One way investors trade the stock market
I recently reached out to other NAPFA fee only advisor members to share differing thoughts on the markets and financial planning through our respective blogs. I got a great response. NAPFA is truly a great organization to be involved with!
The key is these are differing opinions. This type of analysis I don’t personally endorse or engage in.
That being said – it may be interesting to my visitors so I thought I’d put it up for your reading enjoyment!
The following is from Don Martin of Mayflower Capital. Don is a Fee Only CFP in Los Altos, CA and a NAPFA registered financial advisor.
The Bear versus Bull case for the stock market could be summed up as a debate about whether to use the current Price earning (PE) ratio versus the ten year inflation adjusted average PE ratio. This is referred to as the Shiller PE10 but was originally used by Ben Graham, who mentored Warren Buffett.
The Bulls claim that the ten year average of earnings is 70% of current trailing earnings, so they claim the ten year figure misses important data.
My response to that is that first one needs a filtering mechanism to get a clear unbiased view of earnings, so taking a long term inflation adjusted average of earnings is one way to do that. The problem with using current trailing earnings is that a company can go through a temporary growth spurt that is unsustainable due to some faddish product or due to some unethical accounting trick that will be found out in a few years. Look at all the tech companies that were hot for a few years and then faded into obscurity.
Further, current earnings as a percent of GNP are unusually high. This is due to either tech companies with temporary spurts in product popularity, or to companies using foreign subsidiaries in tax haven locations, which reduces, taxes thus raising corporate after-tax profits.
This is unsustainable and dangerous, because Congress could easily take this away. The IRS has already cracked the nut of foreign bank accounts by gaining cooperation of Swiss Banks, etc. So it seems logical that eventually Congress will change the corporate income tax to outlaw foreign corporate tax shelters. This alone could dramatically reduce corporate income.
Open the secrets of investing
When evaluating investments, one must examine risk. Part of the risk is unsustainable corporate earnings that are artificially and temporarily too high.
That is why the responsible way to invest is to examine earnings for sustainability. One of the best ways is to examine the long term average, adjusted for inflation.
The component of a corporation’s earnings that has jumped at an exceptionally high percentage is analogous to a little small cap company that is undergoing a sudden growth spurt: they both have high risk of faddish unsustainability. The small cap component of a successful large cap stock should be carefully evaluated as a source of hidden risk that can lead to sudden disappointment. Using a ten year average of earnings helps to filter out incorrect information.
Greg, I wrote another article “Three bear market strategies you must know”. Your visitors may find it interesting. Thanks for having me guest write for your blog!
Don
As I mentioned, I’m not a bear, I don’t agree with Don’s analysis. But what I am is open to new research and information! Of course it’s always interesting to hear opposing viewpoints.