In “The Independent Musician’s Guide to Not Going Broke“, I made a strong case for what is now the conventional wisdom in finance: That putting away a good chunk of money every month into broad stock market index funds is one of the safest, surest and simplest ways to build wealth over long periods of time.

However, I also made a very important caveat: That when stocks are cheap, you’d be smart to buy more of them, and that when stocks are very expensive, you’d be smart to buy fewer of them—and purchase other things instead. I’ve been writing a lot about that lately.

Recently, I found myself in a conversation with a person who took the idea of index investing much too far: “You can’t know when stocks are expensive!” he said. “People said they were expensive when the Dow was 3,000 and at 10,000! It’s at 17,000 now. The market goes up over time. Buy now and the market could be 100,000 in 10 years!”

While this kind of statement has some grains of truth, it also reveals some tremendous flaws in thinking. It’s hard to blame this gentleman of course, as this is what the mainstream financial media tries to teach us whenever it can: “Buy, buy, buy, buy, no matter the price! No price is too high! Stocks will always go up over time!”

Naturally, the financial media of today has a vested interest in selling that kind of irrational nonsense. But the reality is that it is indeed extremely easy to tell whether stock markets are cheap or expensive, once you know what to look for. In a moment, I’ll show you clearly, and in simple detail.

First, it’s important to recognize that successful stock investing has next to nothing with the price of stocks going “up” over time. I know this sounds counter-intuitive to many, because it’s the opposite of how they were trained to think. But if you look more closely, you’ll soon realize that stocks don’t actually go “up” over time. They go pretty much sideways, in the grand scheme of things.

Let’s take a look at what I mean. First, a recent chart of S&P 500:

Sure, it looks like the stock market is going “up” over time. But it’s not, really. At least not by nearly that much.

A large part of what you’re seeing is not stocks becoming worth more but rather, dollars becoming worth less. This is a concept known as “inflation”. And once we start to adjust this chart for inflation, we start to see a very different picture:

“Inflation Adjusted” S&P 500 Index from multpl.com

This time, we’re zooming out even farther, going all the way back before 1880. Notice that, right now in 2016, stocks are actually still lower in price than they were way back in 1999 and 2000.

This means that the stock market has still not yet recovered in real terms from the great tech bubble. (Excluding the incredibly small amount of dividends you may or may not have earned when buying at those inflated prices.)

But even this chart isn’t quite good enough, because it doesn’t actually track “inflation” at all. What it tracks is “an increase in consumer prices, as measured by the U.S. administration.”

The administration of course, has something of a vested interest in making this figure appear as low as possible, so that that folks don’t get too ornery. And so, there’s a lot of black magic and questionable accounting that goes into creating the “official” figure.

Inflation, more rationally defined, simply means “an increase in the money supply.” So to get a look at what the stock market is really doing, it is best to compare it against something that is relatively more fixed in supply and usefulness than a dollar bill is.

If you were to instead track the stock market in terms of barrels of oil, or ounces of gold, or tonnes of wheat, you start to get a very different picture indeed. Here’s that very same index again, this time, priced in gold ounces:

The S&P 500, priced in ounces of gold.

Very interesting. Where has that “upward” movement gone? Is it really there at all?

But even this chart isn’t quite ideal either. I’m not certain that gold is the absolute best measuring stick for a stock price. What’s truly important to recognize is what the real value of a stock is to begin with.

When you’re buying stocks, you’re buying two things:

1) A share in the “earnings” of a real company. (How much money the company makes after expenses.)
2) A share of the “assets” it owns. (How much all of the stuff and money it owns is worth.)

That’s it. Deep down, that’s all there is to buy.

Sure, you’re also making your best guess about whether these two things are likely to increase or decrease in the foreseeable future. But ultimately, that’s about the size of it.

Simply put: The more stocks cost compared to their earnings and assets, the more “expensive” they are. And the data shows that when it comes to stock indexes, the further above the average real price that you purchase stocks at, the further below the average your real returns are likely be.

Let’s look at this in action. Here is the price of stocks once again, this time compared to their past 10 years of earnings. This is known as the “CAPE” or “Schiller” price/earnings ratio, and it is very predictive of future returns:

The price of stocks compared to an average of the price/earnings ratio over the past 10 years. The average is about 16. Just before the market started tanking this year, it had ballooned to almost 30. This can be seen as nearly 2x overpriced compared to the average.

