Ok, I don’t want anybody to read this and then sell everything they have invested.
So, let me start with my approach to investing first and how I think you should approach the market.
There are a lot of bloggers and vloggers out there that will talk about all of the indicators they see and why they think we are due for a crash. And then will tell you they just sold everything.
DO NOT DO THAT!
I’ll admit. It’s fun for me to analyze the markets. And you will see at the end of this forum, that I do think things are overheated and that a crash could be coming pretty soon.
But that doesn’t mean that I’m selling everything I own, buying gold, and moving into a cave.
It might mean, that I increase my cash position from 5–10% to say 15–25%. And that will be done over time, in terms of many months and possibly years.
For example, I own a few shares of Slack (WORK), which just popped due to the rumored SalesForce Acquisition. So, I haven’t sold yet. But probably will soon. And I probably won’t re-deploy that capital and will just let it just sit in cash.
But if that nice little bit of news didn’t happen, I probably wouldn’t be selling anything. Maybe I take 1–2% off the table, then sit back and wait a few months, then after a particularly hot market run, maybe take another 1–2% off the table.
Because the crash never comes as fast as you think it will. Well at least until it does :)
The best way to look at whether a single Company is overvalued is to look at the Price to Earnings (PE) ratio. Some combination of PE ratio, compound annual growth rate (CAGR) and then a multitude of other factors. Type of revenue, market size, competition, positioning in the market etc. will determine a Companies value.
Valuing the entire market will be the same as valuing a Company.
Except, it’s even more simple. As all of the stuff about competition, positioning in the market and all of the other typical SWOT analysis stuff doesn’t matter when you are trying to value the entire market. As if you own a piece of the entire market, it doesn’t matter which Company wins… you win no matter who does.
So, when looking at the entire market let’s start with the PE ratio.
Here is a chart of the S&P 500 PE Ratio over the last 150 years. You can see the big spike due to the 2008 crash. As well, as the 2001 internet bubble. While currently we are a bit below those, we are definitely on the high end.
The problem, with looking at the PE ratio, is for example, in 2008 when the housing market crashed, banks started failing and credit seized up, it flowed through the economy. And therefore profits plummeted. And when your numerator plummets, it causes your ratio to shoot through the roof. But then it quickly gets back to normal.
Well, that is exactly what just happened in 2020. As we all know GDP plummeted 32.9% from Q1 to Q2. The PE Ratio is calculated off current market cap vs trailing twelve months profits. So, using TTM won’t really be reflective of the current market. If and when hopefully, things get back to normal in the next few months.
To solve this problem we use the Schiller PE Ratio. Which looks at the previous 10 year’s average earnings (adjusted for inflation) as compared to the market cap.
So, let’s look at the Schiller PE Ratio Historical Chart
As, you can see using the previous 10 year’s data smooths out the current PE ratio so we don’t have that huge spike in 2020.
But when you look at things relatively, we are still relatively high. Looks like we might be set for a drop in the near future.
But I want to look at one more chart before we make that call first. When you look at the value of a Company you can’t look at just growth rate. If you do then why would you buy say Amazon trading at around 90 or Tesla who’s PE ratio is even higher than that over say Ford who’s PE ratio is 7.0.
The reason is you are seeing much higher growth in Amazon and Tesla then you are in Ford. i.e. their CAGR is much higher than Ford.
So, let’s look at this S&P 500 mean growth rate chart.
Ok, so growth rate is -25.66%. Obviously, things are way overheated. Everybody sell now!
Well, actually, we have the same problem we had above with the PE ratio. This growth rate is factoring in the plummet in GDP over this last year.
If you expect things to go back to normal. Or you perhaps expect that there is a lot of pent up demand that will be released once the crisis is under control. Perhaps you think once enough people have been vaccinated that people will be going out to restaurants more, traveling more and overall spending more. Then that growth rate perhaps will move higher than the mean and the elevated PE ratios’s are justified.
I do think exactly that. How quick it arrives is one question. But I do think it will arrive. Even so, though, we are still at the high end of PE ratios. And so, I think that increased demand might drive things higher for a year or two and so…
How to Use This Information
And so slowly over time (maybe I don’t do anything until late 2021 (except for that Slack stock) actually) I will start to take some money off the table.
That means selling when a stock gets particularly high… and you don’t think it can go any higher… then it does… well then maybe I sell. Or selling off a percent or two of an index fund after a new S&P 500 high is reached.
But remember, never — ever sell it all off.
I read these stories on Medium, or see YouTube videos. I’m thinking about a story I read where Tim Denning sold everything and is waiting for the crash. Or on YouTube, I saw BeattheBush talking about how he sold everything.
So, anyway, I see these stories about selling it all. And here’s my experience about how those types of stories go. The crash doesn’t actually come. Until say 2022 or 2023 in this case. And these individuals hold out… and hold out… and then finally, a year or two from now they can’t stand they missed out on a 20% or 30% or 50% run in the market. Then they buy back in… then the crash comes in and they have just compounded bad timing, one on top of each other.
Time in the Market beasts Timing the Market
Some Qualitative Analysis
A real crash usually has a trigger. The bankruptcy of Bear Stearns for example in 2008 that started to unveil what was going on in banks and with the credit default swaps, and defaulting mortgages. We may have dips and pullbacks without a trigger. But a real 2001 or 2008 or even 2020 level crash will have a trigger.
Today some might look at what is going on with the “reddit” stocks. I.e. the “meme” stocks such as NIO and PLUG and think that’s a sign of “irrational exuberance” and a sign that things are about to end.
I agree that might be a sign of “irrational exuberance” but unless those types of stocks spread out beyond the current handful I don’t think that amount of money will impact the entire market.
As well as if things return to normal from this crazy 2020, I would expect general consumer optimism to rise. And if that happens then we’re less likely to have a crash in the short term.
We are still overheated, but will have to wait for that trigger, whatever it will be, to happen. And it could be a few years for that.
But here’s one last tip. I firmly believe you will lose more sitting on the sideline waiting for the crash then you will in the crash itself. So, don’t sell everything!