Which Way is the Market Headed? No One Knows

A reader was kind enough to ask me to comment about the market, so here goes:

I don't know whether this is a "correction in a bull market" or the "start of a bear market," but I am far more persuaded by the latter case. After ten years on Wall Street, however, I can promise you this: No one else knows either. Go ahead and listen to the parade of smart guests on Bubblevision--their reasoning ranges from impeccable to hilarious--but just don't let yourself get seduced into betting big one way or the other. Because no one knows. (We have 50/50 odds, though, so half of us will be "right").

One thing we do know: Based on correctly calculated long-term valuation trends (cyclically adjusted P/E), the stock market is still extremely expensive (close to the peak levels of 1929, 1966, and 1987, and only below the all-time peak of 2000). I expect that this will eventually revert to the mean, and that one of these days we will see the "start of a bear market" that could take us below the 7700 trough on the DOW in 2002. This could be it (and if it is, this is just what it will look like). And given the housing market, credit crunch, oil prices, etc., it's not hard to see how we would get there. But anything is possible, and long-term valuation trends are nearly useless for near-term timing calls.

Why is this relevant for Internet companies? Because the direction of the stock market is important for those who run both public and private firms, whether it seems so or not. Crashing markets often herald crashing economies, which lead to reduced consumer spending and advertising revenue. And crashing markets also throw buckets of cold water in the face of those who were just gleefully distributing angel and VC cash.

I've spelled this out in more detail in the second post below, which includes a handy guide laying out the assumptions you should make about how bad it could get. And don't forget to blame Sergey and Larry--their Q2 started it. :)

Google Blows Up the Stock Market

The Market's Crashing: Are You Recession-Proof?

Comments

[marsdeals]

I don't believe we can compare long-term PE ratios of a manufacturing economy (pre-1980) and the service economy of today. The ROAs on a service economy are much higher than that of a asset-intensive manufacturing economy.

If you compare an internet company to a manufacturing company -- both with identical growth prospects and $5 million of earnings -- which would you value higher. I would value the internet company much higher because it is able to generate those earnings with far fewer assets. Thus the capital needs are less so the ultimate return to investors in higher.

I think that explains much of the increase in PEs over the past 20 years. That is not to say that we will not have bear markets again -- we will. But I would not expect a service economy to ever return to the historic means that are comprised of mostly manufacturing economy years.