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Here's How You Figure Out Where the Market Is Headed Next

By Dan Ferris, editor, Extreme Value
Saturday, June 5, 2010

If you want to get an idea of where the overall stock market is likely headed in the next few years, just take a step back and think about Mr. Market's wild mood swings of the past few years...
After a three-year depression lifted in late 2002, Mr. Market became irrationally exuberant all over again. By late 2007, the S&P 500 hit a new all-time high. Stocks were king. Nobody thought about risk.
About a year later, risk was all anyone could think about. The market fell more than 50% from its late 2007 highs. That was the worst year since the Great Depression. Mr. Market continued to sink into an ever deeper funk as the market bottomed in March 2009.
From that point on, Mr. Market went back on the happy pills. He became more wildly manic than he's been in decades. At recent levels, the S&P 500 is up roughly 60% off its bottom.
Where are we now? The question is rarely this easy to answer.
The stock market is clearly overvalued by the three measures that count: price-to-earnings ratios, dividend yields, and the value of stocks relative to the whole economy. Let me show you...
The Wilshire 5000 Index covers all U.S. stocks from ExxonMobil down to those of less than $1 million in market cap. These stocks trade for around 23.4 times earnings. That's expensive. Flip that number upside down, and you get the "earnings yield" of the market. At 23.4 times earnings Mr. Market is offering you a 4.27% return on your money. That's not nearly enough. Inflation will destroy that return in the next few years.
The second important valuation measure of stocks is cash dividend yield. The yield on stocks right now is about 1.75%. At that rate, it'll take about 57 years to double your money. I'm 48 years old. I don't have 57 years to double my money. Dividend yields aren't in Extreme Value territory until they hit about 5% for the overall market.
Finally, U.S. stocks are currently valued at just about as much as the entire U.S. economy. The latest gross domestic product figure published by the Bureau of Economic Analysis is $14.6 trillion. The entire market capitalization of U.S. stocks is right around $14.5 trillion. Historically, the market has been overvalued above roughly 80% of GDP. Today, at close to 100%, the stock market is getting ridiculously overvalued. Mr. Market doesn't seem to understand there's a little more to the U.S. economy than 5,000 publicly traded companies.
I don't waste time predicting the short-term direction of the market. I only assess valuations and make a judgment based on how cheap or dear the market appears to be.
Stocks are pieces of businesses, and Mr. Market is asking too much for most businesses these days. Either the businesses rapidly grow in value, or the market corrects. It's not hard to believe a market correction is more likely than ubiquitous hypergrowth.
Moments like right now are when a compulsion to buy stocks will serve you worst. Don't buy any stock that isn't financially strong and demonstrably cheap.
For example, I love the idea of buying a cash-gushing, World Dominating franchise like Microsoft for around 10 times cash flow... or paying well under 10 times cash flow for ExxonMobil, the world's best-managed big oil company. I can't stand the idea of paying 15 or 20 times cash flow for your average retail, homebuilder, or tech stock.
Microsoft and ExxonMobil are both dirt cheap right now... and I'm willing to bet they'll be dominating their industries and treating shareholders right five, 10, probably 20 years from now. I can't say the same about the vast majority of the overpriced Wilshire 5000.
If you're like me – concerned about the overpriced market, concerned about another leg down in the housing market, and skeptical of Washington D.C.'s plan to borrow and spend our way out of debt – World Dominating companies are where you want your stock portfolio to be.
Good investing,
Dan Ferris

Further Reading:

Everyone wants to know what the market will do next. But as Dan pointed out last year, "Investors who think about questions like these too much aren't investors at all." The antidote, he says, "is learning how to think about valuation." Get more details on the most important measures of value here: Know This and You'll Never Have to Worry About the Market's Next Move.

Dan's not the only guy casting a skeptical eye on the market's high price-to-earnings ratio. Steve Sjuggerud crunched the numbers, too. He says, "You don't make money over the long run when you buy stocks as expensive as they are today." Take a look at the charts that prove it here: Five-Year Outlook in Stocks: You'll Lose Money.

Market Notes


Our chart of the week displays the past six month's action in the July 2010 NYMEX copper futures. This is the most liquid futures contract trading in America right now.
We watch copper because it's a major ingredient in cars, houses, appliances, electronics, and power grids. This "in everything" attribute makes the copper price an excellent indicator of what's happening in the global economy.
Copper enjoyed a huge "stimulus" rally in 2009. Then, as you can see from the chart below, the metal suffered a correction along with most all assets in January (A). This correction took copper down to $2.88 per pound. Copper then staged a rally into the $3.60 area (B). But in the past month, copper has sold off heavily... and just yesterday, it violated that past low (C). Trend traders call this action a "downside breakout."
As we mentioned on Wednesday, the great investment question of the summer is: "Was the May selloff in stocks and commodities the start of hard times to come? Or just a correction to the intact rally?"
We don't like being the bearer of bad news, but we must note that further weakness here answers that question with, "There may be hard times to come."

Copper's MAJOR downside breakout

Stat of the week


Year-to-date decline in the share price of Banco Santander (STD), the largest bank in the Eurozone. The stock hit a new 52-week low on Friday.

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