Identifying a Bottom

In recent weeks I have spoken with many trading friends and hedge fund managers.  Many of them have mentioned that they are "waiting for a real correction" before getting long.  Several have observed that "market bottoms start with a PE ration of 6-8."  They are looking for that opportunity.

These are some very smart people, who manage serious money.  They have accepted Wall Street lore that relates to a very few past market bottoms.  Let me propose a caveat to this thinking:

Citing market PE ratios without reference to interest rates is a serious mistake!

To check out this idea as it relates to market bottoms, let us turn to the guru of the bubble era, Robert Shiller.  The chart below is taken from his wonderful and generous site, providing the data underlying his book (featured at the right) Irrational Exuberance.
(click to enlarge)

If you are waiting for a PE ratio of something below 10, you may have a long wait!  You could go back to the end of the Great Depression.  If you look to the more recent example, about 25 years ago, you should note that interest rates were well into double digits.  If an investor can get 16% on a long bond, why buy stocks?

Do we really believe that long-term interest rates will hit this level again?  For those whose crystal balls predict another round of stagflation, I suppose the answer is "yes."  For most of us, we should consider looking for a different criterion for spotting the time to buy the market.

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