MONEY

What To Expect From This Crazy Market

Sharp one-day drops in the market can be unnerving, but they haven't changed the basic math of investing.

You know the advice: Ignore stock market swings. They don’t mean anything. Just buy and hold.

Of course, that’s easy counsel to live by when the swinging is mostly upwards. It’s even possible to follow such advice after a long market decline, once you’ve gotten used to the bad news. And near the bottom, when even the pessimists start to express some optimism, well, then it’s fairly easy to stay the course.

Times like now, however, are a true test of a long-term investor’s resolve. After a bull-market run so smooth that pundits were complaining about “complacency,” the Dow has delivered a string of triple-digit daily drops, confusingly interrupted by a 274-point rally last Wednesday. At such times, your head is saying no one can reliably predict the market’s next flush of fear or greed. But your gut worries that maybe something’s about to break.

The reality, though, is that if you look at the factors that really drive the long-run returns you care about, the market doesn’t look much different than it did a week ago. Which is to say: It’s priced to deliver kind of meh returns. But those returns still look better than your easiest alternative, bonds.

There’s a very simple Finance 101 way to think about what you’ll make on equities. In essence, a stock is just a claim on the flow of cash from a company. You can think of that as the company’s earnings, or—if you want to keep things tangible—as the dividend checks it pays to investors. (No, not all companies pay dividends, but in theory that’s the eventual purpose of all profits.) Right now, investors who own an S&P 500 index fund get paid a dividend yield of about 2% per year.

The nice thing about a dividend yield is that it’s not just a measure of how much income your investment is delivering to you. It can also tell you whether stocks are generally cheap or expensive. Imagine that a stock paying out $2 in dividends per share is trading at $100—that’s a 2% yield. Now say it falls in price by $35. Terrible news for current holders, but potential buyers can now get the same $2 payout for just $65 a share—a 3% yield. In that light, the stock looks like a better bargain.

So: Low dividend yields suggest pricey stocks, and higher dividend yields cheaper. Right now, even after the recent declines, dividend yields look okay but not fat, just as they have for a while:

ycharts_chart-14

Note that the almost 4% dividends came in 2009, when stocks were at the bottom of the post-crisis crash. Around 2000, at the peak of the tech bubble, yields were about 1%.

Wait, does all this mean I’m only getting a 2% return on stocks? No, it doesn’t, because you also buy stocks expecting their earnings or dividends to grow over time. Using a somewhat simplified, classic rule of thumb — I’m relying on Bill Bernstein‘s book The Investor’s Manifesto plus this useful paper (PDF) from the money managers Research Affiliates — the expected return on stocks right now is the 2% dividend yield plus the historic rate of growth in dividends or earnings-per-share of about 1.5%. So think 3.5%, maybe 4%.

That’s a real return above inflation, but still a disappointment compared to the 7% historic rate for equities since 1926. Then again, it’s much better than the fixed-income alternatives: The real yield on inflation-adjusted Treasury bonds, or TIPS, is 0.35%.

A 4% return is just a baseline. If investors collectively decide they want to value stocks higher in the future, and can live with lower yield payouts, you’ll get a bump on your investment today. If they lose their taste for the risk of stocks, you’ll do worse. But that’s driven by whatever goes on deep inside the wet, gray stuff under millions of investors’ skulls, not the profitability of the companies you buy today.

The past six market days have hardly nudged this math, except to move it slightly toward stocks being a better bargain. Before the start of last week, the S&P had a one-year total return of more than 18%. Now it’s one-year return has tumbled to 12%. That’s disappointing and, yes, anxiety provoking. But if you see 4% annual return as your basic expectation, reversals from years of high gains should come as no great surprise.

MONEY stocks

5 Ways To Tell If There’s More Trouble Ahead for Stocks

Is Monday's triple-digit loss the start of something worse — like a bear market? Here are five things to watch for in the coming days and weeks.

On Monday, the Dow Jones industrial average sank more than 223 points, marking the fifth straight day of triple-digit moves in the closely watched benchmark.

Technically, this is just a “pullback,” which is loosely defined as a drop of around 5%.

^SPX Chart

^SPX data by YCharts

The S&P 500 index has yet to reach a correction, or a 10% plunge. And the broad market is nowhere close to bear market territory, which is a sustained 20% decline in stock prices.

Still, as MONEY recently pointed out, this bull market is starting to show its age. So it’s hard not to wonder if a bear is lurking.

If you’re worried there are more troubled days ahead for equities, here are five things to watch for in the coming days and weeks:

1) Are companies reporting disappointing earnings results?

“I’d be listening to and watching third-quarter earnings reports,” says Liz Ann Sonders, chief investment strategist at the brokerage Charles Schwab.

Why? First, some companies face a new headwind in the form of the stronger dollar. While the strengthening U.S. currency is a sign of global confidence in the U.S. economy, it creates problems for American businesses. A mighty dollar makes it harder for U.S. exporters to sell their goods competitively overseas, which could crimp corporate earnings growth.

