The Worst Possible Environment For Stock Market Investors

by jessefelder

“For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.” -Warren Buffett

“My greatest discovery was that a man must study general conditions, to size them so as to be able to anticipate probabilities.” -Jesse Livermore

It’s popular these days to note that valuation is not a good timing tool. While it may be helpful in understanding the prospects for long run returns it just has little utility for those focused on the near term. At the same time, technical analysis, or more precisely trend analysis, can be helpful in understanding the short-term dynamics in the markets but has little value for those trying to understand the likely trajectory and velocity of stocks over a longer period of time.

This is one of the reasons I have tried to utilize both to try to overcome the shortcomings of each in my own investing process. And I came to this process by learning about the markets the hard way. Buying cheap stocks that are in strong downtrends rarely works out okay; I can testify to that. Conversely, buying stocks trading at their most expensive valuations in history, even if they remain in an uptrend, rarely works well for a long-term investor.

The same can be said about the broad market. A cheap stock market in an uptrend is the ideal scenario as it presents investors with an opportunity to take advantage of greater long run returns and, hopefully, get the timing right. On the flip side, an expensive stock market in a downtrend represents the worst of all possible environments as it likely means poor long run returns punctuated by steep downdrafts.

Currently, this latter one is the situation we currently find ourselves in. The stock market today has rarely, if ever, been more expensive (Robert Shiller’s CAPE ratio current stands at 30). At the same time, it has just recently entered a new downtrend (as defined by price relative to its 200-day moving average). If history is any guide (see the insets in the chart below), investors would be wise to adopt a defensive approach so long as these two ominous conditions exist in concert.

Many thanks to Jason Goepfert (@SentimenTrader) for running the numbers for me.

 

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