In an accelerating world, I find it necessary to always be learning if I hope to survive. With markets exhibiting notable volatility, I would urge all enterprising investors to focus on two important questions that may lead to greater understanding.

Will the Future Look Like the Past?

In his always insightful column in The Wall StreetJournal, Jason Zweig interviewed Robert Shiller, a Nobel laureate in economics and the developer of the cyclically adjusted price/earnings ratio (CAPE). In the interview, there is a particular bit of wisdom for all of us who are condemned one way or another with the task of predicting the future. Shiller said that while the current CAPE level “might be high relative to history . . . how do we know that history hasn’t changed?” The real wisdom is in asking that question. Hopefully, I’ll be able to provide some comparable wisdom of my own in this post. There are at least two reasons to question the validity of the CAPE.

The first reason is that we live in a very dynamically changing financial world. Many trends are old: This is not the first time that governments and their central bank servants have been manipulating interest rates or money. Even in ancient times, monarchs reduced the amount of gold and silver in coinage. But some trends are also very new. The trading markets have changed considerably due to the use of capital restrictions, fragmentation of markets, increased use of lightly capitalized derivatives, and the communication of investment methods.

The second reason to question the utility of CAPE or any price/earnings ratio measure comes from my experiences at the race track. Bettors who put enough of their money on a particular horse to make the horse the favorite often focus on one statistic, almost to the exclusion of any others (Favorites typically win only about one-third of the time). With this background, you can sense my apprehension upon entering the analytical business where there is a need to briefly sum up the reasoning behind an investment decision. Often it boils down to communicating with a shorthand term or a simple label with the caveat that people must still fully understand the limitations of the investment, the intricacies of its construction, and the history of its misapplication.

Since almost every argument to do something in the stock market relies on a P/E ratio, I am increasingly suspicious of its utility. I prefer to understand operational revenue and pre-tax, “pre-other” income growth. In addition, I look at net cash generation after debt service as a comparative measure before focusing on an evaluation of management’s ability to handle future opportunities and problems. Furthermore, because of changes in accounting reporting policies, in many cases earnings a few years back might look very different from today’s version. The calculators of CAPE use reported data for the S&P 500 companies, which is just not good enough for me in the fight for investment survival.

What Are Markets Telling Us?

While I am very sympathetic to Shiller’s concern that history is not an absolute guide to the future, I do pay attention to technical market analysis. I have received separate, thoughtful warnings from analysts based in Chicago, New Jersey, and London, each using individual tools and data, that we are heading into the late stages of a long bull market. They seem to agree that it is likely that the current “correction” will be followed by a rapid rise led by the late-stage large-cap stocks. Nevertheless, one analyst has highlighted the following important levels to watch in the S&P 500 if selling accelerates:

• 200-day moving average: 1905. Breaking down from this level could bring more selling.
• Down 10% from recent top: 1810
• Down 20% from top, similar to 2011 or a cyclical decline: 1610
• Down 33%, as during the 1987 crash: 1350

As frightening as these numbers are, they do not include a once-in-a-generation decline of 50%, which could take us below 1000. Compare this to today’s level of 1906.13. The nice thing about market analysis is that you do not have to know what causes people to sell, just that they are selling in increasing volume and there is not a lot of incentive to buy. All three analyst sources have noted the deterioration of numerous global markets. For example, the German DAX is down 12.4% already. These market participants sense future problems that the various major governments and their central banks are not addressing. Perhaps the markets are suggesting that the emperor is marching naked.

Current moods of businesspeople and investors are much more cautious than national statistics would indicate. An example may be helpful: Large-cap growth stocks were up 2.21% in the quarter. But the much more economically sensitive small-cap value stocks dropped 6.39%.

In order to survive, I have been paying attention to the market analysts and have adjusted most portfolios that have a five-year or shorter time horizon to be more cautious. But each of these bright market analysts sees that we are setting up, in the long run, a major expansion of stock prices and somewhat higher interest rates. I agree with their assessment, but this expansion could be delayed by the political forces utilizing inaccurate data and trying to create a recovery instead of recognizing that they are a main cause of the current malaise. We may need new global leadership.

Last week I suggested that some of the money planning to leave PIMCO should consider reducing its allocation to bonds, and investors might have been listening: The flows this week into money market funds were unusually high. I would hope that, as equity ratios decline because of falling prices and other disappointments, new capital can be prudently introduced into expanded equity holdings. Do you have plans to increase your investments in stocks?