The sensible investor generally operates on the basis of value. You buy shares in a good company, hold them and let the business pay you dividends and make you better off through growth.
That’s the basics.
However these sound principles are fast left behind by the gambling urge. Logic is dumped for emotions. Numbers are ignored for words. Tactic and ego replace strategy and sense.
You used to be able to see this clearly in a trading pit. At one end of the process was a stately board room calmly setting a company’s governance and direction, at the other the S&P futures pit with screaming men scream and waving like people trying to stampede out of a burning theatre.
That panic is never more seen than in a crash. A bubble can create some wild animal emotions but the compressed time scale of a slump magnifies these energies and create an environment where from moment to moment almost anything can happen.
Under the surface of this dramas and froth are realities and as the time horizon stretches out and values are smudged by moving averages, real values are revealed.
This is where the profits are and they are heafty or those who can grasp them and have the patience to ride out the cycle of fear and greed that rack markets.
Right now the equity markets are buffeted with volatility. The dow goes up 200 or three hundred points one day and back down the next. These swing were common place before the central banks of the west fix the markets via QE and the volatility is back because the US is not growing QE and gently letting go its strangle hold of asset prices like stocks.
The market has corrected and may do another leg down to a crash. Crashes are a 25% drop from a high and right now the Dow is down xxx%.
Most crashes settle at 25%, but really large ones like 1929 can go 75%.
The question is therefore what the fundamental status of valuations in the market is? Are stocks ridiculously high? What is the real price.
For this we need a model. The simpler the model the better.
I like the Dow. It is the ultimate bellwether, even if it is eccentric. The world looks to the Dow first to test the days market strength or weakness.
Another market cliché is P/E, roughly speaking how many years of profit you can buy a company for. Accountancy is never that simple of course but as an approximation of value it will do.
A high P/E is a sign of an expensive market, a low one a cheap market.
So lets look at the P/E of the Dow. (Strangely its hard to get a repeatable number for the P/E’s of even the biggest companies, but if you blend and round to the nearest number the figure is 18.
A P/E of 18 is not expensive. It is also not cheap.
London’s FTSE’s P/E is 20, if you take the top 30 stocks and massage the numbers a bit. The FTSE’s biggest companies have outliers unlike the Dow 30. Once you drop the 3 highest P/E and the 3 lowest of the top 30 FTSE companies the average P/E is also 18 to the nearest number.
So you can say that if you take a fat sample of the US and UK’s biggest companies, the ones that move the index and market, then the p/e is 18.
Under 10 is deep value. A 15 p/e is a kind of norm.
So if the market was to correct to a goldilocks P/E of 15 then the Dow would hit 13500.
If the market hit 12 p/e, a level of P/E that companies like Walmart, IBM, Intel and Caterpillar oscillate around, the Dow would be 10866. While Exxon and Chevron trade below 10 p/e, if the Dow was trading at that average it would be 9000.
So what p/e is a solid base?
I would think a p/e of 15 as an average would be a good mid-point, which is not say you you would not expect prices to move aeround that point a fairly broad range.
For me this make 13000-13500 the level to watch out for if the market takes another leg down.
Recession in the emerging markets need not put a damper on economic growth in the developed world. This might seem questionable, but the emerging markets were in boom just when the US, Europe and Japan were suffering most. So if the emerging markets can prosper when the key markets are in trouble the opposite should also be possible.
While 16000 could be a bottom, it is good to have a feel for what could follow and while I’d like the current correction levels to be the final say, it looks like an option rather than a highly likely path.
The markets are changing and a period of uncertainty is on us. Ultimately uncertainty is bad for prices and therefore a lower average p/e for the market is highly likely.