How I know that the stock market is coming down

Every investor would like to be able to predict the future. It is not always easy to do, but neither is it that difficult. It helps if you stick to the math.

Income investors aside, most people buy stocks that they believe will appreciate in value. If you own a stock and do not believe it will go up any higher then why wouldn’t you sell it?

The majority of shares in all financial markets trade between large banks and institutions. They have access to much more relevant information about the shares they trade, the world economy and the markets in general. Good research is the key to purchasing good investments.

For the average investor good research is a non-starter. Most people do not know how to do basic research on a company or where to obtain it. That has not deterred millions of people from investing trillions of dollars based upon bad information. Much of that bad information comes from the financial services industry itself.

Companies in the financial services industry need to grow and to be profitable. They grow by adding new customers and by encouraging existing customers to add more money into their accounts.

It should be obvious then that the one word that the industry is least likely to utter is: sell. If you sell, you might ask for a check and take your money elsewhere. That is something that the industry would like to avoid at all cost.

This is the reason that many financial professionals will tell you not to “panic” when markets start to go down. They will tell you to “stay the course” and that you should not worry because the market will “always come back”.

This is a sales pitch. It is not based upon facts or analysis. The charts that you will see accompanying this advice are bogus. The facts the charts assume are never about you and the facts they assume about the market are never real.

Consider that the market decline in the last month has been widely attributed to two factors, slower growth in China and a sharp decline in oil prices. Upon examination neither would seem to have a negative effect on the US economy.

The Chinese market for US goods is not growing as fast as it has in the recent past. China is not in recession. Certain industries and certain companies will surely be impacted. Overall, there is no indication that China will buy substantially fewer goods from US companies this year than it did last year.

Volatility in the Chinese stock markets is also cited as problematic for the US markets. In truth, very little US capital is at risk in the Chinese capital markets. Volatility and higher risks in the Chinese markets will usually cause capital to seek safer markets. That means more capital coming to the US. This is positive for the US economy.

Oil has been priced by a cartel since the 1970s. The current sharp decline in its price is being caused by a political decision to increase the international supply and to force US suppliers out of the market. Dramatically lower prices are not good for domestic oil companies and domestic oil workers.

Lower prices are also not good for the very largest oil producers whose margins and profits are likely to decrease. Shares of large oil companies are found in many portfolios and account for a significant amount of the weight in the Dow Jones Industrial Average and other indexes. So, yes, declining oil prices will bring averages down, but do not negatively impact many industries like pharmaceuticals or housing.

For the rest of us, dramatically cheaper gas prices increase our buying power for other goods and services. They should reduce the price of any goods that are shipped by truck which is almost everything.

Cheaper gas prices should not crash the market. Indeed low gas prices coupled with lower prices for other commodities and low borrowing costs should all continue to bode well for the US economy.

Why then do I believe that the market is coming down?

The upcoming market “correction” will be the 7th or 8th of my career going back 40 years. Throughout, the single factor about which most professional investors concern themselves is a stock’s price to earnings ratio.

Historically, across the market those ratios fluctuate between 10 to 1 and 20 to 1 with a mean in the middle at 15. It should cost $15 dollars to purchase one share of a stock in a company that is earning $1 per share.

So ingrained is the notion of price to earnings ratio as a market indicator that each of the corrections that I have witnessed over 40 years has been characterized as beginning from a point where P/E ratios where at the high end of the range. Markets usually fall from there to a point below the mean and then begin to level off.

That P/E ratios will always revert to the mean is a verifiable and well known fact.

At January 1, 2016 the average P/E ratio for the overall market was in the neighborhood of 20 to 1, which is at the higher end of the range. It might go up a little higher first, but history and mathematics would suggest that it is likely to drop to the 12 -13 to 1 range before it starts back up.

If you stay in the market, your portfolio will sustain that loss. It might take several years for the value of your portfolio to return to where it is today. If you “stay the course” you will have wasted the earning power of those years. You will have ridden the market down and back up and essentially be back to where you are today.

The better strategy would always be sit on the sideline while the market is going down and to invest in the companies that you like when they are cheaper. There has never been a better investment strategy than “buy low, sell high”.

If you do stay in the market then your portfolio should contain stocks that pay dividends. Dividend paying stocks generally decline less than stocks that do not pay a dividend. If you do sell now and accumulate some cash, you will be able to buy these stocks at lower prices and lock in a more attractive yield going forward.

I know for certain that all but a few market professionals will tell me that I am out of my mind. I submit that a great many of these professionals will have a personal stake in your decision to leave the market or stay the course. If every customer decides to sit on the sidelines these market professionals will be washing cars or waiting tables.

If you would like to “gut check” your broker, ask him/her what the average P/E of your portfolio is today and what your portfolio’s value would be if you do stay the course and your portfolio’s value does decline to a ratio of 15 to one or less. Like I said, do the math.

If you stay the course, you will be robbed of the profits that this bull market has given to you.