Time to sell?

Yale economist and Nobel laureate Robert Shiller published a NYT piece today on stock market valuations.  I have always taken Shiller's word on this subject very seriously; not too many stock pickers have Nobels on the mantel above their fireplace!

Shiller was instrumental in designing the CAPE (cyclically adjusted price-earnings) ratio, which is now near its historic highs.  Today the CAPE ratio is above 25.  It has been above 25 three times before: 1929, 1999, and 2007.  In each case the market crashed within a year.

Does this mean we should all rush to dump stocks?  Not necessarily.  CAPE is not an indicator of market timing.  And US stock prices could get higher before they go lower.  But it looks like a good time to be exploring other assets, even if the returns are low.  A safe 1-2% beats -25% every time.

Picking stocks

Harvard economist Greg Mankiw has a great column today in NYT regarding what stocks he should by.  Economists get this question all the time and Mankiw's answers are noteworthy for being solidly based on economic research.  Here is a quick, high-level summary:

1. Markets always know more than you do.  So unless you have inside info or you see things no one else sees, you should realize your insights are priced into the market's valuation.  Buy index funds to save costs. 
2. Many price moves cannot be explained, even after the fact.  Deal with it.
3. You better own some stocks.  All the research shows that they outperform other assets over the long haul.  
4. Don't put all of your eggs in one basket.  Folk wisdom and high-powered econometrics yield the same conclusion.  
5. Think global.  The US represents slightly less than half of total global valuation; get yourself some EU, Japanese and emerging market stocks.  

I have followed most of this advice, although I must admit my global exposure is a bit out of balance.  Mankiw recommends Vanguard's Total World Stock exchange traded fund FWIW.

Time to sell?

All stock indexes are at historic highs.  We have seen this movie before; remember 1987, 1999 and 2007?  A sharp drop has to be around the corner, right?

Not so fast, say some financial experts at leading business schools quoted in a recent NYT story.  NYU Stern's Richard Sylla (formerly a colleague here at NC State) has shown that buying at market highs sometimes ends up being a wise strategy.  Wharton's Jeremy Siegel says potential buyers need to look carefully at market fundamentals, which he thinks support further increases in stock prices. 

Is the sky falling?

The US stock market has been hammered last week and yesterday, raising both micro and macro issues.  On the micro side, the most immediate question that comes up in day-to-day conversation is whether the decline will continue.  If you have not cashed out your stocks yet, should you do so now?  Or has the recent plunge in values created a great buying opportunity?

Princeton's Burt Malkiel, author of the classic A Random Walk Down Wall Street advises investors not to panic in an op-ed in yesterday's WSJ.  Malkiel thinks that stocks are now significantly undervalued, based on price/earnings ratios and dividend yields.  Sure, the recent economic news is not great, but Malkiel shares one of my all-time favorite economics quotes from Nobel laureate Paul Samuelson: "The stock market has predicted nine of the last five recessions."  Malkiel's advice:

We all need to be aware of the limits of our ability to forecast future stock prices. No one can tell you when the stock market will end its decline, but there are some things that we do know. Investors who have sold out their stocks at times when there have been very large declines in the market have invariably been wrong. We have abundant evidence that the average investor tends to put money into the market at or near the top and tends to sell out during periods of extreme decline and volatility.

Today's WSJ has a worthwhile piece on why 2011 is not likely to be a repeat of 2008.   The key factors in a nutshell: (1) 2008 -- credit bubble in real estate, 2011 -- sovereign debt crisis (brought on partially by government attempts to correct recession created by credit bubble); (2) 2008 -- key players short on liquidity, 2011 -- key players flush with cash; (3) 2008 -- governments thought they were capable of using fiscal, monetary policy options to stimulate growth, 2011 -- governments out of bullets.  Hopefully there will be a fourth difference, with 2011 being a short term stock market correction that will have no effect on consumption or investment.