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The gauge that traditionally lets one know whether or not they are amidst a speculative stock market bubble is the Price to Earnings ratio (P/E ratio). This value is calculated as follows:
P/E ratio = Market Capitalization of Company / Earnings per year
This ratio hovers traditionally around 10-15, but recently it has been skewed upwards in the late 1990s to 20-30. This is more than twice the historical average, and the current levels are much higher than even those of 1929 and 1987, just before remarkable declines.
Why do earnings have to keep up with prices?
The stock market is a great big marketplace for trading rights to the future earnings of a company. Most of us don't view it this way. We view it as either a place to dump our money where it can mysteriously compound into more "money," or we view it as a place to buy something and then sell it to someone else who is willing to pay more. (Everyone started out by learning "Buy low, sell high.")
When you buy a stock for the long run, you become a partial owner of the business. You don't have the same level of involvement in the company as the CEO and the employees, but you are essentially entitled to the company's profits based on how many shares you own.
Now that we know what owning a stock really means--earnings matter because from now until eternity the only thing that business owners can get out is what the company takes in as profit. The Internet stocks that crashed last year because those companies had no intrinsic value--no business model, no profit, etc. Sure, investors traded them around to each other for a while at astronomical prices,but in the end, a useless unprofitable business ended up at $0 per share, even if it had a ".com" in it.
Note: I am only knocking unprofitable Internet companies, not ones with real profits.
Who needs dividends when I have 20% capital gains each year?
Having capital gain increases in value of stock is great while it lasts! When a company can hold onto the profits that it makes, re-invest them and make more money, then you have a winning business. In time, the stock market will notice this and reflect it in the price of the stock.
But the important thing to note about the dividend payout yield (how much companies are paying out in dividends) is that we are at an all-time low (adjusted for inflation). Perhaps it is because we expect so much increase in stock market valuation that we tend to ignore dividend payouts nowadays, but it says something about the actual state of companies. All we really can infer is that companies today are paying out far smaller dividends than they have historically.
It is a well understood fact that Bubbles cannot be labeled that until after the fact. If the speculative rise in stock prices does not return to historical averages, then there will have never been a bubble. But there is also a much more grim possibilitythat prices will fall like they did in 1929 and 1987. If I had one message to investors with money in the market currently: Take caution, Mr. Market does not discriminate during a Crash. Every stock, every investor is affected.
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