One of the first questions to ask when you are thinking about buying stocks is “how many dollars do I have to pay for a dollar of earnings”?

The long-run average is somewhere in the neighborhood of $15 or $16 in price for $1 of earnings. Right before the market started tanking in January of 2016, that ratio had ballooned to nearly $30 for every $1 of earnings. That’s almost double the long term average. And it’s very close to where we were right before the Great Recession.

By this metric, you can confidently say that either the price of stocks (or the value of the dollar) would have to drop by about 40% to return to a more “average” valuation. But it’s worth noting that markets rarely tend to revert right back to average, and instead, almost always seem to overshoot the mark.

For some context, a “price to earnings ratio” of 15 means that it will take you 15 years to make back your initial purchase price out of current earnings.  This is an “average” long-term return expectation for stocks, once you strip out inflation. Similarly, a PE ratio of 10 means that it would take you 10 years to earn back your investment, if all continues on more or less as it is. (Granted, the results could be better in practice if the company or index in question is able to increase its earnings during that period. Or they could be worse. Or the earnings could be improved, only to be canceled out by a parallel rise in inflation.)

A PE ratio of 30 however, implies that it will take you 30 years to earn back your original investment. This implies an effective interest rate of under 3%. For all the downside risk there is in stocks, it is hard to see this as anything but a terrible deal.

We can see the same kind of thing happen when we look at the current price compared to “earnings yield“, which essentially means “how much cash the company earns for you every year, just for you owning the stock”:

S&P 500 Earnings Yield. This is the past year of earnings divided by index price.

As you may notice, this is very close to the lowest levels we tend to see.

The average here is close to 7.5%, and we’re currently around 4.5% today, which once again means that stocks would have to drop by 40% to return to average territory.

If history is any guide however, stocks don’t tend to drop back to average. They tend to drop right through it, and often straight through the floor, passing only briefly through the average, and then proceeding to find rock bottom, going into severe undervaluation for some time, before slowly climbing back up to average (and eventually beyond) over the course of many years.

This means that as likely as it is that stocks will drop by 40%, it is even more likely still that they will drop by more than 40%. How much? I don’t know—possibly 45% or 50% or 60% or 80%. It’s anybody’s guess, really. But it’s also worth recognizing that this drop could be hidden somewhat, due to another important factor: Money printing.

Naturally, people tend to get pretty upset upon realizing that their retirement accounts and home values are built on a house of cards. (I can hear some people grinding their teeth right now and trying to rationalize these numbers away.) And so, governments do what they can to try and ameliorate this effect. If the past 45 years of history serves as any guide, they will tend to do this by effectively “printing money”.

In practice, although there is a significant pressure for stock prices to drop by 40% or more and return to fairer valuations, this “drop” could just as easily be accomplished by devaluing the dollar, thereby masking the drop in real prices.

Through this method, you could easily have stock prices drop by only 20% or so and the dollar devalue by 20% or so, and that way, the people don’t get quite as angry in the short term. Or, you could even have the dollar get devalued by 40% or so over a number of years, while the price of stocks remain in place—at least nominally. This is more or less what happened during the long “silent crash” of the heavily inflationary 1970s.

While this “solution” of printing more money in order to inflate asset prices does lead people to be a bit less acutely angry in the short run, it tends to make them stew with anger in the longer run. This approach brews inequality and loss of opportunity, masked by an illusory “wealth effect”, felt almost exclusively by those at the “top” of society.

This kind of thing leads to phenomenon like “Donald Trump” and “Bernie Sanders”. In hindsight, a bit of short term pain in the form of falling asset prices may very well be preferable to the alternative of a lot of long-term pain under the rule of a divisive and authoritarian strongman of any stripe.

So in short, of course you can know when stocks are expensive. You can look at their price compared to their earnings. You can look at their price compared to their assets, also known as their “book value”.  You can look at their price compared to their dividend yield, which is how much you get paid simply for owning a stock.

It’s really not that complicated, especially when we’re talking straight index fund investing: All other things being equal, if you pay more for earnings and retained assets, then you tend get lower yields than if you pay less for them.

