If you find a bit of nausea creeping in each time you flip on the financial news, that's to be expected. It has been a tough couple of weeks in the markets.
To make sense of this, let’s look at a stock price relative to a company’s earnings, to understanding valuations.
To grossly oversimplify, what you pay for a share in a company is based on a formula called “earnings multiple.” How much you should pay today is a function of how much the company is likely to earn next year. Wall Street analysts put a multiple on it, lets say 15X and voila! We get an estimate for what prices stocks should be next year.
What could possibly go wrong with that? Plenty. Three major things: estimates, multiples and forecasting error.
Estimates: Not only can they be wrong, they often are very wrong, and in a consistent and predictable way. According to McKinsey & Co., Wall Street’s analysts are nearly always too bullish: their earnings estimates ranged from 10 to 12% a year, while actual earnings growth was about 6% annually. The exceptions are during recessions, when they are (surprise!) too bearish.
Multiples: Instead of 15x, the multiple swings to extremes, sometimes wildly: 20x, 25x, even 30x, or to 12x, 10x, even 7x of earnings. History teaches us that these multiples eventually revert to the mean.
Forecasting error: Whenever the economy slips into a recession, estimates that were not so great in the first place turn out to be simply terrible. Wall Street gets it most wrong at precisely the worst time.
Take a proactive approach that recognises these possibilities and plan accordingly — hold a decent amount of cash and bonds (I am at 50%).
(Ritholtz heads quantitative research firm FusionIQ, and wrote the book Bailout Nation.)
In Exclusive Partnership with The Washigton Post