Rarely will you see me give any real credence to any fundamental market metric.
Company P/E ratios, earnings per share, free cash flow… These just don’t factor in to my trading style. I’m far more interested in where the money’s moving in the short term, and none of those stats can tell me that.
But today, in the face of what’s likely to be a far deeper, far more painful bear market… I make an exception.
If you’ve read my work for any length of time, you know I’m a technical analyst. (If you haven’t read my work, that means I study charts, patterns, and technical indicators.)
I’ve dedicated decades of my life to this field. I passed three exams to earn two designations in it. I even teach technical analysis at the New York Institute of Finance. That’s the school founded by Ben Graham, Warren Buffett’s teacher.
I love technicals. They help determine every single trading decision I make. But I also understand markets are more than technicals. At least in the long term, economic news does matter. So does fundamental analysis of the stock market.
Amber Hestla will look at the economy tomorrow. Today, I want to review one critical fundamental metric that’s had a great track record at forecasting prolonged bear markets.
Worst case scenario, we’re looking at a decade-plus of lower stock prices. That’s the bad news. And I’ll show exactly how we get to that conclusion in today’s issue.
There is good news, too. And that’s the fact that a bear market does nothing to stop you from making money…
First, Here’s the Bad News…
The key fundamental metric to watch right now is the cyclically adjusted price-to-earnings ratio — also known as the CAPE ratio.
Nobel Prize-winning economist Robert Shiller developed this indicator in the late 1990s. Its main feature is that it adjusts the popular P/E ratio to account for two persistent economic factors that are otherwise ignored: inflation and earnings.
Specifically, it compares a stock’s price to its average earnings, adjusted for inflation, over a 10-year period.
This does a better job identifying extremes than the traditional P/E ratio. While a bad quarter can create extremes in the P/E ratio, the CAPE’s 40 quarters of data gives a clearer picture.
What’s most important, though, is CAPE has a good record of forecasting future returns. When CAPE rises above 20, negative average returns tend to follow.
And bad news: The current reading is 28.
Source: Robert Shiller
Even worse news: The level we’re at now is amid a sharp reversal from the 2021 peak of 38.
CAPE posted its second-highest reading ever in 2021. Stocks were more overvalued than they were in 1929. The only higher reading was during the internet bubble that ended in 2000. Two declines of more than 50% followed that peak in the next 10 years.
Stock market bulls aren’t worried about the high valuation. They argue higher valuations make sense when interest rates are low.
But rates aren’t low anymore… They’re rising rapidly. This makes the high CAPE reading especially troubling.
You see, falling interest rates followed most of the previous peaks in CAPE. There was only one time when rising rates coincided with a CAPE peak, and that was in 1966. Just like today, inflation was rising then as well.
In 1966, government spending was soaring. Funding for the war in Vietnam and the newly declared war on poverty led to budget deficits. (Deficits of $25 billion seem comically small today when the deficit exceeds $1 trillion, but it was a big deal then.)
While relatively small, those deficits fueled inflation. The Consumer Price Index topped 2.5% for the first time in a decade. It quickly accelerated and remained high for many years, peaking at more than 14% in 1980.
Stocks struggled that entire time. Average nominal returns from 1966 to 1982 were 1.3%. Adjusted for inflation, returns were -1.9%.
By 1979, investors seemed to have given up on stocks. (Businessweek magazine famously ran a cover story on the “Death of Equities” that year. Of course, a great bull market began shortly after that.)
It seems unthinkable that such a dark period for the markets could happen again. But I believe there’s plenty good reason to prepare for such a scenario…
A 16-Year Bear Market?
From a historical perspective, 2022 looks a lot like 1966.
Fundamentals then were pointing to low returns, just as they are now.
The Fed was raising rates then, just as it is now.
And inflation was weighing heavy on consumers’ shoulders, just like it is now.
In 1966, investors were about to suffer a 16-year bear market. Could this bear market last that long? It’s impossible to say, but all these factors coming together tell me we should prepare for a very challenging market.
Lucky for us, challenging markets are my specialty.
A few years back, when the pandemic struck and changed the way markets trade forever, I devised a system that could capture quick, outsized gains regardless of what the market’s doing.
It consists of 29 distinct rules, all of which must trigger before any trade idea fully comes together.
This strategy has historically done best in times of volatility…
Like in 2020, when it beat the Dow Jones Industrial Average handily during the biggest whipsaw year in decades…
And this year, where the strategy has delivered a 78% return while the S&P 500 fell 20%.
All this on a strategy that makes just one trade… on just one ticker symbol… just once per week…
And only stays in these trades for a few days… often less than 24 hours.
I’m coming forward with this now because I’m sick of the BS the mainstream financial media is peddling to everyday investors. They’re telling you the wrong way to make money in a bear market. I can tell you the right way.
The fact is, history’s greatest fortunes were made in bear markets.
No matter what the Fed says, no matter what happens on the world stage, no matter even if we go into another depression…
This strategy will thrive and allow you to take best advantage of bear market rallies and crashes.
I’m going live with the full details on November 15 at 8 p.m. ET. If you have any intention of actually making money over the next several years, you’ll make sure to be there.
Michael Carr, CMT, CFTe
Editor, True Options Masters