Robert Landry, a portfolio manager for USAA, put it this way:

We’re paying attention to whether companies beat, meet or fall short of revenue and earnings estimates. According to FactSet, average sales growth for the S&P 500 is expected to be 3.6% year-over-year and profit growth at 4.6%. The latter number is roughly half of where expectations stood back in late June.

What’s more, many investors think the stock market — at least prior to this sell off — was getting ahead of itself this year. Indeed, the price/earnings ratio (a common measure used to gauge market valuations) for the S&P 500 index had shot up higher than 18, based on the past 12 months of profits. That’s compared to an historic average of around 15. To justify those higher-than-average P/E ratios, investors want to see higher-than-expected earnings growth rates. The volatility of recent days suggests a worry that the bar’s been set too high.

2) Are commodity prices sliding?

The selloff in blue chip stocks recently has “coincided with mounting evidence of a global economic slowdown,” says Edward Yardeni, president and chief investment strategist at Yardeni Research.

Indeed, the reason why the dollar has been strengthening in the first place is that while the U.S. economy has been improving, Europe and Japan are both perilously close to slipping back into recession — for the third time since the start of the global financial panic.

Yardeni adds that global slowdown fears have grown in recent days as industrial commodity prices, including crude oil, have dropped sharply. (This isn’t a big surprise: Slower-than-expected growth in Europe, China and Japan has led to weaker demand for things like steel, copper and oil.)

David Kelly, chief global strategist for J.P. Morgan Funds, notes that Europe is set to release industrial production figures for August this week, along with data on inflation trends. If there’s even a whiff of deflation in the Eurozone — led by tumbling commodity prices — expect another bout of handwringing on Wall Street.

3) Are small stocks getting mauled?
While investors typically pay more attention to large blue-chip stocks, shares of smaller companies can be a harbinger of things to come for the broad market. Why? Because of their size, tiny stocks tend to be more volatile in general and the underlying companies are more easily rattled by changes in the economy.

The bad news is, the market’s tiniest publicly traded companies are already in a correction, as measured by the Russell Micro-cap Index. And should they slide into an official bear — which could be just days away — things could get really dicey on Wall Street.

^RTM Chart

^RTM data by Charts

Sam Stovall, U.S. equity strategist for S&P Capital IQ, noted that there have been 10 calendar years that small stocks have declined in price since 1979. “Of those 10 times,” he said, nine of the S&P 500’s 10 annual returns were 3.5% or less, and six of the 10 years were negative.” What’s more, for all 10 observations, “the S&P 500 posted an average annual price decline of 4.6%,” he said.

4) How is the Nasdaq composite index holding up?

Another canary in the coalmine for the broad market, according to market observers, is the Nasdaq composite index. Relative to S&P 500 or the Dow, the Nasdaq tends to be made up of slightly smaller, faster-growing and economically sensitive companies. In fact, technology stocks still make up around 45% of the index.

This is why in years when stocks slip, the Nasdaq tends to skid further. This happened in 1994, 2000, 2001, 2002, and 2008.

So far this year, the Nasdaq is close to entering into a correction. Should the Nasdaq’s 8% loss expand to 10% or more, look for more volatility in the S&P and Dow.

^IXIC Chart

^IXIC data by Charts

5) Is China’s economy growing less than 7%?

Continuing worries about China have contributed to the recent sell off in stocks. China’s economy, which had been growing as fast as 9% in 2012, slowed to 7.5% in the second quarter. That figure is expected to fall even further, to 7.3% in the third quarter. Some economists, in fact, are bracing for 7% growth or below.

Why is this important?

Brian Jackson, China economist for IHS Global Insight, notes that China’s leaders “signaled somewhere between 7% and 7.2% as a ‘bottom line’ for growth to meet job creation needs; IHS estimates that 7.2% is necessary to generate the roughly 13 million jobs annually to satisfy new job market entrants.”

Should GDP growth slip below 7%, policymakers in China may have start thinking outside the box. And Wall Street hates the unexpected — especially when it comes to governments and economic policy.

MONEY stock market

7 Years Later, Is the Bear Stalking Again?

Grizzly Bear
Scott Markewitz—GalleryStock

While the start of the 2007-2009 bear market now seems a lifetime away, there are a number of similarities between this market and that one that makes it hard to forget.

Exactly seven years ago today, the stock market fell into the worst bear market this side of the Great Depression.

The crash, which unfolded from Oct. 9, 2007 to March 9, 2009, obliterated more than half of the total value of the U.S. stock market and threatened the very existence of iconic companies from General Motors to Merrill Lynch.

Of course, all of this seems like ancient history now that the stock market has fully recovered — and then some.

^SPX Chart

^SPX data by YCharts

After the fourth-longest bull market in history, the Dow Jones industrial average and the S&P 500 are both near all-time highs. The housing market is slowly but surely recovering. And the U.S. economy has recently been growing at an annual rate of 4.6%.

Sounds like a totally different scene than seven years ago, when the economy was about to slip into a recession, the housing market was melting down, and the global financial panic was at full tilt.