You can—quite easily—look at historic averages for these figures to help see where we are in the business cycle for stocks. Look at their price compared to earnings, to book value, or the price to “dividend yield”. Compare the price of stocks to other hard assets like commodities and real estate. Compare the likely return on a stock purchase to the likely return on an education. (And I mean a real education. Not the kind you tend to get in most schools.)

In the world of investing, this should be considered very basic stuff. The idea that a person can’t tell when stocks are overvalued is simply absurd. If you really believe that, it only means that you don’t yet understand how stocks are meant to be valued, and would probably be wise to learn the basics before you consider going and putting all of your money into them.

As always, I cannot give you investment advice, but I can tell you what I am doing: I do own some US stocks that were bought back when they were more fairly valued. I have sold some and kept others. I also also own some undervalued commodities, as well as some foreign stocks that still have more attractive valuations.

Over the weekend, some my thoughts on current market conditions were featured on one of the most popular business & finance podcasts on all of iTunes, The Investor’s Podcast.

If you manage your own savings and investments, I strongly recommend you check it out! It really is one of the very best. (And of course, if you don’t have any savings or investments, it’s time to get started.)

In this episode, Preston and Stig discuss George Soro’s book, The Alchemy of Finance, and then turn to questions and comments from investors.

That’s where you’ll get to hear me reiterate some of the thoughts from my most recent blog post—and hear Preston Pysh give some of his thoughts on the degree to which commodities are likely to be undervalued at the moment.

Check out the episode here. (Or skip to 14:05 if you want to hear the section where I bring up commodities in the current market, and Preston gives his analysis.)

Like me, Preston is a value-focused investor, and also moved to a heavier cash position before the recent market turmoil after taking a long hard look at the fundamentals of the US stock markets.

At the time, we both were exploring foreign value stocks, commodities and physical stores of value. Since this episode was recorded, I’ve made some significant moves in those directions, and Preston too has been preparing to make the leap.

2018 Note: As of March 2018, nothing in this analysis has changed. If anything, the issues noted below have only increased in magnitude. Logic dictates that there are still three potential long-run outcomes, which are noted below.

History shows that credit bubbles tend to pop once every 7-9 years, and it appears that the next big bubble pop may be upon us soon. This one, unfortunately, involves not just the stock market, but bonds as well.

Actually, it’s much bigger than that. There are several bubbles all occurring at once: In student loans, in consumer car loans, in stocks, in high-end art and collectibles, in private debt, and in government debt.

In real estate, housing prices still need to come down significantly compared to rents, wages and other prices to be sustainable. This is almost as true now as it was in 2006. College tuition needs to fall dramatically compared to incomes for it to make any sense as an investment. So do car prices and medical costs and stock prices—as well as bond prices relative to their yields.

All these areas have been propped up by extensive currency creation in recent years. There are good reasons that all this freshly “printed” money has not yet showed up in governments’ consumer price indexes. But it is at least clear that each of these areas is priced unsustainably high compared to median incomes, compared to yields, and compared to long-term norms.

Now that the US central bank (the Federal Reserve), has stopped conjuring up unprecedented amounts of new currency, asset prices are just beginning to fall, and quite dramatically. January 2016 saw, literally, the worst beginning to a year in stock market history.

If you think this while scenario through logically, there are really only three potential ways for this to play out in the near term:

One potential end game is that all these inflated prices will fall dramatically. A correction of nearly 50% would be necessary just to get us back to long term norms in the U.S. stock market, for instance.

But another possible outcome—and perhaps a more probable outcome—is that all these asset prices could stabilize at current levels, while the price of everything else rises up around them.

Then there’s a third possibility: A little bit of both. Let’s look at all three:

Scenario 1: The Great Deflation

I think that this is possibly the least likely scenario, so let’s start here. You could reasonably argue that this is what should happen. But chances are that the central banks around the world won’t let it happen.

If asset prices around the world start to drop really significantly, central banks around the world are likely to step in and print up more currency. The stakes for the central banks, and the governments that support them, are probably too high for them not to do this. Letting all these asset prices collapse would mean tidal waves of bankruptcies that would put 2008 to shame.

