Sunday, April 18, 2010

Dow 11,000

Because I am in general a financial "party pooper," bringing in and highlighting facts, that "no, I'm sorry Suburban Sue, your house is not worth that much and you shouldn't have taken out that HUGE home equity loan to pay for your child's "masters in communications" degree," it is therefore behooved upon me to point out yet another sad fact for those who are woefully financially ignorant (which is most of the population).

I know you're all giggity giggity about the Dow breaking 11,000. But sadly, nobody paid attention to that all important economic lesson - CASH FLOWS DRIVE MARKET PRICES.

You see, prices can go up and down all they want, whether they are actually worth that price depends on the cash profits those assets generation. So yes, you can be very happy the Dow is up to 11,000, but did corporate earnings go up by a proportional amount?

Well, here's your answer;


You see, the PE ratio of the US stock market (as measured by Prof. Robert Shiller) compares the price of a stock to its earnings. Historically this has averaged around a ratio of 15 - 15 dollars in stock price for every dollar in earnings. And after the stock market crashed due to the housing market, stocks were ever so briefly "accurately valued." Meaning they weren't a steal or a great buy, nor were they overpriced.

Of course, that lasted about as long as sanity usually lasts in the financial markets and stock prices once again rallied, driving the PE ratio up to 22.10.

What does this mean for you the average investor? Well, for those of you who religiously invest in your 401k or 403b, you better pay very close attention to the prices you're paying for those stocks and mutual funds. For younger investors, I don't even know why you would invest in a stock market when not only it's overvalued, but it's progressively likely your "Roth" IRA or 401k plan will simply be nationalized and taken over by the government (much like they did in Argentina) to fund unfundable entitlement programs.

But I know, I know, I'm shouting into a hurricane. Why ruin everybody's good time?

Let's just party because an index broke an arbitrary number like 11,000.

8 comments:

Dan Lavatan said...

I think many people use 401k(s) because megacorps provide matching funds which are of greater value than ordinary pay even with the additional tax penalty.

It would be helpful to know which assets are least likley to loose value between now and a reasonable liquidation period, such as the end of the year.

Anonymous said...

Since you can just pay the 10% penalty for early withdrawal, shouldn't you wait on liquidating your 401k until they actually pass a confiscation law? The drag on earnings of an annual tax is huge in terms of future value, and NPV analysis says you should always delay paying taxes because future dollars are worth less, even if you pay the same amount (in some cases more) of tax in nominal dollars. This is especially true if the government turns to inflation to pay its debts, because tax brackets are inflation indexed.

Anonymous said...

What is the source of the P/E graph?

Anonymous said...

Never mind about the source of the CAPE graph. I found it.

I've been looking for this for a while. Thank you for posting it.

Anonymous said...

Randian:

In theory, you are very right. However that presupposed the normal rule of law holds, which it hasn't for some time. In this country, we now have to take into account the same "sovereign risk" or "regime risk" domestically as we would with foreign investments. IF retirement funds are expropriated, it will not be after a public battle in Congress. It will be by Executive Order in the middle of the night with no warning. It becomes a matter of judgment as to how long you feel safe leaving the 401k alone, and having somewhere safe to move any funds you can salvage. Any investment, any savings in this country faces the same risk as if it were in Venezuela, for the same reasons.

Subotai Bahadur

Anonymous said...

While I agree 11,000 is an arbitrary number, the P/E ratios are a reflection on the market's perception of the near to mid term growth rates. I do agree with you in the assertion that the market is excessively bullish at the moment, but P/E multiples should be higher during times of perceived future growth. 22 isn't exactly 50.

MTGirl said...

Capt, for those of us who do participate in a 401k, do you think there are some fund families that safer/more aaccurately valued out there than others? I'm thinking of maybe the metals funds or the foreign businesses funds? I contribute a little through one of my employers and they offer us a variety of mutual funds to invest in, so I would appreciate any (free) advice you might have....

Anonymous said...

Another thing to consider is that if you're eligible for a Solo 401k, or run your own company, you can be the plan's trustee. Since you have custody of the plan's assets, and unlike commercial custodians can't be threatened with loss of your license to do business if you refuse to hand over the plan's assets, you can be assured of your ability to liquidate the plan if an order of confiscation is given.