Yet if you start digging into the details, there are a number of glaring similarities between today’s market and where Wall Street was on this fateful day seven years ago.

The bull market is aging. The stock market rally was an older-than-average five years old on Oct. 9, 2007. On Oct. 9, 2014, the bull is an even-older-than-average five and a half years old.

The market is starting to look its age. One way to tell if a bull is losing steam is to see how many stocks are actually participating in the rally. In 2007, the percent of companies in the S&P 1500 total stock market index that were outperforming the broad market fell to a lower-than-average 35%. Today, it’s even lower at 30%.

The market is pricey. The price/earnings ratio for the S&P 500, based on projected corporate profits, stood at 15.2 on Oct. 9, 2007. Today, that P/E ratio is an even-higher-than-average 16.2.

The market is pricey, part 2. There’s another way to measure the market’s P/E, using 10 years of average profits. In October 2007, the S&P 500’s so-called Shiller P/E stood at 27. That marked one of only four sustained periods in history where this P/E ratio climbed and remained above 25. Today, the market’s Shiller P/E is at 26.

Since 1926, whenever this measure has exceeded 25, the average inflation-adjusted annual return for stocks has been a mere 0.5% over the subsequent decade. By contrast, the historic annual real return for stocks is closer to 7%.

Greed is back. Seven years ago, merger & acquisition activity in the U.S. hit a record high, as risk-taking returned to Wall Street. Today, M&A activity, based on the total number of deals, is on pace to be even higher.

Confidence is back. When company executives are confident that the market isn’t fully appreciating the strength of their business, they initiate stock buybacks of their company’s shares, on the theory that their own stock represents a good value. The Wall Street Journal recently reported that stock buybacks totaled $338 billion in the first half of this year. That marked the highest level of activity in any six-month period since 2007.

Risk-taking is back. You know investors are getting aggressive when they’re willing to use borrowed money to make their bets. The last times margin loan debt as a percentage of GDP exceeded 2.5% were in 2000 and 2007. Well, today, it’s back above this threshold.

Does this mean that the bull market is about to end? Not necessarily. These are signs of an aging bull, not necessarily precise predictors of when the market is about to turn. Still, after growing accustomed to seeing stocks go up and up and up for several years, it’s time to reflect on how scary the market can be when investors grow complacent.

MONEY financial crisis

6 Years Later, 7 Lessons from Lehman’s Collapse

Lehman Brothers world headquarters is shown Monday, Sept. 15, 2008 in New York.
Lehman Brothers world headquarters is shown Monday, Sept. 15, 2008 in New York. Lehman Brothers, burdened by $60 billion in soured real-estate holdings, filed a Chapter 11 bankruptcy petition in U.S. Bankruptcy Court after attempts to rescue the 158-year-old firm failed. Mark Lennihan—Reuters

The venerable investment bank Lehman Brothers went under six years ago today. While Wall Street has recovered from the financial crisis that resulted, lessons endure for Main Street investors.

Exactly six years ago today, Wall Street came closer to imploding than at any other time since the Great Depression.

That was when the venerable investment bank Lehman Brothers filed for bankruptcy on Sept. 15, 2008, amid the global mortgage meltdown, triggering a cascade effect across Wall Street. Within days, the insurer AIG had to be bailed out by the federal government while other investment banks, including Morgan Stanley and Merrill Lynch, were pushed to the brink. Merrill, in fact, was eventually sold amid panic to Bank of America.

Six years later, the nation’s financial system seems to have largely healed. Banks are back to posting record profits. Over the past several years, financial stocks have been among the hottest areas of the market.

^DWCB Chart

^DWCB data by YCharts

And with the housing market recovering, even the dreaded mortgage-backed security — the type of bond that triggered the financial panic in the first place starting in 2007 — are back in fashion.

But even if it seems like it’s business as usual on Wall Street, for Main Street investors key lessons endure. Here are 7 of them.

Lesson #1: The price you pay for stocks matters. Really.

The media’s narrative is that the stock market plummeted into an historic bear market because of the global financial panic. That may be true, but equities may not have fallen that far — and for that long — if the circumstances weren’t ripe for a correction.

Remember that in October 2007, the price/earnings ratio for the stock market — based on 10 years of average profits — rose above 25, marking one of only a handful of times that market valuations rose so high. Not surprisingly, the stock market went on to lose 57% of its value from October 9, 2007, through March 9, 2009. (As an aside, the stock market’s so-called normalized P/E ratio is back above 25 again today.)

By March 2009, the P/E ratio for the S&P 500 had sunk to an historically low 13 (the historic average is closer to 16), which has been a signal of buying opportunities. Had you invested at that moment — listening to the Warren Buffett rule that says “be greedy when others are fearful and fearful when others are greedy” — you would have enjoyed total returns of 230% ever since.

Lesson #2: Don’t bank on any one group of stocks — even financials.

