On Extreme Valuation
Some uber-bears are expecting the market to fall to extreme valuations. I am reading one uber-bear predicting that the market is going to fall to either 8x depressed earnings or 8x normalized earnings.
Can it happen?
Of course it can. It has in the past and it can in the future. The market can go to 4x depressed earnings if it is in the mood. Markets can and will do anything they want.
The uber-bears may very well might be right.
But is relying on the uber-bearish price targets for the stock market prudent?
Usually, the market moves in a range between under-valuation and over-valuation. Occasionally, markets move to extreme levels. But extremes are rare. Basing your investment portfolio around extremes is not a sound investment strategy, in my opinion. It is highly risky and fraught with losses, either real losses or opportunity losses.
If one was extremely bullish, forecasted a peak multiple of 35x peak earnings, and was determined to hold onto the market until 35x peak earnings, one is making a portfolio decision based on an extreme outcome. Holding stocks until 35x peak earnings may seem extreme, but equities peaked at 30x peak earnings in March 2000. If you held stocks up to 30x earnings before selling, you did very well, but you were also taking an extremely improbable bet. If you were waiting until the market hit the slightly more improbable valuation 35x earnings however, then your account has been crushed since.
On the downside, a multiple of 8x depressed earnings is an extreme valuation. The market has reached those levels in the past though rarely.
Current earnings are $45 for the S&P 500. At 8x depressed earnings, the uber-bear’s downside target is 340, a 67% decline from today’s levels. Even 8x normalized earnings – which by my calculation would put the S&P 500 at 560 – is also a rare event.
I generally ignore extremists (in both life and investing), and tend to ignore both the uber-bears and uber-bulls. It is not that I think they will ultimately be incorrect predicting an improbably low event of the market hitting an extreme valuation. Instead, the question is whether or not the market stays at the extreme level of valuation.
Investing is about probabilities. Extreme events are rare. And even if the extreme event comes to fruition, I view the path towards to the climax of the extreme event as either a great time to sell on the upside or to buy on the downside.
For example, selling at 3500 on the Nasdaq when tech stocks were ridiculously over-valued in December 1999 may have felt bad a few months later, when the Naz went up another 50% to the insanely over-valued level of 5132 the following March. However, one felt pretty good watching the Nasdaq eventually fall to 1100 knowing that you cashed out at much higher prices.
The market never stays at an extreme level for an extended period of time. For an investor, valuation will bail you out on the downside if valuation gets too low and sets one up for losses if valuation gets too high.
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