Bear Market Analysis Point #1: Bulls Cannot Understand Bear Markets
The first thing you need to understand to appreciate the power of a bear market analysis of where things are headed for stocks from 2012 forward is that no bull market analysis matters at this point. The is a subtle but highly important point. Please take a few moments to let it sink in.
What does it mean to say that stocks are overvalued? It means that stocks are priced irrationally. Mispricing is always irrational.
Why would large numbers of investors become irrational? No one wants to lose money. How could this happen?
It can happen only when bulls become so convinced that they are right that they will no longer listen to other points of view. Bears were not proven wrong in the late 1990s. They were silenced.
If the bears were right in the late 1990s, then the bull were wrong. And they were not wrong because they are dumb. They were wrong because they stopped listening to the other point of view.
Bulls have not been listening to the other point of view for many, many years now. The smartest bull in the world is uninformed about what causes bear markets because by definition no bull truly listens to the bear case. So, if you believe we are today in a bear market (this article was posted in June 2011), you should not have confidence in anything said by any bull.
Bear Market Analysis Point #2: Bears Predicted the Economic Crisis
In contrast, the most intelligent bears have an amazing track record of predicting events in the stock market in recent years. Robert Shiller predicted the economic crisis. So did Rob Arnott. So did Andrew Smithers. So did Jeremy Grantham. So did John Walter Russell. So did Cliff Asness. So did Ed Easterling. So did John Mauldin. So did Rob Bennett.
How did we all get to be so smart?
Smart bulls say that it is not even possible to predict future stock market events. Yet all the bears just happened to predict the most important event years before it happened? Huh? This is a mighty, mighty strange reality.
Bears predicted the economic crisis because bears were looking at things that bulls never look at. To develop an informed bear market analysis of your own, you need to come to understand what that something is.
Bear Market Analysis Point #3: The Rational Investor Does Not Ignore Evidence of Irrationality
It’s not something that is hard to understand. The thing that the bears got right and that the bulls got wrong is very easy to understand.
Stock investing is not a rational endeavor.
The entire Buy-and-Hold Model for understanding how stock investing works is rooted in a premise that all investors act in their own self interest. This is why we are told that timing never works. If investors were rational, stock prices would always reflect the economic realities and it would be very hard if not impossible for any individual investor to gain access to the special information needed to predict future stock prices effectively.
But if investors are irrational and if stock valuations reveal to us the extent of that irrationality, there is nothing amazing to be found in the ability of the bears to predict future stock market events or in the power of any investor to time the market effectively.
The P/E10 level (that’s the price of a broad stock index over the average of the past 10 years of earnings) reveals where stock prices are headed over the long term. Stock prices must reflect the economic realities in the long run. So, when prices are insanely high, we know that they will be coming down hard over the long run. And, when stock prices are insanely low, they will be rising like a shot in the long run.
In the late 1990s, stock prices were insanely high. Stocks were priced at three times fair value in January 2000. The dollar value of the overvaluation that needed to be eliminated over the next 10 years or so was $12 trillion. Bears do not tune out information about valuations. So we knew that prices were going to fall very hard over the next decade, hard enough to cause the second biggest economic crisis in U.S. history.
Bear Market Analysis Point #4: There Will Be Another Price Crash
The stock crash is not complete. Again, we know this because we are able to examine the historical stock-return data without the blinders that were required of those who remained bulls in the late 1990s.
This is the fourth time in U.S. history that stock prices reached insanely high levels. Prices never fall all at once; bear markets play out in stages as investors gradually let in the extent of their foolishness over the bull years. On the three earlier occasions on which we permitted stock prices to reach two times fair value, prices continued to fall in the subsequent bear until they had reached a P/E10 level of 7 or 8, one half of the fair-value P/E10 level of 14 or 15.
That’s a 65 percent price drop from where we stand today (a P/E10 level of 24). The bear market has a long way to go.
Bear Market Analysis Point #5: Prices Crashes Feed on Themselves Because the Loss of Wealth Scares People
It’s easy to understand why stock prices must drop to fair value. If prices don’t eventually reflect fair value, the entire market would collapse.
But why must we drop to price levels of one-half fair value? Those are prices as insane on the low side as the prices of the late 1990s were insane on the high side.
The reason is that the drop from three times value to fair value scares people to death. Millions of middle-class people made plans based on a belief that the phony numbers on their late 1990s portfolio statements reflected something real. People bought cars they couldn’t afford. People went on vacations they couldn’t afford. People bought houses they couldn’t afford.
Now those people (all of us) are scared.
That’s why prices will drop so low. Yes, it will be irrational for the P/E10 level to drop to 7 or 8. Irrationality begets irrationality. Insanely high prices lead to insanely low prices a few years later. It always happens that way. There is not one exception in the historical record.
Bear Market Analysis Point #6: We Can Overcome People’s Fears By Informing Them of the Realities
Does it have to happen that way? A 65 percent price drop may put us in the Second Great Depression. Can anything be done to head off this disaster?
Yes, something can be done.
We need to see a drop to P/E10 level of 14 or 15, fair value. The economic realities require that. But price drops below that are irrational and can be headed off by doing something about investor fears.
We need to start telling middle-class investors about the realities of stock investing. We have been filling people’s heads with dreamy Buy-and-Hold marketing slogans for 30 years now. We need to tell people what the academic research actually says — that valuations always affect long-term returns, that staying at the same stock allocation at all price levels is buying a ticket to the poor house.
Won’t that upset people?
It will indeed upset people.
But it will also help people come to terms with what they have done to themselves. Bull markets always cause huge economic and political destruction. We should never have let the bull of the 1990s (caused by the promotion of Buy-and-Hold strategies) get so out of hand. That’s over now. We need to act like grown-ups. We need to begin a rebuilding process.
When people learn the realities, they will regain their confidence in the future. No one can say when the 65 percent price drop is coming. But we don’t necessarily have a lot of time to waste. We need to get to work.
Bear Market Analysis Point #7: We Can Bring the Economic Crisis to an End By Acknowledging Our Mistake in Believing in Buy-and-Hold Investing
There’s a lot of good stuff waiting for us on the other side of the Big Black Mountain.
The Buy-and-Holders messed up. Big time. But you know what? They were also right about a lot of important stuff. Short-term timing really doesn’t work. Stocks really are a great asset class. Investors really do need to be focused on the long-term and to tune out the short-term noise. Index funds are the best choice for a majority of investors.
We need to take all the good stuff about Buy-and-Hold and put it in a package that does not include the Get Rich Quick component (the idea that it is okay to stay at the same stock allocation even when stock prices reach insanely dangerous levels) that has caused such human misery. I call this package of ideas “Valuation-Informed Investing.” I hope you will read other articles and listen to podcasts here at the www.PassionSaving.com site explaining what Valuation-Informed Indexing is all about and to share with your friends what you have learned and to encourage them to pay us visits as well.
It was no small group of people who got us into this mess. We messed up as a society. Now we need to dig ourselves out of the hole in the same way. It doesn’t have to be depressing. The most painful stage of the process is the stage we are going through today, the stage in which we all know on some level of consciousness that Buy-and-Hold has failed but in which most of us are still trying to pretend that somehow or other this is all going to go away without us working up the courage to say the Three Magic Words (“I” and “Was” and “Wrong”). Once we say those Three Magic Words, our fears lose their power over us and we become enabled to turn our focus from the past to the present.
I Was Wrong! I Was Wrong! I Was Wrong! I Was Wrong!
— Now it’s your turn!