The turmoil after Lehman’s collapse was different and more frightening than the bursting of the Internet bubble in 2000. Why? This time the stocks that took the biggest hits weren’t shares of profitless startups that no one had ever heard of. In this crisis, the biggest losers were financial titans — some more than a century old — that produced a third of the market’s profits and dividends. No wonder these blue chips were fixtures in many retirement portfolios.

The love affair is clearly over … or is it? Financials have been among the market’s best performers since September 2011, having doubled in value in three short years. As a result, bank stocks, which made up less than 9% of the S&P 500 in 2009, based on total stock market value, now represent more than 16% of the broad market. That means they’re probably among the biggest holdings in your stock mutual funds and ETFs.

Lesson #3: Buy and hold works — eventually.

When the Dow fell to 6547 on March 9, 2009, stocks had already lost more than half their value. And equities wouldn’t fully recover until 2013. So it may seem that investors who pulled $25 billion out of stock funds in March and $240 billion over the next three years — plowing that money into bonds — were on the right track.

They weren’t. March 2009 marked the start of a bull market that saw stocks return 230% so far. Had you simply hung on to a basic 70% equity/30% bond strategy from Sept. 1, 2008, when things started to get scary, you’d have earned nearly the 9% historical annual return for this mix over five-year stretches since 1926. Of course, you’d have earned that only by staying the course.

Lesson #4: There is no such thing as a “conservative” or stable stock.

In past crashes, pundits always pointed out that the “safe” place to be is among giant, blue chip stocks that pay dividends and that are industry leaders. Well, Lehman Brothers, Citigroup, Merrill Lynch, and AIG all fell under those descriptions. Yet all of those stocks plunged more than the broad market.

This taught investors a huge lesson: Treat all stocks as the volatile, unpredictable creatures that they are. Even dividends, which are synonymous with financially stable, conservatively run companies, can’t be trusted, because during the crisis, the financial sector began slashing dividend payments to safeguard their finances.

Lesson #5: Reaching for yield can lead to a fall.

When stocks fall, the stability of cash can cushion the blow. Yet things don’t necessarily work out that way.

Just ask shareholders of Schwab YieldPlus. This so-called ultrashort bond fund — which was marketed as a cash alternative, though it really wasn’t one — fell 35% in 2008 when the mortgage securities that provided the “plus” in the fund’s name turned out to be riskier than thought. (In January 2011 Schwab settled the charges that it misled investors but did not admit wrongdoing.)

Before that, there was the Reserve Fund, the first money fund in 14 years to lose value in part because it tried to boost payouts by holding some Lehman debt.

It makes no sense to take risks with your rainy-day savings, a lesson that’s worth remembering today. Since early 2009, investors have poured billions of dollars into floating-rate bond funds, which buy short bank loans that offer higher payouts than basic cash, as well as ultrashort bond funds.

Lesson #6: Diversification works — but in diverse ways.

In 2008, only one type of diversification seemed to pan out: your basic mix of stocks and bonds. Among equities, everything pretty much fell in lockstep.

Fast-forward more than three years, when the financial crisis unfolded in a different guise — this time with the debt crisis in Europe. Fear of government defaults peaked in early 2012, with rates on Greek debt reaching 29%. Diversification worked here, too, but also in a different guise.

While conventional wisdom said investors should flee the continent, European shares wound up beating the world in 2012, returning 20.3%. The year before that, it was U.S. stocks that performed the best (despite Uncle Sam’s fiscal woes). And in 2013, Japan led the way, despite having experienced another recession.

Spreading your bets globally eventually pays off, especially given how mercurial equities can be. For investors who are hearing that the U.S. looks like the only promising market these days, this is a clear lesson to heed.

Lesson #7: Stocks always recover; people don’t.

The Dow closes at an all-time high, but that’s cold comfort to those who retired in the past five years. Big upfront losses can crack a nest egg, even if the market later improves. That’s because your portfolio has the most potential earning power in the first few years after you get the gold watch.

Historically, investors have been able to tap anywhere from 4% all the way up to 10% of their savings annually based on how markets fared in this all-important first decade of retirement.

Over the next 10 years, return expectations are extremely modest, so even a 4% withdrawal rate may seem optimistic. For boomers nearing retirement, the trick is not to make matters worse, as two out of five older workers did in 2008 by keeping 70% or more of their 401(k)s in equities.

It’s time to dial down the risks in your portfolio — before the next downturn.

MONEY stock market

These 3 Simple Steps Will Protect You If There’s a Market Meltdown

melting chocolate coins
Lara Jo Regan—GalleryStock

Every time the stock market hits a new high, we hear rumblings of a potential crash. But you can stop worrying about a meltdown if you prepare yourself -- and your portfolio -- ahead of time.

It seems that every time the stock market hits a new high these days—or retreats from one—we hear rumblings of a potential crash. In an interview last week after the Standard & Poor’s 500 hit yet another peak, Yale professor Robert Shiller noted that stock valuations were near levels that preceded meltdowns in the past and thus were “a cause for concern.”

But if you’re investing for retirement, should the prospect of a bear market give you a serious case of the jitters?

