2. Ratios such as price to earnings or price to book are merely pictures; what you need to consider is the full context -- the film version.
3. Fair value is an abstract concept, which stocks just wave hello to as they careen past on their way toward becoming dirt cheap or wildly overvalued. However, I am hard pressed to recall an extended period when stocks stayed at fair value for any appreciable period of time.
4. Using a single variable to identify whether a stock is cheap or expensive so radically oversimplifies the concept of valuation as to be worthless. Markets are simply too complex to be adequately reduced to one variable that can tell you whether to buy or sell.
5. There are many variables to consider, as we discussed earlier this week: Economic growth rate, inflation, rising or falling interest rates, income tax increases or cuts, corporate profit growth, war and geopolitics, etc., all affect whether stocks are cheap or dear.
6. Psychology explains much of what takes place during bull and bear markets. Indeed, I have argued that the psychology of valuation is what defines each!
How can we determine, then, what defines these markets? A secular bull market is an extended period of time (10 to 20 years) during which investors show an increasing willingness to pay more and more for each dollar of earnings. Consider the 1982-2000 market, which began with price-earnings ratios in the single digits and ended with a P/E ratio over 30 and markets 1,000 percent higher. About three-quarters of those gains were due to multiple expansion.
A secular bear market is just the opposite: During a period of increased volatility, frequent corrections and ongoing fear, investors become increasingly less willing to pay the same amount for that dollar of earnings. Indeed, I define the bear as investors paying less and less for it.
In both bull and bear cases, the psychological component is what drives stock valuations.
Valuations are most helpful when setting what should be your expected returns. When stocks are cheap, the odds favor higher-than-average returns; when they are expensive, expect below-average returns. But even that is subject to some surprising variations.
Just like the children in Lake Wobegon, if this was easy, everybody would be an above-average investor.
This column was provided by Bloomberg News.