The outlook for traditional investments has rarely been worse. The stock market has only been this expensive three times since 1880, when accurate records started to be collected. The bond market is perhaps even worse! Bond prices have never been as high as they are now. What is an investor to do? Historically, the answer has been, “Move to cash.” But cash will earn you essentially 0% these days, and after inflation takes its toll, you’re losing money. In today’s post, we are going to look at stocks. The next two posts will cover bonds and cash, respectively, and the post after those will cover the answer you’re looking for: what the heck can we actually invest in to make money?
How can we know if stocks are expensive or not? The price to earnings (P/E) ratio gives us a great indicator. Simply put, the price to earnings (P/E) ratio tells you how many dollars you must invest a company in exchange for one dollar of earnings (or profit) the company makes in one year. So if a company has a P/E ratio of 5, then you must invest $5 for every $1 the company makes in profits in one year. That doesn’t sound too bad, right?
What if I told you the average P/E ratio for US stocks right now is 26? Well, it is. A slightly modified version of the P/E ratio, developed by the Economics Nobel prize winner Robert Shiller, stands at 26 as we speak. Check out the chart:
A P/E ratio of 26 means that you’d have to hand over a whopping $26 in exchange for $1 in profit. This has historically meant that there is no money to be made in stocks, and everyone starts selling, causing a market meltdown. In fact, there have only been three times in recorded US history when the Shiller P/E ratio has been this high: 1929, 1999, and 2007. Following 1929, we experienced the Great Depression, and stocks fell 84%. Following the tech bubble of 1999, stocks fell 46%. Following the housing bubble of 2007, we experienced the Great Recession, and stocks fell 55%.
Perma-bulls (or people who always think the market is going up) commonly rebut, “The future of the economy is SO bright that this expensive stock market is warranted.” Well, that’s exactly what people said in 1929, 1999, and 2007. But let’s give them the benefit of the doubt and actually go over factors that drive the economy:
First, demographics. Historically when a large number of people enter the workforce, growth booms. When women began entering the workforce in large numbers in the 60’s and 70’s, growth surged. When adolescents age into adults, growth surges. Now, a huge part of the population is leaving the workforce. The Baby Boomers are retiring, and they’re a huge generation.
Second, the ability to borrow money to fuel growth. This isn’t going to be happening again for a while. In the last 30 years, much of the growth in the economy has stemmed from the government and companies which borrowed money to fuel growth. In short, we’re maxed out on debt. The punch bowl is empty. Now, resources are going towards paying down debt instead of towards machinery, hiring, and innovation.
Third, the Federal Reserve is almost out of ammo. Historically, the Fed has been able to lower interest rates to spur growth. By lowering interest rates, the cost to borrow money goes down. Therefore, businesses and individuals are more likely to borrow money to expand or start businesses. Now, interest rates are essentially zero, and while the Fed has indicated that they’re open to negative interest rates (!!), negative rates in Europe and Japan have failed to boost their economies.
These are three major drivers of growth. Their outlooks are certainly bleak, and when combined with crazy high P/E ratios, I see a perfect storm brewing for stocks. I would be surprised if we don’t see a major drop in the stock market within the next year. If you insist on investing in stocks, stick with consumer staple companies like Kroger (KR) and Walmart (WMT), healthcare stocks like Johnson & Johnson (JNJ), and utility stocks like Southern Company (SO). These companies will be able to better weather the storm because their products will be in demand come hell or high water. Otherwise, invest in precious metals or short to intermediate term municipal and treasury bonds.