I don’t want to downplay the effects that a market meltdown can trigger. It can wreak havoc with the economy. And if you’re on the verge of retirement and have a big portion of your savings in stocks, a setback on the order of the 2007-2009 50%+ drop in stock prices could force you to sharply scale back your post-career lifestyle or stay on the job longer than you want.

But if retirement is many years away, even a severe downturn isn’t necessarily a big deal. It could even work to your advantage, as the stocks you scoop up at at a market bottom can earn the highest long-term return.

Regardless of what stage of retirement planning you’re in—just starting out, mid-career, ready to retire, or already retired—there are two important things you need to know about market crashes. One is that there’s no avoiding them. Bear markets have been around as long as we’ve had stock markets. Since World War II alone, we’ve had eight major downturns averaging nearly 39% and lasting an average of 19 months. Big, scary dives in stock prices are a normal part of the investing landscape that will always be with us. Rather than trembling in fear of their onset, smart investors learn how to live with the certainty that sooner or later stock prices will collapse.

The second thing you need to know is that, far more important than the meltdown itself, is how you handle it. And that largely depends on how well you prepare ahead of the crash. Once a major correction is really under way, there’s not a whole lot you can do to stave off damage to your portfolio; indeed, scrambling to mitigate the damage may make matters worse. Nor can you depend on some gut instinct or trusty technical indicator to get you out of the market just before things fall apart. In retrospect, it’s always easy to see when the meltdown started. But in real time, it’s impossible to tell in the early stages of a bear market whether it’s The Big One or is just another false alarm.

So what should you do to prepare in advance for an inevitable market setback, while also staying positioned to share in the gains if the market continues to rise rather than drop (which ends up being the case most of the time)?

1) Know thyself. Start by getting a handle on your true appetite for risk, specifically how much of a drop in the value of your savings you can stand before you start unloading stocks in a panic. The Investor Questionnaire in RDR’s Retirement Toolbox can help you make this assessment. As you do this risk evaluation, keep in mind that investors have a tendency to underestimate how much risk they’re taking when stock prices are rising and overestimate the risks they’re taking after prices have plummeted. Be careful not to get swept up in irrational exuberance when the market’s on a tear, and avoid becoming overly pessimistic in the wake of a crash.

2) Adjust your investments accordingly. Next, make sure your portfolio jibes both with the level of risk you’re willing to accept, and that your mix of stocks and bonds makes sense given your investment goals. Reconciling these two aims can be tricky. If you’re risk-averse by nature, you may feel much better emotionally by hunkering down almost exclusively in bonds or cash. But such a low-risk portfolio may not give you the returns you’ll need to build an adequate nest egg or allow you to draw sufficient income from your savings once you’ve retired.

So you need to balance your emotional needs with your financial needs. Your aim is to end up with a portfolio that has enough exposure to stocks so that you have a decent shot at earning a reasonable rate of return, but not so stock-heavy that you’ll be reaching for the Maalox every time some pundit prophesies doom. The Retirement Income Calculator in RDR’s Retirement Toolbox can help you gauge whether the mix of stocks and bonds you’re contemplating can give you a reasonable shot at achieving your retirement goals.

3) Sit tight. Once you’ve done that, you should largely stick to your mix of stocks and bonds regardless of what’s going on in the market or how your portfolio is doing at any particular moment. That can be tough. You can always come up with reasons to justify straying from your investing principles or strategy “just this once.”

Resist that temptation. Often, what seems like a good move in the moment isn’t wise for the long run. In the spirit of full disclosure, I recently wrote a column explaining how I abandoned my investing principles years ago by selling shares of Warren Buffett’s Berkshire Hathaway company only seven months after buying them. As a result of that lapse, I missed out on a near $400,000 gain on that stock. Ouch.

Hanging on every twist and turn of the market is no way to live, especially in retirement. So instead, learn to live with the fact that the market is flighty and the knowledge that every now and then it’s going to tumble. Just prepare ahead of time, so you can handle that volatility, financially and emotionally.

Walter Updegrave is the editor of RealDealRetirement.com. He previously wrote the Ask the Expert column for MONEY and CNNMoney. You can reach him at walter@realdealretirement.com.

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MONEY

Are Stocks Overpriced?

James Montier (L) says stock returns won't keep up with inflation over the next seven years. Richard Bernstein (R) thinks the five-year-old bull market has several more years to run. Photos: joe pugliese

Facing a stock market that has doubled in price over the past five years—and with memories of the last market collapse still vivid—you can’t help but wonder: Is another disaster lurking around the corner?

Holding vastly different opinions are two strategists with decades of insight and experience. Richard Bernstein, former chief investment strategist at Merrill Lynch, now an adviser to funds for Eaton Vance, is bullish. James Montier, who helps manage $117 billion at GMO — itself an adviser to two Wells Fargo funds — is bearish.

Both make strong arguments — ones that may challenge your view of today’s investing climate.

THE BULL: RICHARD BERNSTEIN

Are stocks overpriced?

