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Over the past 15 years or so, U.S. asset prices have gone through repeated cycles of boom and bust. Many investors thought this dangerous pattern would end following the financial crisis in 2008. But since hitting bottom in March 2009, the stock market has been on a tear, surging 166 percent in less than five years.
It’s clear that this is yet another asset bubble, and it’s clear what’s driving it — the Federal Reserve’s unprecedented quantitative easing program, which all but forces investors into the stock market. But just knowing that equities are in a bubble isn’t enough — investors want to know when that bubble will burst.
PE Ratios Are a Useless Risk-Management Tool
One of the most important jobs that any investor has — whether you’re playing with some extra cash in an online account or deciding how to allocate a multi-million dollar portfolio — is managing risk.
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| Successful investors know how to manage risk. |
So what’s the best way to monitor the market’s risk-reward profile? One popular method is through price-earnings ratios. But are elevated PE ratios really a reliable warning signal that the bubble is about to burst?
A good way to test this theory is by looking at the dot-com bubble in the late 1990s. On January 1, 1999, I was managing a mutual fund for Sir John Templeton. I remember that we were both worried about the stretched PE ratios in equities. The S&P 500 was trading at a PE ratio of 32, more than double its historical average. Meanwhile, the Nasdaq Composite’s PE ratio was an astonishing 90.
Based on these numbers, it was very tempting to play it safe and pull our money out of the stock market in anticipation of the inevitable bust. But if we had done that, we would have missed out on 15 additional months of the bull market, which returned 25 percent in the S&P 500, and 134 percent in the Nasdaq.
The moral of this story is that PE ratios make lousy timing tools. And the dot-com bubble is just one example — throughout history, PE ratios have proven to be useless in predicting busts.
A Bust Is Imminent
You may not be comfortable with the artificially inflated equity prices in today’s market environment. But as an analyst and editor at Weiss Research, my job is to help you make money and manage risk within the global financial system. So I don’t have to agree with the system; I just have to understand it. And for now, U.S. stocks are still the place to be.
Merry Christmas,
Douglas Davenport
