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Know This and You'll Never Have to Worry About the Market's Next Move

By Dan Ferris, editor, Extreme Value
Thursday, September 3, 2009

Everybody wants to know what the overall stock market will do next. Will it rise more? Will it fall? If it falls, will it be a small dip... or a giant crash?

Investors who think about questions like these too much aren't investors at all. You don't get to know what the stock market will do next. No one does, at least not often enough to profit consistently from it. Over the short term, the stock market is a random walk. You never know which direction its next step will be.

The antidote for the universal obsession with the market's ups and downs is learning how to think about its valuation. Here are the three numbers to watch...

1) Total stock market value as a percentage of GDP
[If total stock market capitalization divided by GDP] falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200% – as it did in 1999 and a part of 2000 – you are playing with fire. – Warren Buffett, in a 2001 Fortune article
Buffett should have noted "slam dunk" buy territory on this ratio doesn't really kick in until you get down around 50% or 60%... well below today's level. Greater than 100% is once-an-eon, "slam dunk" sell territory. It rarely gets above 90% and has spent decades under 75%.

Right now, it's at 84%. The stock market has become too large a part of the economy.

2) Earnings yields and price-to-earnings ratios for the big indexes

An earnings yield is simply a price-to-earnings (P/E) ratio turned upside down. A P/E of 10 = 10% earnings yield. A P/E of 20 = 5% earnings yield, and so on.

Right now, the S&P 500 trades for more than 117 times Standard & Poor's 2009 net income estimates... for an earnings yield of less than 1%. That's clearly a highly depressed level of earnings, strongly influenced by write-downs of loans, mortgages, and other financial assets. But even if you "normalize" net income back to pre-bubble levels, you still get more than 18 times net income, an earnings yield of 5.56%.

Earnings yield is a proxy for the type of return you may expect from stocks overall. At 5.56%, it's not very attractive.

3) Dividend yields for the big indexes

Dividends are probably the most important thing most stock market participants completely ignore.

In his excellent book, Behavioural Investing, James Montier showed that over the long term, dividends have provided more than half the returns from equities.

Think about the implications of this for a minute. You're fantasizing if you think you're going to learn to pick bottoms and make big capital gains on a regular enough basis to make any money. That doesn't happen.

You must learn to find the stocks worth holding over the long term, and they're almost always the ones that pay higher dividends every year. If you don't find those stocks and put most of your money into them and leave it there for a long time, you're never going to get rich in stocks, except by sheer dumb luck.

The Dow Jones Industrials yields 3.5%, the S&P 500 yields 2.6%, the Wilshire 5000 yields just 2.1%. At such low yields, inflation could easily put your real yield in negative territory. Slam-dunk buying territory is 5%-6% dividend yields.

So all the criteria that really matter tell the same story... Stocks are too expensive relative to GDP, earnings yields are low, and dividend yields are low.

Be very careful what you buy. In general, sell or avoid garbage. Buy only the best-quality stocks and only at extreme value prices. I've covered some of the safest, cheapest stocks to buy here.

Good investing,

Dan Ferris

P.S. With these numbers saying what they do, I don't think investors should feel optimistic about overall market returns. But if you want something to feel bullish about, one of the world's greatest "safe and cheap" assets is on sale right now.

These "gold-backed" annuities allow you to capture the enormous potential upside in precious metals right now... while offering a large amount of safety. Click here to learn more.

Market Notes


About that "big money volume" thing...

For the past several months, we've published several columns that offer the skeptic's take on the stock rally. The skeptic's take goes like this: Sure... the stock market has enjoyed a big price rise since June. But the rally has enjoyed scant participation from giant investors... the hedge funds, mutual funds, and insurance funds with multibillion-dollar piles of cash in their care. It is only with their participation that a healthy bull market can take place.

An easy way to track the big money is through shares of the SPY. A proxy for the benchmark S&P 500 index, it's the largest, most-liquid investment fund in the world. Today's chart features a pane at the bottom that displays the SPY's trading volume since March. Red bars are the volume on down days. Black bars are the volume on up days. The taller the bar, the greater the trading volume... the greater the market participation that day.

As you can see, volume dried up during the June-July rally. Big investors were either unconvinced of the market's value or on vacation. But take a look at that "tall tree" at the bottom right. It's the volume that came in on yesterday's huge 2.3% decline. That's the big money getting interested in selling the market.

Veteran market analyst Joe Granville used to say, "Volume is the steam that makes the choo-choo go." A skeptic would have to say what steam this market does have, it has it on the downside.

S&P 500 ETF

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