The market is priced roughly at fair value. You have to look at valuations in light of inflation. Our firm uses sophisticated models for that, but a rule of thumb is that the price/earnings multiple and the inflation rate should add up to less than 20.

Inflation is now at about 1.5%. The P/E for stocks in the Standard & Poor’s 500, as we speak, is about 17, based on trailing earnings. So a little below 20, or roughly fair value.

Related: American Airline employees locked out of 401(k) funds — here’s why

Stocks are not cheap, but that doesn’t mean the bull market is over. Pension funds in the U.S. have their lowest equity allocations in 40 years. Wall Street strategists recommend an underweight of equities. I’ve found, over three decades, that the consensus asset allocation is a very reliable contrary indicator of where the market is headed.

A version of the P/E that carries a lot of weight now is the one championed by Yale’s Robert Shiller. By that measure, based on 10 years of earnings, P/Es are very high.

In the past, when these high Shiller P/Es signaled an overpriced market, we’ve had much higher rates of inflation than we do now.

Related: Tools to make your money grow

When interest rates and inflation decrease, P/Es tend to expand. When rates or inflation rise, P/Es contract. The theory is that inflation eats away at a company’s future value, for several reasons. Earnings might rise, but inflation-adjusted earnings might not. Earnings quality tends to decline, in part because you’re simply paying off debt with cheaper dollars. And overall investor confidence tends to deteriorate. So you have to adjust for inflation, but professor Shiller doesn’t.

If you do adjust for lower inflation, it predicts normal returns — about 8% to 9% a year. We look at more than valuation, though. For example, sentiment is still attractive. We actually think you’re going to get above-average returns — say, 10% to 15% a year over the next several years.

Two years? Five years?

I think we’re halfway through one of the biggest bull markets of our careers. The stock market has been up for the same reason it always goes up in an early-cycle environment. Expectations are extremely low, monetary and fiscal policies kick in, and the economy begins to grow. That’s what happens every cycle, and it happened this cycle too.

Now we are entering a mid-cycle phase in which you get the tug of war between rising rates — a bearish sign — and unanticipated improvement in the economy — a bullish sign. Sentiment isn’t exactly ebullient, and the economy keeps improving.

Related: How to get in trouble in your 401(k)

But when your readership believes there’s no risk in equities, the bull market is almost over. And in the kiss of death, the yield curve inverts, meaning that long-term interest rates drop below short-term rates. In other words, people are so desperate to lock in long-term rates that they pay more for them than for short-term rates.

Watching for an inverted yield curve will keep you out of trouble. That simple little indicator suggests the bond markets are beginning to expect significantly weaker growth. Generally this occurs before the stock market begins to anticipate slower growth. And we haven’t seen it yet.

You’ve noted that a classic sign of a bubble is increased use of borrowed money to invest. Margin buying of stocks is at a record high.

Nobody knows how much of that is long — betting that stocks will rise — and how much of it is short — betting stocks will fall. In the past, when individuals played a greater role in the market, you assumed that margin was used to be levered long. Today hedge funds are a much bigger force, and my research suggests they’re relatively neutral. Some of that margin is being used for shorting. So I don’t think increased leverage is driving up prices.

What other bubble indicators do you look for?

When sentiment becomes overwhelmingly bullish to the point where people jettison diversification, that is very, very worrisome.

Related: How we feel about our finances

You see that now in highflying tech, social media, some biotech. Valuations are so out of whack with reality. You’d think that people would have learned from the hot stove.

What do you say to analysts who worry that equities are inflated by the artificial suppression of interest rates by central banks?

I get that question all the time. The point of stimulative monetary policy has always been to artificially inflate asset prices. Interest rates are lowered so that people take more risks and multiples expand. Companies get a cheaper cost of capital, which they can then use to invest.

The notion that the Fed is the only reason the stock market is up is what people claim during the early stages of every bull market. The time to worry is when the Fed inflates asset prices too much and the characteristics of a bubble emerge.

What happens if earnings — the “E” in P/E — drop to historical norms?

Profit margins are at an all-time high. There’s no doubt about that. But profit levels are also a function of sales. When margins compress, companies generally start to fight for market share. We think earnings forecasts for large-cap multinationals may be way too optimistic; we are concerned about emerging markets and the impact they could have on multinationals’ earnings. But domestic U.S. manufacturing is gaining market share. I’m not talking about 3D printing. I’m talking about ball bearings and grease. Small- and mid-caps.

Examples, please?

I’m not a stock picker. But we believe investors should probably focus on more domestically oriented stocks and avoid emerging-market stocks as much as possible. In addition, since profit margins around the world seem likely to contract, investors should aim at market-share gainers. We like U.S. small-cap industrials. If you know the name of the company, the odds are that they have too much international exposure.

Also, I think that high-yield municipal bonds are a tremendous value play right now.

Really?

They yield more than high-yield corporates for the first time in history.

So when will you know your portfolio is overpriced — that it’s time to get out of small-cap industrials or high-yield munis?

