Neither far out nor in deep

There’s an old Turkish story about a village wise man who appealed to the Sultan to reduce the crushing taxes he had levied after conquering the province. “If you’ll reduce your taxes,” the wise man said, “I will teach this donkey to talk, and I’ll present him to you.”

The throne room in Topkapi Palace, Istanbul.
The throne room in Topkapi Palace, Istanbul.

The Sultan, amused, said, “How long will you need to teach the donkey to talk?”

The wise man considered, and said, “This is no easy thing. I’ll need five years.”

The Sultan said, “Fine. But if you don’t have this donkey talking in five years, I’ll have you skinned alive.”

Afterwards, the villagers crowded around the wise man and said, “How can you promise such a thing? The Sultan will skin you alive!” The wise man shrugged. “Many things could happen in five years. I could die, the Sultan could die, or the donkey could die.” As it turned out, the Sultan died three years later.

The moral of the story is that no one can promise that anything will happen in the reasonably far-off future. Everyone would like to know what the stock market will do in the next five years. But it’s more likely that someone will teach a donkey to talk than be able to predict the market accurately in five years.

And right now is a particularly difficult time to prognosticate. An old rule of thumb is that if you take the inflation rate and subtract it from 20, you’ll get the market’s fair value price to earnings ratio. (The PE ratio — price divided by earnings — is a measure of how expensive a stock or index is. The higher the PE, the more expensive the stock market is, and vice-versa.)

The core inflation rate is 1.9%, meaning the market’s fair value is 18.1 times earnings. Standard and Poor’s says the estimate for the 2015 price-to-earnings ratio is 17.3 on an operating basis, which would make the market slightly undervalued. On an as-reported basis, which is probably less accurate, the estimate is 19.3 times earnings, which makes it slightly overvalued. We may as well split the difference and call the market fully valued.

Naturally, there are all sorts of ominous things on the horizon that could push prices lower. For example, manufacturing seems to be slowing down dramatically, partly because the global economy is so weak. Then there’s the Middle East. And Russia.

Less apocalyptic would be a slowdown in earnings, and there are signs of that already, Rather than pay employees more or invest more heavily in their own businesses, companies are electing to buy back shares — a useless exercise for anything except making your company’s earnings look better than they really are.

sentimentOn the other hand, housing prices are rising at a moderate and sustainable pace. The Case-Shiller 10-city composite home price index rose 4.7% the past 12 months ended August, and consumer sentiment is also fairly chipper. The unemployment rate is 5.1% (albeit still unstatisfying), interest rates are low, and the economy is growing modestly. We have no boom, but no bust, either.

But here’s the thing: If you’re investing for a goal in the next five years, you’re about as likely to forecast the stock market correctly as you are to find a talking donkey. Typically, stocks are a good investment for the long-term, patient investor. If you’re spending your days fretting over the next jobless report, you probably have too much money in the stock market.

2 thoughts on “Neither far out nor in deep

  1. John;

    I have a link to your blog on my desktop and I check it every day. I find your comments to be very useful and also, often, very fun. We are rather crazy-alike. I admire your style, elegant, and at the same time, comfortably conversational. I’m a fan.

    Wayne Engel
    Gresham, Oregon

    Like

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