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Wall Street 101: Bulls vs. Bears

Are we in a bull or bear market? The answer to this question depends on who you ask. A bear or bull market is simply a question of investor emotion that creates momentum in the markets. A better question would be, "Are more people buying or selling stocks right now, and is the market under or over valued?" So far this year more people have been selling stocks, in general, on the U.S. stock exchange and developed foreign nations. Emerging market stocks (Brazil, Hong Kong, Mexico, Republic of Korea, South Africa and Taiwan) have seen more buyers, as is confirmed by the average emerging market mutual fund being up 2.1 percent this year.

To look at the answer to the second part of the above question, we need to determine the best parameter to use and then state the historical average for this factor. The best parameter, in my opinion, to measure the value of the U.S. stock market is the Price to Earnings ratio, commonly referred to as the P/E ratio. The 100-year average of the P/E ratio for U.S. stocks is around 15. However, the P/E for the S&P 500 is currently around 23 (53 percent over priced). As bad as this may look, it is nowhere close to the near 40 P/E ratio most U.S. stocks were carrying in early 2000! So the most important factor determining the future performance of stocks is its worth or value, and good measure for this is the P/E ratio.

Asset Valuation vs. Technical Chart Investing: What It All Means …

The stock market has been studied for a century. Mathematicians, statisticians and even beauticians have created all types of technical chart patterns to make them feel confident about their selections. One of the first well-known studies of a market came from Louis Bachlier, a French mathematician at the University of Paris who in the early 1900s examined the market price behavior of the futures market on French government bonds.

His goal, like so many today, was to study statistics to determine if he could predict market movements using historic price trends. His conclusion, although it wasn’t widely accepted then, would become the basis for modern financial theory: There is no useful information contained in the historical price movements of securities. Why is this true?

Using past prices is basically looking back on human emotion at the time. Not only that, it takes into consideration what is driving some of these human emotions. For example, before 9/11 there was absolutely no way a technical chart could have predicted that the Twin Towers were about to undergo a terrorist attack that would therefore lead to a market drop. No economists know the future, and additionally there is no way to determine how society will react to news influencing the markets. Sometimes investors get scared about a particular issue and sell even though when an identical issue happened earlier they bought or took no action.

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On the flip side of the coin, just as many studies have shown that P/E ratios for U.S. stocks tend to give the investor general ideas as to how the market will perform, if nothing else, over the next 10 to 20 years. Think of this as a balanced perspective between the two systems.

Crestmont Research has done some excellent work on showing the relevance of P/E ratios to the performance of the U.S. stock market. So unlike using previous prices, which is totally unpredictable for short- and long-term forecasting, valuation methods (P/E ratio comparisons) at least tell the investor where the market is trending. Sure there are going to be years that break trend, but at least the investor has a clue!

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