We look at gaps between perception and reality. Over the past several years, the sentiment toward small-cap stocks, despite their superior performance, has been quite poor. But ultimately that gap between perception and reality will begin to change.

There will be more negative-earnings surprises because expectations get too high. Flows into small-cap funds will pick up. We’ll hear people talking about how cheap they are, as opposed to how expensive they are. [Laughs.] Then we’ll find other investments that look more attractive.

THE BEAR: JAMES MONTIER (cont.)

THE BEAR: JAMES MONTIER

Are stocks overpriced?

There is no doubt that the U.S. stock market is exceedingly overvalued.

What makes you so sure?

The simplest sensible benchmark is the Shiller P/E. Right now we’re looking at a broad index like the Standard & Poor’s 500 trading at something like 26, 27 times the Shiller P/E. Fair value would be 16 or 17 times historical earnings.

But bulls say the Shiller P/E doesn’t look so bad if you adjust it for interest rates or inflation.

It doesn’t make any sense to do that. The history of stock prices shows that they are good long-run inflation hedges. That’s because companies can generally raise their prices when their input costs rise, which protects their profits and dividends from inflation. And since equities are valued based on profits per share, equities are largely immune from inflation too.

Adjusting for interest rates is even more bizarre. Empirical horseraces show that valuation ratios — say, P/Es — unadjusted by current interest rates have predicted long-run returns far better than valuations adjusted by interest rates.

What if you look at P/Es based on expected earnings for the next year?

I spent nearly 23 years working at investment banks surrounded by analysts, and I have to say I think analysts probably were put on this planet to make astrologers look like they know what they’re doing.

The idea of basing a valuation on a forward earnings number is laughable. Most analysts spend all of their time being spoon-fed by company management and thinking about the next quarter’s earnings release — a horizon that is just not meaningful.

But maybe rising profits will justify higher stock prices. Maybe corporate profit margins will be higher than they used to be.

It is possible. We spend a lot of time worrying about that: What could prevent margins from falling?

[GMO co-founder] Jeremy Grantham puts it very well. For most investors, he says, “This time is different” are the four most dangerous words. But for value investors [who buy stocks they think the market has undervalued], “This time it’s never different” are the five most dangerous words. They lead to simple-minded extrapolation — an unchecked belief that the future will be like the past.

For a really good example of that, think of value managers who bought financials in 2008 because they were “cheap.” They failed to understand the dangers posed by the bursting of the credit bubble and the way in which earnings had been inflated during the housing bubble.

But profits as a percentage of gross domestic product have indeed been elevated for a sustained period. Now the data show profit ratios are not increasing anymore, and that may be the first sign that they’re beginning to peak. Looking forward, more federal budget cuts are coming, which should reduce profits.

Are we in a bubble now?

The technology bubble of ’99 was a good old-fashioned mania. People really did believe this time was different — that the dotcoms would change the way the world worked forever. I think what we are seeing today is more of a near-rational bubble.

When you have central banks around the world setting interest rates below the rates of inflation, effectively telling you that cash will earn nothing, then you tend to seek out other vehicles for investing. That distorts pricing across a wide range of assets.

I’d call it a foie gras market, in which investors are the geese being force-fed risk assets by central banks. It isn’t pleasant, but it may be the best that you can do given the alternatives that are available to you.

So what should investors do?

Personal investment advice is not our business. But when you look at the S&P 500 at today’s valuations, our return forecast is negative 1.5% annually after inflation. Cash will earn something like minus half a percent over the next seven years.

It’s hard to find bits of the market that are actually attractive. So we look for high-quality stocks, which have three features: high profitability, stable profitability, and low leverage: the Johnson & Johnsons JOHNSON & JOHNSON JNJ 0.8569% , Procter & Gambles THE PROCTER & GAMBLE CO. PG 0.3139% , and Microsofts MICROSOFT CORP. MSFT -1.1141% of the world. They’re certainly not cheap. But they are the best of the bad bunch.

And outside the U.S.?

Globally, European value stocks also probably deserve a place in a portfolio. So do some emerging markets, which is probably a brave call given the events that are unfolding around the world. In our unconstrained portfolios, we have just under 50% in equities spread among those groups, and then the rest in a combination of things like Treasury Inflation-Protected Securities and cash.

Related: How much will I need to retire?

You don’t want to be fully invested or else you give up the ability to take advantage of shifts in the opportunities you face. Also, we have found that if you shift assets depending on your opportunities, you’ve greatly reduced the risk of lifetime ruin — running out of money before you die.

Does that mean timing the market? Or simply having a global portfolio and rebalancing once a year? That is, selling the asset that’s performed the best and buying the one that’s done the worst?

Rebalancing is the simplest of all valuation-based strategies and a really good start. But I think one absolutely should try to market-time based on valuation.

Ben Graham actually said that in Security Analysis [a classic investing book co-written by David Dodd and first published in 1934]. He said, “It is our view that stock-market timing cannot be done…” and that’s the bit everybody quotes. But he goes on to say “unless the time to buy is related to an attractive price level,” which I think is exactly right.

