Investors would be wise to quit when they're ahead

The volatility of stock prices in the past couple of weeks has made many investors nervous - but not nervous enough. Investors are continually being told they should not panic. The lucky investors will be those who panic early. So far, only a tiny bit of froth has been blown off the top of what is still a ridiculously over-inflated worldwide stock market bubble.

The volatility of stock prices in the past couple of weeks has made many investors nervous - but not nervous enough. Investors are continually being told they should not panic. The lucky investors will be those who panic early. So far, only a tiny bit of froth has been blown off the top of what is still a ridiculously over-inflated worldwide stock market bubble.

If you ask a silly question you get a silly answer. Today's silly question: "Is this the start of the bear market?" Since demand tends to bring forth supply, there are plenty of stockbrokers, financial advisers and journalists offering answers. So the old adage is true - question and answers are silly. If it were possible to answer the question, the bear market would have happened already.

We do know shares are wildly overpriced in all major markets, especially Wall Street. The US stock market is two and a half times overvalued. This represents worse value even than at the peak of August 1929.

To make US shares good value again, that stock market would need to fall by around 60 per cent. Wall Street would inevitably bring the other major markets down with it. Such a fall may seem unimaginable to many investors used to the idea that stock market investment is apparently a one-way bet.

In fact the tables here (taken from our book) show a fall of this size would be typical of the falls registered after previous market peaks, in the US and elsewhere. It is highly probable that stock prices will be lower, in real terms, in five and 10 years than they are today.

Our bad news message that all shares (not just the dot.coms) are wildly overvalued is, somewhat paradoxically, based on what is normally a good news story. For a long-run investor, staying in the stock market makes sense, most of the time. The reason is simple. When investors buy stocks, they are really buying the underlying real assets firms own.

In bad times, stock markets are compared by disgruntled investors to a casino. This is unfair. In casinos the odds are stacked against you. The good news about the stock market is that the odds are usually stacked in your favour because the real assets firms own generate real returns that ultimately reward investors. But the catch is that the odds work in your favour only as long as the prices you pay in the stock market for the assets firms own offer reasonably fair value.

There is a simple way to measure whether they do - compare the value the stock market places on these assets with what it would cost to produce them from scratch. Nobel Laureate James Tobin encapsulated this comparison in a simple ratio he christened "q".

His "q" acts like a piece of elastic. Through the forces of competition, it pulls the stock market back towards its fundamental value when it gets too high or too low. Also, like elastic, its pull is stronger the more it is stretched. In normal circumstances, this makes the stock market such a good place for long-term investors to put their money.

But these are not normal circumstances. Investors in the stock market are not usually forced to take casino-type risks; but they are when the elastic is, as at present, at full stretch. At today's prices the odds are stacked against the stock market investor, to a greater extent than at any time for at least a century.

The second chart, also taken from our book, shows that at the end of the 20th century the US stock market was more overvalued than at any previous peak in the century, including 1929.

If you have money tied up in the stock market, how should you respond to the signal that "q" is sending out? The answer is simple: sell shares, and hold safer assets, until stock markets are again fairly valued. In our book, we show that investors who respond to "q" warning signals would have earned higher returns, with lower risk, than those who stuck to stocks through thick and thin. Investors who hold on to stocks are likely to have to wait 10 or even 20 years - just to get their money back.

It is not just 1929 that illustrates this, but the recent experience of Japan. More than 10 years after its own bubble burst, the Tokyo market is still stuck at less than half the level it reached at its peak. Wall Street today is probably as overvalued as Tokyo was in 1989.

But the bubble is not all bad news. Even after the recent (and still modest) falls, investors who sold out today would still walk away having earned wonderful returns that may never be repeated.

As we said, no one can hope to know whether the bear market has started, or whether the market may rise to even crazier levels. We cannot claim that "q" can tell you precisely when to get out of the stock market.

It is not easy to convey clearly the difference between showing that a market is over-priced (which is possible) and predicting when it will fall (which is impossible).

Put this another way - if the brake pipes in your car are wearing thin, there is a high probability that at some stage your brakes will fail, and you will crash. There is no way of knowing precisely when this will happen, but if the brake warning light starts flashing, most people get out of the car, and stay out until the brakes are fixed. So "q" acts as a warning light for the stock market.

The warning light has been flashing for some time. Investors who get out now will indeed arguably be more lucky than wise, since thereally wise thing would have been to have got out long ago at lower prices.

Investors would be well advised to cash in on their run of luck soon, before the opportunity disappears. This may be very fast.

Andrew Smithers is chairman of Smithers & Co Ltd, which provides asset allocation advice to 80 of the world's largest fund management companies inLondon, New York and Tokyo. Stephen Wright teaches and researches in the economicsfaculty of Cambridge University. They wrote 'Valuing Wall Street: Protecting Wealth in Turbulent Markets' (McGraw-Hill, £19.99). Further details from www.smithers.co.uk or www.valuingwallstreet.com.