 500’s net worth is valued by investors at the highest price in history, 149% above its average.
Now look at the blue line on the chart. It shows the S&P 500, adjusted for inflation. Notice that buying the S&P 500 at such high Q ratio valuations as we had in 1905, 1929, 1937, 1968, and 1999 – and as we have today – was never a good decision in terms of market timing.
Predictable Trend
The main reason valuations are so high is because the feds are meddling with interest rates and the U.S. money supply. That has made the stock market (and the property market and all sorts of other asset markets) look extremely attractive – but only temporarily.
These valuations are simply not sustainable over the long term. Sooner or later, investors will demand a greater return on their capital more in line with historical norms, and the ratios will adjust down.
We can’t predict when that will be. And we don’t have to. We just need to weigh the probabilities.
At these levels, we must ask ourselves, is the trend more likely to rise or fall? That’s easy. It’s more likely to fall.
In the past, we’ve seen a cycle reversal – from peak to bottom – every 20 years or so.
But this cycle has been stretched by central-bank intervention… And the down stage of the cycle is now long overdue.
Terrible Time to Own the S&P 500
When will the decline back to normal valuations begin? Only time will tell.
But we know that the best time to own the S&P 500 is when valuations are likely to expand. And we know the worst time is when valuations are likely to contract.
With all that we know, I’m left with the unshakeable conviction that now is a terrible time – perhaps the worst in all financial history – to own the S&P 500.
In my opinion, the correct course of action is to stand aside and avoid all exposure to the S&P 500.
For us, this means owning gold, silver, and other cheap hard currencies, and waiting for the bubble in the S&P 500’s valuation to burst.
When it does, we’ll swoop in like vultures and buy great businesses at much more reasonable prices.
We are prepared to wait as long as it takes… even if we have to wait another decade…
Regards,
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Tom Dyson
Editor, Tom’s Portfolio
P.S. My conviction about the stock market is not new. Three years ago, I put my money where my mouth is, sold everything I owned, and put all my money into gold and silver.
So if you’re alarmed by the charts I presented above, click here to find out more about how to protect your wealth from the monumental stock market crash I see looming.
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