Any tips on how to market-time?

My colleague Ben Inker says you should smoothly and slowly enter and exit markets. Rather than trying to pick the top or bottom, which you’ll never do, move maybe 5% or 10% of your portfolio in or out each quarter. That’s what we’re doing.

We are slowly drawing down our equity exposure in recognition of the fact that the markets have been expensive. If they get more expensive, we may sell a little faster, and if they get less expensive, we may stop selling.

Being patient is a massively underestimated virtue when it comes to investing because there is nothing worse than sitting there watching your neighbor get rich because he’s been invested and you haven’t because you think the market’s expensive. But if you can be patient, a valuation-based framework is exactly the right way to do things.

MONEY

Market Timing: Not a Good Retirement Strategy

I’ve been working for five years now and save religiously for retirement. But I feel that I’ve begun investing at a bad time for the markets. Most of all I worry about what will happen to my 401(k) if the market tanks again. Am I right to be concerned? — Aaron, Nashville, Tenn.

It would be nice if I could assure you that the market gyrations that have spooked investors recently and over the past dozen years — i.e., stock prices dropping by 50% or more in 2000 and 2007 — aren’t likely to occur again. But I can’t do that.

If anything, recent research shows that these sorts of gut-wrenching episodes — while not exactly the norm — are likely to occur more frequently than we previously believed. So I can virtually assure you that over the course of your career, the market will tank many times.

But I don’t think that’s something you should worry about when you’re investing for retirement. Investors have gone through many tough times before.

Since 1929, we’ve had 14 recessions and 13 bear markets, an average of about one of each every six or so years. And each time stock prices eventually recovered from these setbacks and climbed to new highs. I see no reason for that dynamic to change.

Besides, as counterintuitive as it may seem, you may actually be better off starting to invest in a lousy market if you’re just beginning to save for a retirement that’s many years down the road.

Related: What is an index fund?

A T. Rowe Price study from a few years ago examined how four hypothetical retirement investors who put their savings into a diversified portfolio of stocks would have fared over four different 30-year periods depending on whether they began investing on the eve of a bull market or a bear market.

I’ll spare you the details, but the upshot is that the investors who got their start in a bear market accumulated more than twice as much in savings as those who began investing on the verge of a bull. The reason: the shares that investors acquired at depressed prices during a setback soared in value as the market rebounded, significantly boosting the eventual size of their nest egg.

Of course, neither you nor I really know whether this is, as you fear, “a bad time for the markets.” Bear and bull markets are easy to identify in hindsight, but difficult to impossible to predict in advance. If that weren’t the case, everyone would get out of the market just before it drops precipitously and jump back in just as prices are rebounding.

So it makes little sense to try to time your retirement saving and investing based on what you think the market may or may not do. The most you can do is play the cards you’re dealt as best you can.

As a practical matter, that means investing most of your retirement savings — say, 70% to 90% — in stocks at the beginning of your career when you have plenty of time to recover from those inevitable market downturns. As you get older, you can begin shifting more of your savings to bonds.

You can expand beyond a simple stocks-bonds portfolio if you like. But don’t feel you have to load up on all the gimmicky little niche investments Wall Street’s marketing machine churns out. In general, a simpler mix is better.

Related: What is the right mix of stocks and bonds for me?

By the time you’re ready to retire — and more interested in protecting your nest egg than growing it — you probably want to have roughly 50% of your savings in stocks and 50% in bonds. For a guide of how to achieve this transition, you can check out the “glide path” of a target-date retirement fund. After you’ve retired, you can then shift your focus on the best way to turn your savings into retirement income.

But however worrisome you may feel the outlook for the economy and the markets may seem today, what with the constant talk of the fiscal cliff at home and the debt crisis abroad, you would be making a big mistake if you let your anxiety sidetrack you from continuing to save diligently for retirement and putting 401(k) money into the investment that’s generated the highest long-term returns in the past and is likely to do so in the future — stocks.

MONEY

More Money Friday Roundup: Part-Time Workers & Waiting on Estate Planning

Personal finance from around the Web:

  • The official unemployment rate fell in January to 9.7%, but a new study finds 6.4% of workers have taken part-time jobs because they can’t find full-time employment. Unemployment is so bad in many places that insolvent state unemployment insurance trust funds have borrowed more in this recession than they did during 1981 and 1982. [Boston Herald, ProPublica]
  • The Federal Reserve policy of buying up mortgage-backed securities is widely believed to have kept mortgage rates close to record lows, but it’s slated to end March 31. Now the president of the Federal Reserve Bank of New York says the Fed may reopen the program if interest rates spike or if the economy shows new weaknesses. [Washington Post]
  • The past decade has brought two painful bear markets. Here are the lessons you can learn from them, especially since bearish sentiment is at its highest level in three months. [Wise Investing, The Pragmatic Capitalist]
  • Need help getting a dinner reservation or a car to the airport, but can’t afford a personal assistant? A new, free app iphone app promises to serve as a virtual personal assistant. [Bits]

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