Although bankruptcies are no fun, they are part of the way markets are supposed to work. Markets are a system of profit and loss, and the “loss” part is just as important as the “profit”. Normally, seeing bad businesses go out of business is a healthy thing. But when it happens systemically and all at once, it can be quite destabilizing in the short term.

In the absence of central bank interference, a major debt deflation probably would have occurred way back in 1999 or 2008 at a smaller and safer scale, but the governments and central banks of the developed world prevented this. If they didn’t have the stomach for it then, chances are they won’t have the stomach for it now, when the stakes are even higher.

In our last two big crashes, inflated asset prices should have dropped dramatically (which they did), many more bad businesses and bad banks should have gone out of business (which they didn’t) and a whole lot of excess credit and money should likely have disappeared from banks’ balance sheets as well (which only happened a little bit.)

But instead, the Federal Reserve started flooding the financial markets with newly-created dollars in the form of Quantitative Easing. They bought the bad loans that no one wanted to buy, and this re-inflated asset prices, effectively kicking the can down the road. Now, we have stumbled upon that can once again.

What will the Federal Reserve do this time? Its new chair, Janet Yellen, has effectively gone on record saying that they will take this same can-kicking approach yet again in response to any large market downturn because—in her words—she believes the Quantitative Easing program “worked so well” the last time. This means that the Fed is likely to fire up the virtual “printing presses” and create as much money as is necessary to avoid a massively deflationary outcome.

If a “Great Deflation” actually did occur, we would have a very severe recession with a tremendous number of personal and business bankruptcies, and a default on a good portion of the US government debt as well.

That would likely result in the most short-term pain, though potentially the most long-term gain—if were were to make necessary reforms. (And that’s a very big “if”.)

It’s also the least outcome to occur in my view, because it is not in the Federal Reserve’s interest; nor is it in the interest of the bankers who own it, or politicians who select its chair.

Scenario 2: The Rollercoaster Crash

I believe this is the second most likely scenario.

There is a reasonable chance that the Federal Reserve would allow asset prices, debt levels, and money supply to fall significantly before rushing in with “helicopters dropping money” on the financial markets once again.

This would mean a tremendous drop in asset prices, but followed by an enormous increase in all prices. If history is any guide, the prices that would rise the most in this case would likely be hard assets, commodities and consumer goods (as well as foreign stock prices) as the market sought a new equilibrium.

Until now, we have been stuffing a good deal of newly-minted dollars into domestic asset prices and bailed-out banks’ balance sheets. But we have also been exporting much of our inflation, in the form of foreigners’ holdings of US dollars, thanks to our status as the world’s reserve currency.

As soon as more money printing occurs, foreign holders of dollars would become less likely to hold onto them, and would instead benefit from exchanging those rapidly-devaluing dollars for hard assets, causing them to effectively bid up prices across the board. This would significantly exacerbate increases in the cost of living for everyday Americans.

Scenario 3: The Great Stagflation

A “Great Stagflation”, similar to the 1970s, strikes me as the most likely scenario for the near-term, though it could occur in concert with some smaller degree of a crash preceding it.

I believe that the Federal Reserve will most likely jump in with additional money printing before markets drop too excessively and a massive deflation begins to set in. They could even do this in response to no crash at all. A large series of new government programs that need to be financed by debt would be enough to trigger it.

This would cause inflated asset prices to stabilize more or less where they are, while hard asset prices and foreign equity prices go through the roof in comparison.

This would result in massive declines in purchasing power for Americans, runaway increases in the cost of living, and we’d see a marked increase in consumer prices, while unemployment rises. But nominally, we’d never see a “crash” in assets.

It would basically be what happened in the 1970s on a somewhat more dramatic scale.

In this scenario, Americans’ 401(k)s and home prices would not fall to dramatically in nominal terms if they dropped at all. They would only in real, inflation-adjusted terms. That is one factor that makes this “solution” much more politically viable.

Americans who have big mortgages or a lot of student loan debt would benefit to some degree. (There are a lot of them. And they vote.) They would effectively be able to pay back their loans with essentially “cheaper” dollars.

Meanwhile, Americans with low debt who diligently save money in dollars would be hammered pretty hard. (There aren’t nearly as many of them these days, unfortunately.) This because each time a new dollar is printed, it detracts relative purchasing power from a dollar that already exists.

