I’ve posted Entry #255 to my weekly Valuation-Informed Indexing column at the Value Walk site. It’s called How Developments Like the Greek Debt Crisis Affect Stock Prices.
Juicy Excerpt: Say that stocks are priced at two times fair value. There is only so much higher they can go. We cannot say when the market will fall, it might take a few years. But once prices hit two times fair value, we can say with a high degree of confidence that the odds favor a big price drop over a big price increase. You might see a year or two or rising prices following a time when prices hit two times fair value. But the odds are against you being able to retain those gains. The odds are strong that all of those gains are going to be lost and that the market price is going to continue falling hard at least until it has hit fair-value levels. Buying stocks when prices are at two times fair value is betting against the house; all wins are temporary.
The opposite is of course true when prices are at one-half of fair value. At that price level, even the worst economic news tends to push prices up. Why? Because all the bad news imaginable is already priced in to the market price. Things cannot get any worse in the minds of investors. So bad news bounces off investors like bullets off of Superman’s chest. Prices can only go so low. Buy stocks when prices are low and you are purchasing the proverbial sure thing. Valuation levels might remain the same for a time, in which case you still earn the average long-term average return of 6.5 percent real. Or prices might rise, in which case you do better than that. In the event that you see a price drop starting from a time when the market is selling at fair-value prices, it is highly unlikely that that price drop will remain in place for long.