Nick Massey

“Then you better start swimmin’ or you’ll sink like a stone. For the times they are a-changin’.” Those words, written by Bob Dylan in 1964 might describe where we could be now with the stock market.

Did you feel it last week? No, not the earthquake. I mean the sudden shift in feeling about the economy and the markets. It started about a month ago. Subtle at first, like the early hint of fall in the air before winter arrives. Then suddenly last week the unstoppable bull market got mauled by the bear. If you watched too closely you could have gotten seasick with all the violent up and down movements.

Suddenly there’s a new feeling in the air about the economy and markets. Unbridled confidence has been replaced with doubt and worry. Was this the long overdue correction I have been talking about? Some of you thought I was crazy, but now you’re not sure. Was that it, or is there more downside to come? Those are tough questions with difficult answers. I suspect we will find those answers in the coming weeks.

Late last year I wrote a story about economist Hyman Minsky. Minsky was known for his theory that basically said stability breeds instability. The longer things are good, the more complacent people become, the more risk they take, the more unstable things become. Finally, the “Minsky Moment” arrives and triggers a collapse, much like the final grain of sand on a sand pile causes it to suddenly collapse. Perhaps we just saw a preview of one of those Minsky Moments.

Is the long overdue correction happening now? I think this is probably round one of several rounds to come. Will the market continue down from here? Probably not right now. That would be too easy. The markets always do something other than what people expect. We are rebounding this week and I suspect we will see several more weeks of volatile action as people digest recent events. But make no mistake about it, the easy-money ride is over and this is where it gets really tough.

Many analysts, except me, have been telling you that when you look back in history, stocks are not overvalued. Really? It’s truly puzzling to me how they arrive at that conclusion. Even though Price-Earnings ratios (P/E ratios) aren’t quite as high as they were when the market peaked in early 2000, it doesn’t mean that stocks aren’t overvalued. (P/E Ratio is the price of a stock or index divided by the earnings per share.)

A better way to look at P/E ratios is the methodology created by Yale professor Robert Shiller. Rather than looking at P/E ratios based on current earnings or estimated future earnings (which may or may not happen), Shiller takes the average of the last 10 years of inflation-adjusted earnings. This has become known as the Cyclically Adjusted Price/Earnings (CAPE) ratio. This method takes some of the volatility out of the number and creates a longer term reference point. Traditional P/E ratios often get understated near market tops due to strong surges in earnings. As I have stated many times, things always look good at a market top and they don’t ring a bell to tell you it is time.

The CAPE P/E ratio for the S&P 500 was near 27 in 2007 and higher than all previous major tops, with the exception for the ones in 1929 and 2000. Today the CAPE ratio is 29. Based on that analysis, stocks are clearly overvalued today. That doesn’t necessarily mean that stocks could fall now, but it certainly tells us they are not bargains.

Economies go through seasons just like our weather and in my opinion we are in, or about to go into, a deflationary (winter) season. But corporate earnings are good now — right? Profit margins are up, so life is good. How can the market drop when earnings are good? It’s the rapidly growing risk premium, not the drop in earnings that investors bring on when they suddenly flip from confident to fearful. P/E ratios dropped to 8.2 in late 1974 and then dipped further in late 1982 to 6.6. I would expect to see P/E ratios decline as risks grow in the next downturn.

Now that investors have nowhere else to go with their money and are convinced that the Fed will not let the market fall, all we need is for something to go wrong and flip them from their sense of false security into extreme fear like in late 2008. If we had a contraction in P/E ratios similar to the contraction in 1974, it would result in a 58 percent decline in stocks as well as a sharp decline in earnings. While I certainly don’t think things are that dire, you can see that stock prices can fall simply due to P/E contraction.

I think markets are likely to remain in this volatile range through this month and early November. We could see another rally after that as we come into November and December. However, we may already have seen the peak for this year. We’ll see.

Since I started this story with Bob Dylan, I think I’ll end with another one of his famous lines. “You don’t need a weatherman to know which way the wind blows.” Watch out. That breeze might soon turn into a strong gale. Thanks for reading.

NICK MASSEY is a financial adviser and president of Householder Group Financial Advisors in Edmond. Massey can be reached at www.nickmassey.com. Investment advice offered through Householder Group Estate and Retirement Specialists, a registered investment adviser.