Because of that demographic reality, where the US now has a huge proportion of borrowers compared to savers, this will likely be seen as the most politically acceptable outcome. (At least for the near term, which is all politicians really care about.) And so, I believe this is the situation most likely to occur.

Actionable Tips

No matter what, in each of these three scenarios, the same underlying phenomenon occurs:

The real value of US stocks, bonds and bank holdings goes down. Meanwhile, commodities and other hard assets get bid up. And, in either case, the purchasing power of Americans goes down compared to those who live in developing economies throughout the world.

The silver lining is that this will likely lead to less inequality on a global level. But that silver lining is hard to see when it comes at the expense of your retirement savings.

So, if you want one actionable tip, here it is: If your savings are not yet diversified into some reasonable percentage of commodities and foreign stocks and, now is the time to do it. They are both currently dirt cheap in dollar terms.

In the case of massive deflation, their values are very unlikely to drop as much as the value of stocks and bonds, because they have already dropped so far, as deflationary expectations are essentially already “priced in”. In the somewhat more likely case of significant inflation however, those prices will once again go through the roof.

Even if their value didn’t increase in real terms, their relative value would increase compared to other assets, helping you to retain your purchasing power and storing value until more reasonably priced equity and bond investments are available in the future.

Whatever happens, there is no likely case in which the prices of commodities and hard assets would not rise relative to most other paper assets in the coming years.

Especially cheap right now are oil, silver, platinum, palladium, steel, copper, and many soft agricultural commodities.

Gold prices are already starting to ratchet up dramatically, and while they are not the cheapest buy, they are likely to rise first, most quickly and most dramatically do to the metal’s history as a hedge against paper currencies.

There are also great deals in foreign equity markets, when compared to the US stock market. Some of these deals may get better still as the Federal Reserve continues to “play chicken” with interest rates and suggest that it may continue its current tightening cycle.

(Incidentally, many investors still do not recognize that the current tightening cycle actually began way back in 2013 with the “tapering” of QE programs, so we’re actually quite very far into it.)

But as soon as the Fed flinches, which it most likely will, these prices will likely skyrocket. Historically, stocks tend to rise slowly and fall rapidly, while commodities tend to do the exact opposite.

If the Fed actually does continue tightening, these already-depressed values are likely to go down less compared to others, as they have already fallen very significantly on deflationary expectations.

So be forewarned. That’s what’s coming in the relatively near term. Those your likely scenarios. If anyone wants to discuss what happens in the longer term, that’s quite interesting as well.

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2018 Update: Not much has changed since this was written, except for one thing: As U.S. asset prices become even more wildly irrational, some people have  become even more excited to buy them.

This should not be surprising. It happens again and again throughout history. Market crashes tend to begin on optimism, when the last once-skeptical buyer has gone all-in, and there are no more new irrational buyers left to keep prices unsustainably high.

Those who are blindly buying US stocks today—at even higher valuations when this was written—are doing so under the rationale that tax breaks or deregulation or new government spending may justify such high prices sometime in the future. But this is foolish.

Without their realizing it, people who make this wager this are effectively betting on outcome #3. They are wagering their life savings on a “silent crash”. They are betting on losing their capital to inflation, rather than to a crash.

While this might be wise if nominal returns were all that mattered, in the real world, it is inflation-adjusted purchasing power that matters, not nominal returns. Purchasing power is the true measure of your investments’ performance. And you can’t measure it in dollars over any reasonably long period, because the total quantity of dollars keeps growing.

If the current, excessively-high US stock valuations do end up being justified by future growth in earnings, all that will mean is that inflation will have accrued to such a degree that the purchasing power of your stocks holdings will have decreased. Don’t make the mistake of confusing nominal gains for real ones.

Justin Colletti in an educator, and engineer, and an econ nerd.

PS: Obviously, you should talk to your financial advisor before making any major changes to your portfolio.

I can’t give specific financial advice, but I can tell you what I have done and am doing. And that’s to diversify a reasonable portion of my savings into more modestly-priced foreign equity markets, commodities and physical assets.

Your needs may be different, and remember that there is no one-size-fits-all advice. Investing—even wisely—always carries some risk.